3.1.4 Manufacturing Businesses

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Accounting Full Scale Course

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Purpose of a Manufacturing Account

• A manufacturing account is prepared by businesses that convert raw materials into finished goods.
• Its purpose:
  • Calculate cost of production of finished goods.
  • Differentiate between direct costs (prime cost) and indirect costs (overheads).
  • Determine factory profit, where manufacturing accounts are prepared at a transfer price rather than cost.
• Final figures are transferred to the Statement of Profit or Loss to compute gross and net profit.

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Direct vs Indirect Costs

Direct Costs (form part of Prime Cost)

• Costs directly attributable to production of each unit.
• Examples:
  • Direct materials (wood for furniture, fabric for clothing).
  • Direct labour (wages of factory workers).
  • Direct expenses (royalties per unit produced, hire of special machine).

Formula:
Prime Cost = Direct Materials + Direct Labour + Direct Expenses

Indirect Costs (Factory Overheads)

• Costs incurred in running the factory, but not directly traceable per unit.
• Examples:
  • Factory rent, heating, lighting.
  • Supervisor salaries.
  • Depreciation of factory machinery.
  • Indirect materials (lubricants, cleaning supplies).

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Layout of a Manufacturing Account

Format (basic):

Particulars	$
Opening raw materials	X
Add: Purchases of raw materials	X
Less: Closing raw materials	(X)
Raw materials consumed	X
Add: Direct labour	X
Add: Direct expenses	X
Prime cost	X
Add: Factory overheads	X
Add: Opening WIP	X
Less: Closing WIP	(X)
Factory cost of production	X
Add: Factory profit (if applied)	X
Transfer to Trading Account	X

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Worked Example 1: Manufacturing Account

Data (2024):

• Opening raw materials = 8,000
• Purchases = 50,000
• Closing raw materials = 10,000
• Direct labour = 30,000
• Direct expenses = 2,000
• Factory rent = 12,000
• Factory depreciation = 6,000
• Indirect wages = 4,000
• Opening WIP = 5,000
• Closing WIP = 7,000

Manufacturing Account:

Particulars	$
Opening raw materials	8,000
Add: Purchases	50,000
Less: Closing raw materials	(10,000)
Raw materials consumed	48,000
Add: Direct labour	30,000
Add: Direct expenses	2,000
Prime cost	80,000
Add: Factory overheads:
Factory rent	12,000
Depreciation	6,000
Indirect wages	4,000
Total overheads	22,000
Add: Opening WIP	5,000
Less: Closing WIP	(7,000)
Factory cost of production	100,000

This 100,000 is transferred to the Trading Account.

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Statement of Profit or Loss (with Manufacturing)

Format:

Particulars	$
Sales	X
Less: Cost of Sales
Opening finished goods	X
Add: Cost of production	X
Less: Closing finished goods	(X)
Cost of Sales	X
Gross Profit	X
Less: Admin + Distribution expenses	X
Net Profit	X

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Worked Example 2: Trading & Profit/Loss

Data:

• Sales = 150,000
• Opening finished goods = 15,000
• Closing finished goods = 20,000
• Cost of production (from above) = 100,000
• Distribution costs = 10,000
• Admin expenses = 12,000

Trading Account:

Particulars	$
Sales	150,000
Less: Cost of Sales:
Opening finished goods	15,000
Add: Cost of production	100,000
Less: Closing finished goods	(20,000)
Cost of sales	95,000
Gross profit	55,000
Less: Distribution costs	10,000
Less: Admin expenses	12,000
Net profit	33,000

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Factory Profit and Transfer Price

Some manufacturers transfer goods to the Trading Account at cost + profit margin (factory profit).

Why show factory profit?

• To measure efficiency of factory separately from selling/distribution.
• To encourage factory managers to control costs.
• To value finished goods at cost + markup.

Example:
If cost of production = 100,000, factory adds 20% profit = 20,000.
Transfer to Trading Account = 120,000.
Later, unrealised profit on closing inventory must be removed.

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Unrealised Profit on Closing Inventory

When goods are transferred at cost + profit, unsold finished goods include unrealised profit (not yet earned).
This must be eliminated to avoid overstating profit.

Adjustment:
Unrealised Profit = Closing Inventory × Factory Profit %

Example:
Closing inventory = 20,000 (valued at transfer price, includes 20% factory profit).
Factory profit element = 20,000 × 20/120 = 3,333.
Adjustment: Reduce profit by 3,333.

