Accounting (0452) | Manufacturing accounts

Welcome to Manufacturing Accounts!

Hello! This chapter is where accounting meets the factory floor. So far, you have mainly dealt with trading businesses (buying goods and selling them). But what if a business actually makes the goods it sells?

This is where Manufacturing Accounts come in. They help us figure out the true cost of producing the items before we even think about selling them.

Why is this important? If a business doesn't know how much it costs to make a product, it can't set a smart selling price or control its waste!

Section 1: The Difference Between Trading and Manufacturing

What is a Manufacturing Business?

A manufacturing business takes raw materials and converts them into finished goods, which are then sold.

Example: A baker buys flour and sugar (raw materials) and turns them into bread (finished goods).

The Accounting Challenge

In a simple trading business (like a retailer), calculating the Cost of Goods Sold is easy:

\( \text{Opening Inventory of Goods} + \text{Purchases} - \text{Closing Inventory of Goods} \)

In a manufacturing business, 'Purchases' is replaced by the Cost of Production (the cost to make the goods).

Section 2: Cost Classification – Direct vs. Indirect Costs

Before we can calculate the cost of production, we must clearly sort all factory expenses into two main groups: Direct Costs and Indirect Costs.

1. Direct Costs

Direct costs are expenses that can be clearly and easily traced to the specific product being made. They are essential ingredients.

• Direct Material: The raw materials that form a physical part of the finished product.
  Example: Timber for a table, cotton fabric for a shirt.
• Direct Labour: The wages paid to employees who physically work on the product, changing its form.
  Example: Wages paid to the assembly line worker, or the carpenter building the table.

2. Indirect Costs (Factory Overheads)

Indirect costs, often called Factory Overheads (or Manufacturing Overheads), are expenses incurred in the factory that cannot be easily traced to a specific unit of production. They are necessary to keep the factory running.

• Indirect Material: Materials used up that are not a major part of the product.
  Example: Lubricating oil for machines, cleaning supplies, or glue used in tiny amounts.
• Indirect Labour: Wages paid to staff who support the production process but do not physically make the product.
  Example: Wages of the factory supervisor, maintenance staff, or security guard.
• Other Indirect Expenses: Costs like factory rent, factory insurance, and depreciation of factory machinery.

Section 3: Calculating Prime Cost and Cost of Production

1. Prime Cost

The first major calculation is the Prime Cost. This is the total of all the main, direct costs.

\( \text{Prime Cost} = \text{Direct Materials} + \text{Direct Labour} \)

Memory Aid: "Prime" means essential or fundamental. These are the fundamental costs of the product.

Step-by-Step: Calculating Direct Materials Consumed

We rarely use all the raw material we buy in the year. Therefore, we must calculate the cost of raw materials actually used (consumed) in production.

This calculation looks very much like the Trading Account calculation, but uses only raw materials:

1. Opening Inventory of Raw Materials
2. ADD: Purchases of Raw Materials (and carriage inwards on raw materials)
3. LESS: Closing Inventory of Raw Materials
4. EQUALS: Cost of Raw Materials Consumed

2. Factory Overheads

These are the indirect costs you identified in Section 2. Remember to include all necessary adjustments (from syllabus section 5.1):

• Depreciation of factory machinery or equipment.
• Accruals (expenses owed) for factory costs.
• Prepayments (expenses paid in advance) for factory costs.

Section 4: The Work in Progress (WIP) Adjustment

What is Work in Progress?

Work in Progress (WIP) refers to partially completed units that are still in the factory at the end of the accounting period. They are past the raw material stage but haven't yet become finished goods.

Example: A chair that has been cut and assembled, but still needs to be varnished and polished. The costs (material and labour) are already sunk into it, but it cannot be sold yet.

Adjusting for WIP

We only want to calculate the cost of goods that were completed this year.

The cost of WIP needs to be adjusted in the Manufacturing Account:

• Opening WIP: The partially finished goods we started with at the beginning of the year. We must ADD this cost because we finished them this year.
• Closing WIP: The partially finished goods remaining at the end of the year. We must SUBTRACT this cost because we didn't finish them this year.

Section 5: Preparing the Manufacturing Account

The Manufacturing Account is an internal statement designed solely to calculate the Cost of Production.

It is usually presented in a vertical format.

Structure of the Manufacturing Account (The Formula Flow)

Manufacturing Account for the year ended...

1. Direct Materials

Opening Inventory of Raw Materials ................. X
Add: Purchases of Raw Materials ................... X
Less: Closing Inventory of Raw Materials ...............(X)
Cost of Raw Materials Consumed ........................ X

2. Prime Cost Calculation

Add: Direct Labour/Wages .......................... X
Add: Direct Expenses (if any) ...................... X
Prime Cost ........................................ XX

3. Factory Overheads

Add: Factory Overheads:
  Indirect Wages ................................ X
  Indirect Materials ............................ X
  Factory Rent and Rates (allocated part) .......... X
  Depreciation of Factory Machinery ............... X
  Total Overheads ................................. X
Total Manufacturing Cost Incurred (before WIP) ........ XXX

4. Work in Progress Adjustment

Add: Opening Work in Progress .................... X
Less: Closing Work in Progress .................... (X)
Cost of Production (Transfer to Income Statement) ... XXXX

Section 6: Integrating with the Final Accounts

Once the Manufacturing Account is complete, the financial statements follow the usual IGCSE format, but with specific changes related to inventory.

1. The Income Statement (Trading Section)

The Trading Account section calculates the Gross Profit. Instead of "Purchases," we use the "Cost of Production."

Inventory of Finished Goods

We now deal with Finished Goods Inventory (the goods that came out of the factory).

Trading Section of the Income Statement
Revenue ...................................... XXXX
Less: Cost of Sales:
  Opening Inventory of Finished Goods ........... X
  Add: Cost of Production (from Manufacturing A/C) .. XXXX
  Less: Closing Inventory of Finished Goods ........ (X)
Cost of Goods Sold ............................. (XXXX)
Gross Profit ................................. XXX

Did you know? Sales of raw materials (if any) or sale of factory scrap are usually treated as reductions in the Cost of Production within the Manufacturing Account, or sometimes as other revenue in the Income Statement.

2. The Statement of Financial Position (SFP)

The SFP will show the business's inventory levels, now split into three distinct categories under Current Assets:

• Raw Materials Inventory: The unused basic ingredients. (The closing inventory figure from the Manufacturing Account).
• Work in Progress (WIP) Inventory: Partially completed goods. (The closing WIP figure from the Manufacturing Account).
• Finished Goods Inventory: Completed products ready for sale. (The closing inventory figure from the Income Statement).

All three are valued at the lower of cost and net realisable value, just like normal inventory.

Section 7: Specific Adjustments in Manufacturing Accounts (Recap of 5.1)

Don't forget the general year-end adjustments you learned earlier! They must still be applied, but you have to be careful about where the expense is recorded.

A Common Mistake to Avoid: Allocation of Expenses

Many expenses relate to both the factory (production) and the office (administration/selling). You must allocate them correctly:

1. Depreciation: Factory machinery depreciation goes into the Manufacturing Account (as an Indirect Cost/Overhead). Office equipment depreciation goes into the Income Statement (as an Administration Expense).
2. Rent/Rates/Insurance: If the factory occupies 80% of the building and the office 20%, then 80% of the rent goes to the Manufacturing Account, and 20% goes to the Income Statement.
3. Wages: Direct wages go to Prime Cost. Factory supervisor wages go to Factory Overheads. Sales staff salaries go to Selling and Distribution Expenses in the Income Statement.