Manufacturing Accounts
A business that makes its goods cannot use ‘purchases’ in its trading account: it needs the cost of the goods it produced. The manufacturing account calculates that cost — direct costs (prime cost) plus the indirect factory costs (overheads), adjusted for work-in-progress — and the result replaces purchases in the trading account. Costs of the offices and of selling and distribution never go into the manufacturing account; they are expenses in the statement of profit or loss.
1 Introduction
You will know from earlier chapters that the gross profit is calculated in the trading account as the sales less the cost of goods sold. If the business is simply buying and selling goods, then the cost of goods sold is the purchases as adjusted by the opening and closing inventories. However, if the business is manufacturing goods itself then a little more work is needed in order to calculate the cost of actually making the goods, and the calculation statement is known as a manufacturing account.
The lecture works Example 1 as far as gross profit. The answer in section 5 goes one step further, deducting the offices’ share of electricity and maintenance to reach the profit for the year that the question asks for.
2 Production costs
If a business actually makes the goods that they sell, we need to calculate the cost of producing the goods and use this instead of ‘purchases’ in the trading account.
There are two types of production costs:
Type | Meaning | Examples |
Direct costs | Costs directly associated with, and measurable for, each unit produced — they are directly related to the level of production. The total of the direct costs is known as the prime cost. | Direct materials and direct labour; there may be others (direct expenses) such as packaging and royalties paid per unit |
Indirect costs | All other costs concerned with production, i.e. other costs in the factory. Indirect costs are also known as overheads (production overheads). | Rent of the factory, lighting and heating in the factory, indirect labour (e.g. supervisors’ salaries), depreciation of factory plant and equipment |
Only factory costs are production costs. Depreciation of non-current assets that are not used in the factory, such as computers in the accounts department, is not; nor are delivery costs or salespeople’s salaries. The table shows where common costs belong:
Cost | Where it goes |
Raw materials used; direct wages; royalties or packaging per unit | Manufacturing account — direct costs (prime cost) |
Factory rent, heat and light; factory supervisors’ salaries; depreciation of factory machinery; factory maintenance | Manufacturing account — indirect costs (production overheads) |
Office rent and electricity; accounts staff salaries; depreciation of office equipment | Statement of profit or loss — administrative expenses |
Salespeople’s salaries; advertising; depreciation of delivery vehicles | Statement of profit or loss — distribution costs |
Where a cost such as electricity is shared between the factory and the offices, the question tells you how to split it. You are not required to calculate overheads or inventory balances yourself; you place the figures you are given.
3 Inventories
A manufacturing company is likely to have three types of inventories.
Inventory | What it is | How it is used |
Raw materials | Materials bought for production but not yet used (e.g. wood, if the business makes desks). | Raw materials used = opening inventory of raw materials + purchases of raw materials − closing inventory of raw materials. This goes into the manufacturing account. |
Work-in-progress | Goods that we are producing but are not yet finished at the end of the period (they will be finished next period and will then be finished goods). | The total production costs include the work done on unfinished goods, but we want the cost of the goods that were finished: opening work-in-progress + total production costs − closing work-in-progress. This is done in the manufacturing account. |
Finished goods | Goods that have been completely produced and are ready for sale. | Cost of sales = opening inventory of finished goods + cost of production − closing inventory of finished goods. This is done in the trading account. |
All three closing inventories are current assets in the statement of financial position.
4 Pro-forma Manufacturing Account
$ | $ | |
Opening inventory of work-in-progress | X | |
Direct costs: | ||
Opening inventory of direct materials | X | |
Purchases of direct materials | X | |
Less: Closing inventory of direct materials | (X) | |
Direct materials used | X | |
Direct labour | X | |
Other direct costs | X | |
Prime cost | X | |
Indirect costs: | ||
Indirect labour | X | |
Depreciation of factory plant and equipment | X | |
Factory rent | X | |
Factory heating and lighting | X | |
Other indirect factory costs | X | |
Total indirect costs (production overheads) | X | |
X | ||
Less: Closing inventory of work-in-progress | (X) | |
Cost of production of finished goods (to be transferred to the Trading Account) | X |
Prime cost plus the production overheads is the total production cost of the period (sometimes called the factory cost incurred). The cost of production of finished goods is also called the cost of goods manufactured. Some layouts make the work-in-progress adjustment after the factory cost instead of starting with the opening work-in-progress; the result is the same.
The trading account then uses the cost of production in place of purchases:
$ | $ | |
Sales | X | |
Opening inventory of finished goods | X | |
Cost of production of finished goods | X | |
Less: Closing inventory of finished goods | (X) | |
Cost of sales | (X) | |
Gross profit | X |
5 Worked example
The following balances have been extracted from the books of Jimmy Ltd as at 30 June 2016:
$ | |
Inventories at 1 July 2015: | |
Raw materials | 15,600 |
Work-in-progress | 18,960 |
Finished goods | 44,200 |
Factory wages: | |
Direct | 343,200 |
Indirect | 131,000 |
Electricity | 31,200 |
General factory expenses | 64,800 |
Maintenance expenses | 42,100 |
Purchases of raw materials | 298,000 |
Sales | 1,356,000 |
Depreciation of plant and machinery | 21,600 |
Additional information:
At 30 June 2016, inventories were as follows: raw materials $11,900; work-in-progress $16,680; finished goods $51,600.
Electricity and maintenance expenses are to be split 80% to the factory and 20% to the company’s offices.
At 30 June 2016, an electricity bill of $1,920 remained unpaid, and maintenance costs paid in advance amounted to $1,820.
Produce a Manufacturing Account, and a Statement of Profit or Loss for the year ended 30 June 2016.
Show answerHide answer
Lahore Furniture Ltd, owned by Nadia Hussain, makes office desks. Its records for the year ended 31 March 2020 show:
$ | |
Inventory of raw materials: 1 April 2019 | 6,000 |
Inventory of raw materials: 31 March 2020 | 7,500 |
Work-in-progress: 1 April 2019 | 3,200 |
Work-in-progress: 31 March 2020 | 4,100 |
Purchases of raw materials | 48,000 |
Direct wages | 36,000 |
Royalties paid per desk made | 1,500 |
Factory supervisor’s salary | 9,000 |
Factory rent | 12,000 |
Depreciation of factory machinery | 4,000 |
Depreciation of delivery vans | 2,500 |
Office salaries | 14,000 |
Required:
Calculate the prime cost.
Calculate the cost of production of finished goods.
State which of the costs above do not belong in the manufacturing account, and where they are shown instead.
Show answerHide answer
6 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Manufacturing Accounts
12 questionsAnswer the questions one at a time. Your progress is saved so you can leave and come back.
Open chapter practice