The Manufacturing process and elements of cost
There are 4 things that make up the production costs:
Direct materials - the raw materials that are required in making the finished product.
Direct labour - cost of the workforce engaged in production e.g machine operators.
Direct expenses - Expense incurred as a direct result of making the product e.g royalties
Production (factory) overheads - all the other costs of manufacturing -> indirect costs.
A Direct cost is a cost that can be directly linked with making a unit of a product.
An Indirect cost is a cost that cannot be easily linked with a unit of product.
Prime cost - Total of all the direct costs - materials, labour and expenses.
Production cost is the factory cost of making a product after adding production overheads = prime cost + factory overheads = production/ manufactoring cost
The Manufacturing account
Adding all the direct costs and production overheads give a total production cost. As we need to calculate the cost for the units that are completed, an adjustment needs to be made. Work in Progress needs to be calculated and then deducted to leave us with completed goods only.
The manufacturing account should look like this:
Direct materials x
Add Direct labour x
Add Direct expenses x
Equals Prime cost x
Add production/ factory overheads x
Equals Total production cost x
Adjust for work in progress ( x )
Equals production cost of goods x
completed (finished goods)
Work In Progress Calculation steps
Step 1) Find the cost of raw materials used.
cost of raw materials used = Opening inventory of RM + Purchases of RM - Closing inventory RM
Step 2) Calculate the Prime cost (direct costs)
Step 3) Add the production overheads (indirect costs)
Step 4) Adjust for the Work in progress
Production cost of completed goods = Opening inventory = production costs - Closing inventory
In the manufacturing account:
Total production cost x
+ opening inventory of WIP x
- Closing inventory of WIP ( x )
= production cost of finished goods x
The income statement
The income statement deals with non production costs. The cost of sales is calculated by adding the production costs of completed goods which is calculated in the manufacturing account instead of adding purchases.
So the income statement looks like this:
Opening inventory ( FG) x
Production cost of FG x
Less: Closing inventory ( FG ) ( x )
Cost of goods sold x
Gross Profit x
Admin ( x )
Depreciation ( x )
Profit for the year x
Transfer Prices and Factory Profit
The goods that a business sells may have been
- Manufactured themselves or
- Bought from a supplier
If the goods can be made more cheaply than if they were bought from a supplier, then the factory would have been said to make a profit. Factory profit.
A transfer price is the price at which the goods are transferred from the factory to the warehouse.
factory cost 1.50
factory profit (10%) 0.15
Transfer price 1.65
Transfer Price effects of Financial statements
In the Balance sheet :
- Inventory of finished goods in the trading account is valued at transfer price
IAS2 states that inventory must be valued at the lower of cost and NRV. An adjustment therefore has to be made to take out the 'unrealised profit' from the closing inventory figure.
Example: There are 100 units of inventory valued at £165 which must be valued at £150
Cr provision for unrealised profit - Reduces the inventory value in Balance sheet
Dr increase in provision for unrealised profits - Shown in the Income statement after 'profit from trading' is calculated.
Provision for Unrealised Profit
Closing inventory x percent of mark up (factory profit ) / 100 + % of mark up (factory profit)
Example: £650 of inventory. Factory profit is 25% on cost.
650 x 25 = 130 This reduces the finished goods inventory in the balance sheet at cost.
Calculating the change in provision for unrealised profit: (Closing inventory - Opening inventory) x mark up % / 100+ mark up %
valued at transfer price
Example: Closing inventory is £650, Opening inventory was £320. Factory profit is 25% 620 - 320 = 330 x 25/ 125 = £66. This is shown in the income statement.
As there is an increase in the provision, it means the expense is increasing which would decrease profit. In the balance sheet you would - the provision from the current assets section.
The balance sheet
The balance sheet is prepared in the same way as for any other business. However there would be three different forms of inventory, raw materials, work in progress and finished goods.
It would look like this:
Inventories: Raw materials x
Work in progress x
Finished goods x
Inventory values at transfer price x
Less: Provision for unrealised profit ( x )
Total inventory x
The Income statement
The provision would need to be in the income statement to take out the unrealised profit. This is because if the income statement included the unrealised profit, it would not be in accordance with the accounting standard IAS 2 inventories as inventory needs to be valued at the lower of cost or NRV.
The entire provision is included in the balance sheet but on the change in the provision is in the income statement. The provision can be calculated as:
The (closing) inventory at transfer price x % of factory profit
The change in the provision is calculated as: (closing inventory - opening inventory) x % / 100+%
An increase in the provision means that this amount needs to be taken away as an expense
A decrease means it can be added as income.
This is the same logic as the provision for doubtful debts.