What Is a Manufacturing Account? A Complete Guide to Cost of Production
One-hour paid trial · Same-day reply · from RM50/hr
A manufacturer is different from a trader
An ordinary trader buys finished goods and sells them again without changing their form. A grocery shop buys packaged bags of rice and sells them to customers exactly as they are. For this kind of business, the only cost to work out is the cost of buying finished goods, and this goes straight into the trading account to work out gross profit.
A manufacturer does not buy finished goods. Instead, it buys raw materials and then converts those materials into finished products using workers and machines in a factory. For example, a furniture factory buys timber, then saws, planes and paints the wood until it becomes a finished chair ready for sale. Because this production process involves many kinds of cost, a manufacturer must prepare an extra account before the trading account.
This extra account is called the manufacturing account, sometimes called the production account. Its purpose is to gather together every cost involved in making the finished goods, so that we know the true cost of producing those products. Without a manufacturing account, we cannot accurately determine the cost of the goods that have been manufactured.
The purpose of the manufacturing account
The manufacturing account is a special account prepared to calculate the total cost of making finished goods during an accounting period. It brings together all production costs, that is the cost of materials used, the wages of factory workers, and other costs connected to running the factory.
The final result of the manufacturing account is the cost of production, or more precisely the cost of goods manufactured. This figure is then transferred to the trading account. For a manufacturer, the cost of goods manufactured replaces the purchases of finished goods found in a trader's trading account.
Remember that the manufacturing account deals only with factory activity. Selling costs, office administration costs and distribution costs are not included in the manufacturing account. Those costs are treated as expenses and recorded in the profit and loss account after gross profit has been calculated.
Direct costs and indirect costs
Before preparing a manufacturing account, we must be able to tell the difference between direct costs and indirect costs. A direct cost is a cost that can be traced directly to each unit of product made. The wood that becomes a chair, and the wages of the carpenter who builds that chair, can be measured directly for each unit, so they are direct costs.
An indirect cost, on the other hand, is a cost that is needed to run the factory but cannot be traced directly to a single unit of product. Examples include the rent of the factory building, the electricity used to power the machines, and the salary of the factory supervisor. These costs support the whole of production, but we cannot say that a specific amount of factory rent belongs to one chair.
This distinction matters because in the manufacturing account all direct costs are gathered first to form the prime cost, while all indirect factory costs are gathered as factory overheads. Misclassifying a cost will cause both the prime cost and the cost of production to be calculated wrongly.
Direct materials used
The first part of the manufacturing account is the cost of direct materials used. Direct materials are raw materials that become part of the finished product, such as wood for a chair or flour for bread. We count the materials used in production, not the materials bought.
To find direct materials used, we start with the opening stock of raw materials, add the purchases of raw materials during the period, and then subtract the closing stock of raw materials still left in the store. The formula is: opening stock of raw materials plus purchases of raw materials minus closing stock of raw materials.
Suppose a factory has an opening stock of raw materials of RM8,000, buys RM50,000 of raw materials during the year, and has a closing stock of raw materials of RM6,000. The direct materials used are RM8,000 plus RM50,000 minus RM6,000, which equals RM52,000. This RM52,000 is what entered the production process.
Direct labour and prime cost
After direct materials, we add the cost of direct labour. Direct labour is the wages paid to workers who directly convert raw materials into finished products, such as the carpenter who makes the chair or the tailor who sews the shirt. Their wages are directly linked to each unit produced.
When we add direct materials used to direct labour, we get the prime cost. The prime cost is the total of all direct costs in production. The formula is: direct materials used plus direct labour equals prime cost. Sometimes there are also other direct expenses, such as hiring a special machine for a particular order, and these are also included in the prime cost.
Continuing our example, suppose the factory pays direct labour of RM20,000. Then the prime cost is RM52,000 plus RM20,000, which equals RM72,000. The prime cost shows the core cost of the product before any indirect costs are added.
Factory overheads
After the prime cost, we add factory overheads, which are all the indirect costs involved in running the factory. Examples of factory overheads include factory rent, depreciation of machinery, factory electricity and water, the supervisor's salary, and machine maintenance. These costs are essential for production but cannot be traced to a single unit of product.
Be careful to separate factory costs from office costs. Office rent, the salary of an office clerk and advertising are not factory overheads, because they have nothing to do with the manufacturing process. Only costs incurred in the factory for the purpose of production are included as factory overheads.
Suppose the same factory incurs the following factory overheads: factory rent RM10,000, depreciation of machinery RM5,000, and factory electricity RM3,000, giving total factory overheads of RM18,000. This total is then added to the prime cost.
The work-in-progress adjustment
At the end of the period, there are usually goods that are not yet fully finished, that is goods that have started to be made but have not yet become finished products. These half-finished goods are called work-in-progress. A chair that has been cut and joined but not yet painted is an example of work-in-progress.
We must adjust for work-in-progress so that the manufacturing account only recognises the cost of goods completed during the period. To do this, we add the opening work-in-progress and subtract the closing work-in-progress from the total factory cost. This is because opening work-in-progress is finished during this period, while closing work-in-progress is not yet finished.
Suppose the factory has opening work-in-progress of RM4,000 and closing work-in-progress of RM6,000. The total factory cost so far is the prime cost of RM72,000 plus factory overheads of RM18,000, which equals RM90,000. After the adjustment we add RM4,000 and subtract RM6,000, giving a cost of production of RM88,000.
Cost of production flows into the trading account
The final figure in the manufacturing account is the cost of production, also called the cost of goods manufactured. In our example, the cost of goods manufactured is RM88,000. This figure is transferred to the trading account.
In a manufacturer's trading account, the cost of goods manufactured replaces the purchases of finished goods seen in a trader's business. We start with the opening stock of finished goods, add the cost of goods manufactured, and subtract the closing stock of finished goods to get the cost of goods sold. Then sales minus cost of goods sold gives gross profit as usual.
Suppose sales for the year are RM130,000, opening stock of finished goods is RM10,000 and closing stock of finished goods is RM12,000. The cost of goods sold is RM10,000 plus RM88,000 minus RM12,000, which equals RM86,000. The gross profit is therefore RM130,000 minus RM86,000, which equals RM44,000. Office and selling expenses are then deducted in the profit and loss account to arrive at net profit.
Summary of the flow and next steps
In short, remember this sequence: direct materials used plus direct labour form the prime cost; the prime cost plus factory overheads give the total factory cost; adjust for work-in-progress to get the cost of production; the cost of production flows into the trading account as the cost of goods manufactured. If you memorise this sequence, the manufacturing account becomes straightforward.
Above all, classify costs accurately. Before you place any figure, ask yourself two questions: is this a direct cost or an indirect cost, and is it a factory cost or an office cost? The answers decide where the figure belongs.
If you are still unsure how to separate direct materials, direct labour and overheads, or how to adjust for work-in-progress, our experienced teachers can guide you through a manufacturing account step by step in online 1-to-1 lessons. The paid one-hour trial class starts from RM50 per hour; WhatsApp us to find out more.