Cambridge IGCSE Accounting(0452)/O Level Principles of Accounts(7110) Notes: Introduction to Manufacturing Accounts
- Thus far we have taken it for granted that businesses purchase everything they sell
- While it is true that a lot of business purchase inventory and sell it at a profit
- There are some businesses that manufacture products
- These manufacturing businesses typically:
- Acquire Raw materials
- Process this raw materials using various processes and
- Ultimately transform these raw materials into finished goods of sorts
- These finished goods are then sold by the business usually at a profit
- For such businesses a Manufacturing Account has to be prepared in addition to the Trading and Profit and Loss Account (Income Statement)
- A manufacturing account is prepared internally in order to establish the production cost of goods
- The production cost of goods is the sum of all the costs incurred in bringing the goods into their saleable condition
- It is made up of:
- The cost of raw materials used
- The Direct Costs,
- Direct Labour Costs as well as
- All the indirect costs
- This production cost is used instead of purchases in order to establish the cost of sales
Direct costs
- A cost that can be traced directly into the product or are easily identified with the product
- Examples include:
- The cost of raw materials used for example water,flour,sugar,salt and milk in manufacturing (baking) of bread
- Direct Labour costs such as those of the actual bakers that are making the bread
- Other direct costs such as royalties and patents paid out to designers of the products
- Royalties-is compensation, consideration, or fee paid for a license or privilege to use an intellectual property (brand, copyright, patent, process) or a natural resource
- For example a local company might start making Lenovo laptops, they will have to pay the Lenovo company royalties on each laptop made
- Royalties are paid to the patent holder
- Patents are granted to individuals or businesses that come up with inventions
- They are a form of licence that grants exclusive rights to use that idea to the patent holder only
- Anyone else that wants to use the idea has to pay royalties to the patent holder
- Patents are especially popular in technology for example the touch screen in modern smart phones is patented
- The total of direct costs in a given period is known as Prime Cost
- It is important to note that Direct costs by their very nature vary directly in proportion to the level of production
- What this means is that Direct costs increase if the level of production (number of units made increases) and decrease if the number of units made decreases
Indirect Costs/ Factory Overheads
- This comprises all the other costs that are part of the manufacturing process but cannot be directly traced to each unit of production
- These include examples such as:
- Property Plant and Equipment rentals
- The cost of lubricants used on machines
- Lighting and Heating costs
- Salaries and Wages for supervisors
- Depreciation of machinery etc
- Overheads do not really vary with the level of production
Carriage Inwards
- Raw materials usually have to be ferried to the manufacturing business
- The cost of transporting raw materials is known as carriage inwards
- Carriage Inwards must be added to the purchase cost of raw materials
- Also any returns must be deducted from the raw materials figure
Work in progress
- It is not unusual for there to be goods that have not yet been completely processed at the end of the period
- This is especially true if the business makes large items for example builds and sells ships or even small items like furniture
- The opening inventory of Work In Progress is added to the total cost of production for the period
- The closing inventory of Work In Progress is deducted from the production cost
Administration and Selling and Distribution Expenses
- Normally every manufacturing business has an administrative arm
- In such instances it is important to note that only manufacturing expenses are to be included in the manufacturing account
- Administration and Selling and Distribution Expenses are to be put in the Trading and Profit and Loss Account (Income Statement)
- Examples include:
- Depreciation of office equipment
- Rent for office buildings
- Advertising expenses
- Carriage outwards
- Salaries of Administration staff
Apportionment of costs
- Often there are costs that cover both manufacturing and administrative aspects of a manufacturing business
- For example:
- A business whose electrical supply measures power used by the entire business
- A van that is used to transport both raw materials and finished goods to customers
- In such instances costs must be apportioned using an appropriate basis
- Usually in the exam you are given the basis to use
Manufacturing profit/loss
- Most businesses manufacture goods with the hope that they can do it cheaply than they would otherwise have to pay by purchasing the products
- The difference between the production cost and expected purchase price of the goods
- Is known as Manufacturing profit if the expected purchase price of the goods exceed their production costs
- The opposite is known as manufacturing loss
- In cases where there is such a profit it means at least part of Gross Profit is attributable to the fact that we chose to manufacture products instead of purchasing inventory for resale
- In such instances the business may opt to use the market value (expected purchase price) of the goods instead of the cost of production in the calculation of Cost of Sales
- Once the Gross Profit (Loss) is calculated the gross profit (loss) on manufacturing is added/(subtracted back) to the gross profit
- The Net Profit is not affected
- One thing to note in this case is to make sure that only the profit for the period is added back into gross profit
To see the actual structure of a manufacturing account please click here
To see a worked example of a manufacturing account click here
To access more topics go to the Cambridge IGCSE Accounting(0452)/O Level Principles of Accounts(7110) Notes.