Manufacturing Accounts PDF

MANUFACTURING ACCOUNTS Manufacturing business: A business that produces or manufactures goods are called manufacturing businesses. Manufacturing account: Manufacturing business prepare manufacturing account as part of their internal financial statements. A manufacturing account shows the cost of r...

MANUFACTURING ACCOUNTS Manufacturing business: A business that produces or manufactures goods are called manufacturing businesses. Manufacturing account: Manufacturing business prepare manufacturing account as part of their internal financial statements. A manufacturing account shows the cost of running and maintaining the factory in which a final product is made. It is an account prepared at the end of a financial period to calculate the production cost of manufactured goods. The manufacturing account only includes information about the factory and the actual manufacturing process. All other non-production costs, i.e. administration, finance, and distribution costs, are recorded in the Statement of Profit or Loss, just as they are for non-manufacturing organizations. A manufacturing business can trade by selling its finished goods to wholesalers or retailers, so it will prepare a trading account in its income statement as well as manufacturing account. Types of inventory in manufacturing business: The manufacturing account has to deal with the fact that products may take time to produce and it is quite possible that the business may have three types of inventory: 1. Raw materials: Any materials that will form part of the product but have not yet had anything done to them. Example would be wood for a furniture manufacturing company. 2. Work-in-progress: Product that has been started but still requires further work to put it into a state of completeness where it is ready to be sent to the customer. Example would be a table with missing legs for a furniture manufacturing company. 3. Finished/Completed goods: Product that is ready to be sent to the customer. Example would be a table or chair for a furniture manufacturing company. Note: All three types of closing inventory will appear as current assets in the Statement of Financial Position. Manufacturing cost: Also known as the cost of production, it is calculated by adding the factory overheads (indirect production costs) to prime cost (direct production cost). Manufacturing cost = Direct production cost + Indirect production cost 1. Direct production cost: Direct production cost is also known as a prime cost. Direct costs are the costs that are involved in the actual manufacture of the product. These are the cost that can be easily identified or calculated on a single unit produced.  a. Direct labor b. Direct material c. Direct expenses (royalty, patents, direct lighting, direct heating, etc.) Prime cost = raw material + direct labor + direct expenses 2. Indirect production cost: These are the cost that is incurred in the manufacturing process but they cannot be traced directly to the goods being produced. a. Indirect material b. Indirect labor c. Indirect expenses (factory rent, factory insurance, factory supervisor’s salary, etc.) Manufacturing Account format: A manufacturing account is split into two main sections showing prime costs and indirect costs. Name of the manufacturing business Manufacturing Account for the year ended … $ $ Cost of raw material consumed: (Direct material) Opening raw materials xxx (+) Purchases of raw materials xxx (-) Purchase returns of raw materials (xxx) (+) Carriage on raw materials xxx (-) Closing raw materials (xxx) xxx Direct production/factory wages (Direct labor) xxx Direct expenses xxx Prime cost (Total of the above direct costs) xxx Factory overheads: (Indirect costs) Indirect material xxx Indirect labor xxx Factory rent xxx Factory insurance xxx Depreciation of plant and machinery xxx Depreciation of factory building xxx xxx Cost of manufacturing (Total of prime costs and factory overheads) xxx Opening work-in-progress xxx (-) Closing work-in-progress (xxx) xxx Cost of production xxx (+) Factory profit (Cost of production * Rate of factory profit) xxx Transfer price xxx Transfer price: It is the production cost of completed goods plus a percentage mark-up. It is the price that one part of an organization sells its product (or service) to another part of the organization. Note: In some questions, increase or decrease of work-in-progress is given. In such cases, increase in work-in-progress is deducted and decrease in work-in-progress is added to the total production cost to obtain the cost of production. Factory/Manufacturing profit: Manufacturing profit is also known as factory profit. It is the amount added to the factory cost of completed goods to arrive at the transfer price. It is the difference between the transfer price and the production cost of completed goods. Importance of Transfer Price: Better control of manufacturing cost. Transferred price is compared with the market price. Manufacturing department is a profit center. Better way to measure the performance of the manufacturing department. Drawbacks of Transfer Price: The use of this technique does not improve the overall profitability of the business. Can give unrealistic view of the factory