👋 Welcome to Manufacturing Accounts!
Welcome to one of the most exciting and practical chapters in Advanced Accounting! So far, you've mostly dealt with Trading Businesses (who buy and sell finished goods, like a shop). But what about companies that make things? That's where Manufacturing Accounts come in.
In this chapter, we learn how to calculate the true cost of production, which is essential for setting prices and managing efficiency. Don't worry if this seems tricky at first—we'll break down the factory process step-by-step, just like building a product!
Section 1: The Basics of Manufacturing Costing
1.1 Distinguishing Manufacturing Costs
A manufacturer takes Raw Materials and, using Labour and Machinery, turns them into Finished Goods. To account for this, we must categorize all costs related to this transformation.
Key Cost Categories (The Ingredients)
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Direct Costs: Costs that can be directly and easily traced to the specific product being made. Think of the main ingredients.
- Direct Materials (DM): The raw stuff that ends up in the product (e.g., flour for bread, metal for a car chassis).
- Direct Labour (DL): Wages paid to employees who physically work on the product (e.g., the assembly line worker, the baker).
- Direct Expenses (DE): Rare expenses incurred specifically for a product (e.g., royalties paid per unit produced).
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Indirect Costs (Overheads): Costs necessary for the factory to run, but which cannot be easily traced to a single unit. These are the supporting costs.
- Factory Overheads: All indirect costs incurred inside the factory (e.g., factory rent, machine depreciation, supervisor salaries, heating/lighting for the production floor).
The term Prime Cost literally means the "primary" or most important costs in production. It's the total of all direct costs.
$$ \text{Prime Cost} = \text{Direct Materials} + \text{Direct Labour} + \text{Direct Expenses} $$1.2 Managing the Three Types of Inventory
A crucial difference for a manufacturer is that they hold three types of stock, not just one:
- Raw Materials (RM): Stock that hasn't been used yet (e.g., a pile of cotton before weaving).
- Work-in-Progress (WIP): Goods that are currently being made but are incomplete at the end of the financial period (e.g., a half-built computer chassis).
- Finished Goods (FG): Products that are complete and ready for sale (e.g., the packaged computer).
The Raw Materials and WIP inventories are used only within the Manufacturing Account. Finished Goods inventory is used only in the Income Statement.
Students often confuse factory overheads (like factory rent) with administration or selling overheads (like office rent). Only costs directly related to the production process go into the Manufacturing Account. Selling and Admin costs go straight into the Income Statement.
Section 2: The Manufacturing Account
The Manufacturing Account is a specialized statement designed to calculate the total cost of goods produced during the period. Its final figure, the Factory Cost of Finished Goods, is then transferred to the Income Statement.
2.1 Step-by-Step Layout of the Manufacturing Account
Step 1: Calculating Raw Materials Consumed
We start by figuring out how much raw material was physically used up in production:
Opening Inventory of Raw Materials
Add: Purchases of Raw Materials (Net of Returns)
Less: Closing Inventory of Raw Materials
= Cost of Raw Materials Consumed
Step 2: Calculating Prime Cost
We combine all the direct costs:
Cost of Raw Materials Consumed
Add: Direct Labour
Add: Direct Expenses
= Prime Cost
Step 3: Calculating Total Production Cost (Adding Overheads)
We add all the indirect factory costs to the Prime Cost:
Prime Cost
Add: Factory Overhead Costs (Rent, Depreciation of Machinery, Indirect Labour, etc.)
= Total Manufacturing Cost (before WIP)
Step 4: Adjusting for Work-in-Progress (WIP)
Since we only want the cost of goods that were completed in the period, we must adjust for items that were started but not finished (WIP).
Total Manufacturing Cost (Step 3)
Add: Opening Work-in-Progress Inventory
Less: Closing Work-in-Progress Inventory
= Factory Cost of Finished Goods
This final figure, the Factory Cost of Finished Goods, represents the cost to the company of making all the products that are now ready to be sold. It is transferred to the Income Statement.
RM Consumed + DL + DE = Prime Cost
Prime Cost + Overheads = Total Production Cost
Total Production Cost + Open WIP – Close WIP = Factory Cost of Finished Goods
Section 3: Internal Transfer Profit (Profit on Manufacture)
In some manufacturing businesses, the factory division is treated as a separate cost center from the sales division. To assess the efficiency of the factory, management might decide that the finished goods are transferred to the sales division not at cost, but at a price that includes an internal markup, known as a Profit on Manufacture.
