ZIMSEC O Level 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.