profitability unless other production prices are researched and used to set the transfer price. Provision for Unrealized Profit: The finished goods at the year-end are valued at cost plus the manufacturing profit margin. Unrealized profit should not be anticipated and the profit element should be removed from the inventory by creating a provision for unrealized profit. Unrealized profit: It is the profit which is not recognized until the inventory is sold and a contract of sale has been negotiated. If a transfer price is used, finished inventories will include an element of unrealized profit. Unrealized profits should not be recognized within the Statement of Financial Position as it contradicts both the realization and prudence concepts and goes against the IAS 2. Why do we account for Provision for Unrealized Profit? We account for Provision for Unrealized Profit in order to remain consistent with the following accounting concepts and standards:  1. IAS 2: Inventories should be valued at a lower of cost and net realizable value. 2. Prudence concept: Profits and assets should not be overstated. 3. Realization concept: Profits should only be realized or recognized once it is earned. Provision for Unrealized Profit Account Format: Provision for Unrealized Profit $ $ Statement of Profit or Loss (Decrease) xxx Balance b/d xxx Balance c/d xxx Statement of Profit or Loss (Increase) xxx xxx xxx The increase in provision for unrealized profit is treated as an expense in the Statement of Profit or Loss and the decrease in provision for unrealized profit is treated as an income in the Statement of Profit or Loss. Statement of Profit or Loss Format: Name of the Business Statement of Profit or Loss For the year ended … $ $ Revenue xxx (-) Cost of sales Opening inventory of finished goods (at transfer price) xxx (+) Transfer price (From Manufacturing Account) xxx (-) Closing inventory of finished goods (at transfer price) (xxx) (xxx) Gross profit xxx (+) Factory profit (From Manufacturing Account) xxx (+ / -) Adjustment of unrealized profit xxx xxx (Add: Decrease in provision for unrealized profit and Subtract: Increase in provision for unrealized profit) Effective gross profit xxx Administrative expenses xxx Distribution cost xxx (xxx) Profit for the year xxx Inventory valuation in Statement of Financial Position: $ $ Current assets: Inventory: Raw materials xxx Work-in-progress xxx Finished goods at transfer price xxx (-) Provision for unrealized profit (xxx) xxx  Theory questions: Explain the accounting treatment in the statement of profit or loss and statement of financial position of the provision for unrealized profit. Support your answer with reference to the accounting concepts. Provision for unrealized profit is accounted for in order to remain consistent with prudence concept, realization concept, consistency concept and International Accounting Standard 2. The reason we say profit is unrealized is because the finished goods have not been sold to third party yet. Accounting treatment in statement of profit or loss: Increase/Decrease in provision for unrealized profit is adjusted in the statement of profit or loss in order to represent both the opening finished goods inventory and closing finished goods inventory are stated at cost. An increase in provision for unrealized profit is treated as an expense whereas a decrease in provision for unrealized profit is treated as an income. Accounting treatment in statement of financial position: Provision for unrealized profit is deducted from the transfer value of finished goods inventory, reflecting the cost of the finished goods inventory. Advise the directors whether or not they should stop accounting for factory profit. The use of transfer price allows managers to compare the transfer price with the cost of buying from an external supplier which helps to make decisions regarding whether to continue manufacturing goods or buy in from an external supplier. The use of factory profit recognizes factory as a cost centre which can be further used to assess departmental performance, specially to calculate pay or bonuses for factory workers and factory managers. However, setting the rate of factory profit is subjective; ideally, it should be set considering the competitor’s prices. Additionally, factory profit does not alter the total profit for the year. Since the use of factory profit aids in setting the selling prices, the directors should not stop accounting for factory profit. Advise the directors whether or not they should apply a rate of factory profit of 50%. Justify your answer. If the rate of factory profit of 50% is applied, then the transfer price would be extremely high as compared to the cost of buying from an external supplier and therefore be subjective. This would increase the factory profit which then decreases the gross profit, but the overall profit would remain unchanged. Due to the high rate of factory profit, the pay and bonuses of factory workers and factory managers could be inflated. The use of a fixed rate of factory profit would be consistent year on year and it also avoids large fluctuation in the provision for unrealized profit. Due to this reason, the directors should not change the rate of factory profit to 50%.