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Worked Example 3: Manufacturing Profit Adjustment

• Cost of production = 100,000
• Factory profit = 20,000 (20% on cost)
• Transfer = 120,000
• Closing inventory of finished goods = 24,000 (valued at transfer price)

Unrealised profit: 24,000 × 20/120 = 4,000

Adjustment: Deduct 4,000 from gross profit and reduce inventory to cost.

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Reasons for Accounting for Manufacturing Profit

1. Performance measurement
   • Distinguishes between factory efficiency and trading/marketing performance.
2. Management control
   • Factory managers are accountable for production costs.
   • Encourages cost reduction and efficiency.
3. Internal pricing
   • Where a factory supplies goods to retail divisions, transfer pricing with factory profit reflects internal trade.
4. Better financial analysis
   • Separates manufacturing performance from selling/distribution.
   • Helps in budgeting and variance analysis.

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Summary Table – Manufacturing Businesses

Concept	Explanation	Example
Prime cost	Direct materials + direct labour + direct expenses	48,000 + 30,000 + 2,000 = 80,000
Factory overheads	Indirect costs of production	Rent, depreciation, supervisor wages
Factory cost of production	Prime cost + overheads ± WIP	80,000 + 22,000 + 5,000 – 7,000 = 100,000
Transfer to trading	Cost of production (or cost + factory profit)	100,000 or 120,000
Unrealised profit	Factory profit in unsold inventory	Closing inventory × margin %
Reasons for factory profit	Measures efficiency, control, analysis	Separate performance reporting

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Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Accounting Full Scale Course

3.1.4 Manufacturing Businesses

Introduction

• A manufacturing business converts raw materials into finished goods by applying labour and overheads.
• Unlike trading businesses (that buy and sell finished goods), manufacturers must record:
  • Manufacturing Account → to calculate cost of production.
  • Statement of Profit or Loss → to calculate gross and net profit.
  • Statement of Financial Position → to show assets, liabilities, and capital.

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Purpose of Manufacturing Accounts

• To show cost of goods produced during the accounting year.
• To separate direct costs (materials, labour) from indirect costs (factory overheads).
• To calculate factory profit or loss if required.
• To value closing inventory of finished goods at cost.
• To ensure fair reporting of manufacturing performance.

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Structure of Manufacturing Account

The Manufacturing Account is prepared to calculate the cost of production.

Main Sections:

1. Direct Costs (Prime Cost)
   • Direct Materials
   • Direct Labour
   • Direct Expenses

   Formula:
   Prime Cost = Direct Materials + Direct Labour + Direct Expenses

2. Factory Overheads
   • Indirect labour (factory supervisors, cleaners)
   • Indirect materials (lubricants, small tools)
   • Factory rent, depreciation of machinery, electricity, insurance
3. Factory Cost of Production
   • Prime Cost + Factory Overheads – Closing Work in Progress (WIP) + Opening WIP

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Distinction between Direct and Indirect Costs

• Direct Costs: Can be traced directly to production of goods.
  • Example: Wages of machine operators, cost of wood for furniture.
• Indirect Costs: Cannot be directly linked to production of a specific unit.
  • Example: Factory rent, electricity, depreciation of factory machines.

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Example Table – Manufacturing Account (Format)

Particulars	Amount ($)
Direct Materials
Opening Raw Materials Inventory	20,000
Add: Purchases of Raw Materials	80,000
Less: Closing Raw Materials Inventory	(15,000)
Raw Materials Consumed	85,000
Add: Direct Labour	50,000
Add: Direct Expenses	5,000
Prime Cost	140,000
Add: Factory Overheads	30,000
Add: Opening WIP	10,000
Less: Closing WIP	(8,000)
Factory Cost of Production	172,000
Add: Factory Profit (if applicable)	8,000
Transfer to Trading Account (as Cost of Goods Produced)	180,000

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Factory Profit

• Some businesses add a factory profit margin when transferring goods to the trading account.
• Purpose:
  • To compare cost efficiency with standard/market value.
  • To ensure head office and factory performance can be evaluated separately.

Example:
If Cost of Production = $172,000 and a 5% factory profit is applied:
Factory Profit = 172,000 × 5% = 8,600
Transfer Value = 172,000 + 8,600 = 180,600

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Statement of Profit or Loss for Manufacturing Business

After preparing the manufacturing account, the statement of profit or loss is prepared.

