Introduction to Manufacturing Accounts
Welcome to the world of manufacturing! So far, you have likely studied retail businesses—companies that buy finished products and sell them at a higher price. But what happens if a business makes the products themselves? This is where Manufacturing Accounts come in.
The main goal of a Manufacturing Account is to calculate the Production Cost of the goods completed during a specific period. This figure is then transferred to the Statement of Profit or Loss to help calculate the Cost of Sales. Don't worry if this seems like a lot of steps; we will break it down into four simple "building blocks."
1. The First Building Block: Prime Cost
The Prime Cost represents the total of all direct costs. These are costs that can be traced specifically and easily to a single unit of production. If you are making a wooden table, the wood is a direct cost because you know exactly how much wood went into that table.
The formula for Prime Cost is:
\(Direct Materials + Direct Labour + Direct Expenses = Prime Cost\)
Direct Materials
This is the cost of the raw materials used. To find the cost of materials actually used in production, we use this standard calculation:
Opening inventory of raw materials
+ Purchases of raw materials (including carriage inwards on materials)
- Closing inventory of raw materials
= \(Cost of raw materials consumed\)
Direct Labour and Direct Expenses
Direct Labour (often called manufacturing wages) is the pay given to workers physically making the goods. Direct Expenses are other costs directly linked to production, such as royalties paid to a designer for every item produced.
Key Takeaway: Prime Cost is the "bare bones" cost of production before any factory rent or bills are added.
2. The Second Building Block: Factory Overheads
Factory Overheads (also known as indirect costs) are expenses that are necessary to run the factory but cannot be easily traced to one specific item. Imagine the lightbulbs in a massive car factory—they are necessary, but you can't say exactly how much "lightbulb cost" is in one specific car!
Examples of Factory Overheads include:
• Factory rent and rates
• Indirect wages (e.g., factory supervisors or cleaners)
• Depreciation of factory machinery
• Factory heat, light, and power
Allocation and Apportionment
Sometimes, a business has one building that contains both a factory and an office. In these cases, we must split the costs. Allocation is used when a cost belongs entirely to one section. Apportionment is used when we split a cost between the factory and the office based on a fair ratio, such as floor area or the number of employees.
Example: If the total rent is \( \$10,000 \) and the factory takes up \( 80\% \) of the space, we apportion \( \$8,000 \) to the Manufacturing Account and \( \$2,000 \) to the Statement of Profit or Loss as an operating expense.3. The Third Building Block: Work in Progress (WIP)
At the end of an accounting period, there are almost always items that are half-finished. These are called Work in Progress (WIP). We need to adjust our costs to account for these.
• Opening WIP: These are goods started last year and finished this year. We add their value to our costs.
• Closing WIP: These are goods started this year but not yet finished. We subtract their value because they aren't part of this year's completed production cost.
Quick Summary Formula:
\(Prime Cost + Factory Overheads + Opening WIP - Closing WIP = Production Cost\)
4. Factory Profit and Unrealised Profit
Some businesses like to charge their "Sales Department" a higher price than what it actually cost to make the goods. This is called a Manufacturing Profit or "Factory Profit."
Why do this?
It allows the business to see if the factory is more efficient than an outside supplier. If the factory "sells" goods to the sales department at the market price, the factory's "profit" shows how much the business saved by making the goods itself.
The Trap: Unrealised Profit
According to the Prudence concept, we should not record profit until it is actually earned by selling the goods to an outside customer. If the factory adds a \( 10\% \) profit to the goods, but those goods are still sitting in the warehouse (Closing Inventory of Finished Goods) at the end of the year, that profit hasn't been "earned" yet.
We must remove this Unrealised Profit from the value of the inventory in the Statement of Financial Position and the Statement of Profit or Loss. This ensures we don't overstate our assets or our profit.
Common Mistakes to Avoid
• Mixing up inventories: Remember there are three types! Raw Materials (used in Prime Cost), Work in Progress (adjusted after overheads), and Finished Goods (used in the Statement of Profit or Loss).
• Office Costs in the Manufacturing Account: Never include office salaries, showroom rent, or distribution costs in the Manufacturing Account. These are Operating Expenses and belong in the Statement of Profit or Loss.
• Carriage Outwards: This is the cost of delivering goods to customers. It is an office/selling expense, not a manufacturing cost.
Quick Review: The Flow of Costs
1. Manufacturing Account: Calculates the Production Cost.
2. Statement of Profit or Loss: Uses the Production Cost (instead of "Purchases") to find the Gross Profit.
3. Statement of Financial Position: Lists all three types of Inventory (Raw materials, WIP, Finished goods) as Current Assets.
Note: For more on how these figures look in the final statements, see the chapter on "Sole trader financial statements."
Did you know? Using ICT in accounting (like spreadsheets) makes it much easier to apportion costs between the factory and the office instantly! However, for your exam, you will need to be able to do these calculations manually.