3.1 Recording the Profit on Manufacture
If the factory adds a percentage markup (e.g., 10%) to its cost, this must be reflected in the final statements.
- In the Manufacturing Account: The account will show the Total Cost of Finished Goods, and then a line item is added for the Profit on Manufacture. $$ \text{Transfer Price} = \text{Factory Cost} \times (1 + \text{Markup Rate}) $$ The total transfer price is then used as the figure transferred to the Income Statement, usually labelled as Transfer to Income Statement at Transfer Price.
- In the Income Statement: The Profit on Manufacture is shown as an additional income item *before* calculating gross profit, as it is a profit generated by the internal operation.
3.2 The Provision for Unrealised Profit (PURP) - Crucial A-Level Concept
This is often the hardest part of the chapter, so pay close attention!
If the factory transfers goods to the sales division at a price including profit, and those goods haven't been sold externally by the end of the year, that profit is unrealised (it hasn't been earned yet from an outside customer).
Why is PURP Necessary? (The Prudence Concept)
The Prudence Concept requires assets (like closing finished goods inventory) not to be overstated. If we hold finished goods inventory that includes an internal markup, we are overstating its value in the Statement of Financial Position (SFP) and overstating the current period's profit. We must remove this internal profit from the closing inventory value.
Calculation and Double Entry for PURP
The provision is calculated only on the Closing Inventory of Finished Goods.
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Calculate the required Provision:
$$
\text{Required PURP} = \text{Closing Finished Goods Value (at Transfer Price)} \times \frac{\text{Markup \%}}{100 + \text{Markup \%}}
$$
Example: If the markup is 25% on cost, the fraction is 25/125.
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Calculate the Change in Provision: We compare the required PURP for the *current* year's closing stock with the PURP held for the *previous* year's opening stock.
$$ \text{Change in PURP} = \text{Closing PURP} - \text{Opening PURP} $$ -
Effect on Income Statement:
- If the Provision increases (Closing PURP > Opening PURP): This increase is treated as an expense and deducted from Gross Profit.
- If the Provision decreases (Closing PURP < Opening PURP): This decrease is treated as income and added to Gross Profit.
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Effect on SFP: The Closing PURP is deducted from the value of the Closing Finished Goods to show them at their true cost.
Current Assets:
Finished Goods Inventory (at Transfer Price) XXX
Less: Provision for Unrealised Profit (XXX)
Finished Goods Inventory (at Cost) XXX
Did you know? Transfer pricing (charging a markup internally) is a management accounting tool to motivate factory managers and ensure they control costs, as their "profitability" can be tracked.
Section 4: The Final Financial Statements of a Manufacturer
4.1 The Income Statement
The Income Statement for a manufacturer looks very similar to a trading business, but the calculation of Cost of Sales is significantly different because it relies on the output of the Manufacturing Account.
Key Differences in the Income Statement Structure
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Gross Profit Calculation:
Sales Revenue
Less: Cost of Sales:
Opening Inventory of Finished Goods (at cost)
Add: Factory Cost of Finished Goods (or Transfer Price from MA)
Less: Closing Inventory of Finished Goods (at cost)
= Cost of Sales (at cost)
= Gross Profit (based on true cost)
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Adjusting for PURP and Other Expenses:
Gross Profit (based on true cost)
Add/Less: Change in Provision for Unrealised Profit (PURP adjustment)
Add: Profit on Manufacture (if using transfer pricing)
= Adjusted Gross Profit
Less: Selling and Distribution Expenses
Less: Administrative Expenses
= Profit for the Year
Remember: Factory Overheads are already dealt with in the Manufacturing Account and must NOT be listed again as an expense in the Income Statement. Only non-production overheads are included here.
4.2 The Statement of Financial Position (SFP)
The SFP is largely the same, but the Current Assets section must reflect the existence of the three types of inventory and the necessary PURP adjustment.
Extract of Current Assets Section:
Current Assets
Inventory:
Raw Materials XXX
Work-in-Progress XXX
Finished Goods (at Transfer Price) XXX
Less: Provision for Unrealised Profit (PURP) (XXX)
Total Inventory XXXX
Trade Receivables, Bank, etc. XXX
The Manufacturing Account calculates what it costs to make the goods, feeding this figure into the Income Statement, which calculates what profit was made when selling the goods. The SFP simply reports the value of the three categories of stock remaining unsold.