Format:

1. Revenue (Sales)
2. Less: Cost of Sales
   • Opening Finished Goods Inventory
   • Add: Cost of Goods Produced (from manufacturing account)
   • Less: Closing Finished Goods Inventory
     = Cost of Sales
3. Gross Profit = Revenue – Cost of Sales
4. Add: Other Income
5. Less: Administration, Selling & Distribution Expenses
6. Net Profit (before/after tax depending on syllabus scope)

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Example – Statement of Profit or Loss

Particulars	Amount ($)
Revenue	300,000
Less: Cost of Sales
Opening Finished Goods Inventory	25,000
Add: Cost of Goods Produced	172,000
Less: Closing Finished Goods Inventory	(22,000)
Cost of Sales	175,000
Gross Profit	125,000
Less: Administration Expenses	40,000
Less: Selling & Distribution	20,000
Net Profit	65,000

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Statement of Financial Position (Balance Sheet)

• Shows assets, liabilities, and capital.
• Inventories must be split into:
  • Raw Materials
  • Work in Progress
  • Finished Goods

Example Extract:

• Current Assets:
  • Raw Materials: $15,000
  • WIP: $8,000
  • Finished Goods: $22,000

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Elimination of Unrealised Profit

• When factory profit is added, part of it may remain unrealised if goods are unsold.
• This must be eliminated from closing inventory.

Example:

• Transfer Price = $180,600 (includes $8,600 factory profit)
• Closing Finished Goods Inventory = $22,000 (includes factory profit portion).
• Unrealised Profit = 22,000 × (8,600 ÷ 180,600) = $1,048 approx.
• Adjust closing inventory by reducing it: 22,000 – 1,048 = 20,952.
• This ensures profit is not overstated.

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Reasons for Accounting for Manufacturing Profit

• To separate the efficiency of factory operations from head office functions.
• To evaluate cost control in production.
• To ensure fair pricing between factory and trading department.
• To avoid inflating profits when unsold goods contain factory profit.

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Example – Comprehensive Case

Information:

• Raw Material Opening Inventory: $10,000
• Purchases of Raw Materials: $50,000
• Closing Raw Materials: $12,000
• Direct Labour: $30,000
• Direct Expenses: $5,000
• Factory Overheads: $15,000
• Opening WIP: $8,000
• Closing WIP: $6,000
• Opening Finished Goods: $20,000
• Closing Finished Goods: $25,000
• Sales: $180,000
• Administration: $12,000
• Selling Expenses: $8,000

Step 1 – Manufacturing Account

Raw Materials Consumed = 10,000 + 50,000 – 12,000 = 48,000
Prime Cost = 48,000 + 30,000 + 5,000 = 83,000
Factory Cost = 83,000 + 15,000 + 8,000 – 6,000 = 100,000

Step 2 – Statement of Profit or Loss

Revenue = 180,000
Cost of Sales = 20,000 + 100,000 – 25,000 = 95,000
Gross Profit = 180,000 – 95,000 = 85,000
Net Profit = 85,000 – (12,000 + 8,000) = 65,000

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Summary

• Manufacturing accounts help calculate cost of production.
• Distinguish direct vs indirect costs.
• Statements must include manufacturing account, profit or loss, and financial position.
• Unrealised profit in inventory must be eliminated to avoid overstating profits.
• Purpose of factory profit: internal performance measurement and cost control.

Comparison: Trading Business vs Manufacturing Business

Feature	Trading Business	Manufacturing Business
Nature of Business	Buys and sells finished goods.	Converts raw materials into finished goods.
Main Accounts Prepared	Trading Account, Profit or Loss, Statement of Financial Position.	Manufacturing Account, Trading Account, Profit or Loss, Statement of Financial Position.
Inventory Types	One type only: Finished Goods.	Three types: Raw Materials, Work in Progress (WIP), Finished Goods.
Prime Cost	Not calculated.	Always calculated: Direct Materials + Direct Labour + Direct Expenses.
Factory Overheads	Not included.	Included in Manufacturing Account.
Cost of Goods Sold (COGS)	Based on opening and closing finished goods only.	Based on cost of production transferred from Manufacturing Account, adjusted for finished goods inventory.
Purpose of Accounts	To find Gross Profit and Net Profit.	To calculate Cost of Production and then Gross Profit/Net Profit.
Unrealised Profit Issue	Does not arise.	Arises if factory profit is included in transfer price of goods to trading. Must be eliminated.
Performance Measurement	Efficiency measured mainly by sales, gross margin, and expenses.	Efficiency measured by production cost control and profitability of both factory and head office.
Users of Information	Owners, managers, tax authorities, investors, banks.	Same users, but they also evaluate factory operations separately.