Principles of Accounting: 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 Principles of Accounts Notes.