In a trading business we work out the value of our inventory by just looking at the supplier’s invoice (how much did it cost me to buy the goods?). In a manufacturing business we work out the value of our inventory by calculating how much it cost us to make the goods.
So in order to calculate how much our inventory are worth we need to calculate how much it cost us to manufacture the finished goods. These manufacturing costs and calculations are shown in the manufacturing cost statement(explained further below).
Manufacturing costs are divided into three broad categories:
1. Direct materials
Direct materials are materials that are directly used in making the product. Also known as raw materials. For example, wood used to make tables or furniture.
2. Direct labor
Direct labor is labor directly involved in manufacturing the product, such as a mechanic. This includes people working with their hands or operating machines used to manufacture the product.
Overheads are other general business expenses attributable to manufacturing the product.
This includes rent (on the factory building), insurance (for the factory building or factory machines), and water and electricity (specifically for the factory building).
If a business had a factory building and also an office building (where administrative work was done), the overheads would not include any of the expenses to run the office building (only expenses for the factory).
The first two costs above taken together (direct materials plus direct labor) are known as the conversion costs of a product.
Before we look at the manufacturing cost statement we need to go over a few more key terms that will appear in this report:
These are inventories that are used in the manufacturing process but whose cost is insignificant. For example, in manufacturing a car, the nuts, screws and bolts would be indirect materials. Cleaning materials that are consumed in producing a completed, clean car would also be indirect materials.
Indirect materials are recorded separately from direct materials, and actually fall under the category of overheads.
This is the cost of personnel not directly involved in manufacturing the product, but whose cost forms part of the factory expenses.
Included in this are wages and salaries to factory supervisors, cleaners and security guards. Indirect labor is recorded separately from direct labor, and, just like indirect materials, falls under the category of overheads.
Work in progress
These are inventories that have started the manufacturing process but that are not yet finished goods. An example of this would be a car without an engine or fitted windows. Or tables that have been assembled but need sanding or finishing work.
These are inventories that have not yet been used in the manufacturing process at all. An example of this would be the raw (untouched) copper used to make parts of a car, or wood to make a table. Raw materials are also called direct materials.
The Manufacturing Cost Statement: Format and Calculations
Now that we have covered all the necessary terms, here is the statement (shown here specifically for a business using the periodic system of inventory accounting):
Now if you're a bit confused looking through the above statement I don't blame you. You might be asking yourself how some of the above calculations in the manufacturing cost statement were obtained. For example, why are we adding opening work in progress and minusing closing work in progress? Don't worry, I'm going to explain these calculations in more detail below.
To calculate the value of direct or raw materials used in the manufacturing process, we use a similar formula to that used to calculate the cost of the finished goods sold (cost of sales) in the income statement:
When we swap this formula around we get:
We use a similar equation for work in progress:
And once again, when we swap the formula around we get:
Our last formula above concerning work in progress completed is a tricky one to find in the manufacturing cost statement. If you look at the statement, “opening work in progress" and “closing work in progress" are right there (towards the bottom), but where is the “total cost of work in progress" this year? The answer is that this is equal to everything in the statement above the opening and closing work in progress.
The "cost of finished goods manufactured this year" is the exact same as the “work in progress completed" in our formula.
And that is why the manufacturing cost statement is structured the way it is.
The above formulas are the basis of the manufacturing cost statement. Refer back and forth between the formulas and the statement and see how the formulas are actually in the statement itself.
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