At the end of every accounting period, trading firms which buy ready-made goods and resell them at a profit, prepare the Trading and Profit and Loss Accounts. However, for those firms which manufacture the goods they sell, a Manufacturing Account is prepared in addition to these two final accounts.
The Manufacturing Account is prepared to determine the total manufacturing or production cost of goods completed during the accounting period. The production cost includes all costs incurred in converting raw materials into finished goods, i.e. cost of raw materials, direct labour and direct expenses, and factory overhead expenses.
Manufacturing or Production Cost
Production cost can be divided into two categories, i.e. prime cost and factory overhead expenses. Both these costs are charged to the Manufacturing Account for the calculation of production cost. The following is a description of the different components which make up prime cost and factory overhead expenses.
Prime Cost
Prime cost includes all costs which relate directly to the manufacturing process. They include raw materials, labour and expenses which are traceable to the particular unit of goods manufactured.. These prime costs will vary with the units of output produced. Increasing output means using mere raw materials, direct labour and direct expenses, e.g. if production is increased by 50%, the cost of raw materials, manufacturing wages and direct expenses will rise by approximately the same extent.
Cost of Raw Materials
The cost of raw materials used to make the finished good represents one of the major prime costs. The opening and closing stock of raw materials, together with the purchase of raw materials must be taken into account when calculating the cost of raw materials.
Any other costs incurred in the purchases of raw materials, like duty, freight or carriage, should be added to the net purchases of the raw materials.
Direct Labour Cost
These refer to the wages paid to labour which is directly involved in the manufacture of goods. These wages paid to workers who are employed on the actual production line are called direct wages.
Direct Expenses
Besides raw materials and labour cost, other expenses directly related to manufacturing may be incurred. These include expenses for water and electricity that can be traced by the units of goods produced, e.g. the amount of water used in the production of bottled drinks and the amount of electricity consumed in the baking of bread can be computed by each unit of goods produced.
Direct expenses may include royalties which are payments made to the patentee for the right to use the patent for each unit of goods produced.
A patent confers upon its holder, the right to be the only producer of a certain product for a particular period of time.
Factory Overhead Expenses
These costs are not directly related to the actual manufacturing of goods but more so to the general operations of running of the factory where production is carried on.
Overhead expenses do not vary with output. Even if output is increased or decreased, the overhead expenses remain relatively fixed.
Factory overhead costs include:
- rent and rates of factory
- insurance of factory
- factory power and lighting
- repairs and maintenance of plant and machinery
- depreciation of tools, plant and machinery
- indirect labour cost – wages and salaries paid to those employed in the general operations of the factory and who are indirectly associated with actual production, g. factory engineer, supervisor, manager, forklift and crane drivers, cleaners and security personnel.
Production Cost
Production cost measures the total cost of goods produced during the period and is made up of prime cost and factory overhead expenses used in production.
Work in Progress
In the above example, it is assumed that all the work that started in the factory was finished by the end of the year and that there was no partly finished goods. It is possible for a manufacturing firm to have work-in-progress which is partly completed goods at the end of the accounting period.
Where there is work-in-progress, production cost incurred during the accounting period will cover both the finished and unfinished goods.
If we wish to know the cost of manufacturing only the finished goods during the year, we must deduct the work-in-progress at the end of the year from the production cost. The work-in-progress is valued according to the cost of materials, labour, factory overhead expenses and other expenses that have gone into it.
Where there is work-in-progress at the beginning of the accounting period, this must be added to the production cost before deducting the work-in-progress at the end of the year to give the cost value of finished goods for the year.
Cost Flows in the Manufacturing Account and the Determination of the manufacturing Profit
Summary
- The following steps are taken by the manufacturer to arrive at his net profit figure:
- Calculation of production cost by setting up a Manufacturing Account: Production Cost = Prime Costs (raw materials cost + direct labour and direct expenses) + Factory Overhead Expenses
- Calculation of gross manufacturing profit by comparing the market price of goods manufactured with the production cost in the Manufacturing Account: Gross Manufacturing Profit = Market Price of Goods Manufactured – Production Cost
- Calculation of gross trading profit by setting up a Trading Account: Gross Trading Profit = Net Sales – Cost of Sales
- Calculation of net profit by setting up a Profit and Loss Account: Net Profit = Gross Manufacturing Profit + Gross Trading Profit + Any Gains – Expenses
- To the Manufacturing Account, charge all manufacturing expenses incurred in the production of finished goods.
- To the Trading Account, charge all buying expenses incurred in the purchase of goods for resale.
- To the Profit and Loss Account, charge all selling expenses incurred in the sale and distribution of goods including all administrative expenses.
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