AL WADI INTERNATIONAL SCHOOL ACCOUNTING GRADE-12 NOTES

MANUFACTURING ACCOUNTS

So far, we have considered the final accounts of sole traders who do not make the
goods that they sell. In all prior examples, the firms generate profits by purchasing stock
and then selling this stock for a price higher than the cost, meaning a profit has been
earned - i.e. the difference between sales and the cost of those goods that were sold. In
reality, most firms do not act in this way. Even if a firm does not make its own products,
it is likely to add something to the products themselves.
If a firm actually produces the goods that they sell then there will be no obvious
'purchases' figure to include in the trading account. The costs incurred in the production
of goods will appear instead and these will be calculated in a manufacturing account.

A manufacturing account shows the cost of producing the goods that are sold during an
accounting period.

Stocks in manufacturing organisations

There are three types of stock that we deal with in manufacturing accounts. These are
as follows:

1. Raw materials - the purchases of these will be adjusted for opening stock and
closing stock in the prime cost.
2. Work-in-progress - partly completed goods will be dealt with at the end of the
manufacturing account.
3. Finished goods - opening and closing stocks will be dealt with, as is normal, in
the trading account
All three types of closing stocks will appear as current assets on the balance sheet.

How to prepare a Manufacturing Account:

Select from the trial balance those expenses that relate to the company’s
manufacturing operation. The expenses are either direct (e.g the cost of materials from
which the goods are made, and the wages of the workers who actually make the goods)
or indirect (all other manufacturing expenses).

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AL WADI INTERNATIONAL SCHOOL ACCOUNTING GRADE-12 NOTES

The following outline shows how expenditure is allocated to Manufacturing Accounts.

1. Direct material: material from which goods are made. The cost includes carriage
inwards on raw material. For example “raw material”.

2. Direct labour : the wages of the workers who actually make the goods. For
example “manufacturing wages”

3. Direct Expenses: royalties, licence fees, etc. Which have to be paid to other
persons for the right to produce their products or to use their processes. The
payment is a fixed sum for every unit of good produced.

4. Prime cost : the total of the direct costs. This description must always be shown.

5. Indirect materials: all materials purchased for the factory but which do not form
part of the goods being produced for example cleaning materials, lubricating oil
for the machinery.

6. Indirect wages: the wages of all factory workers who do not actually make the
goods for example factory managers, supervisors, stores staff, cleaners, etc.

7. Other overheads: overheads relating exclusively to the factory and production,

for example factory rent, heating and lighting, depreciation of the factory building
and machinery, etc.

8. Work in progress: goods in process of being made at the end of the previous
year but which were not finished are brought into the current year as an input to
this year’s production. Goods that are not completely finished at the end of the
current year must be deducted from the year’s costs in order to arrive at the cost
of finished goods.

9. Factory cost of finished goods : either these words or the alternative, cost of
production, should be shown at this point in the account.

10. Factory profit : the percentage to be added to cost of production as profit. The
amount is decided by management and will always be given in questions if
necessary. It is debited in the Manufacturing Account and credited in the Profit
and Loss Account.

11. The total of the Manufacturing Account is debited in the Trading Account under
the heading cost of sales.

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AL WADI INTERNATIONAL SCHOOL ACCOUNTING GRADE-12 NOTES

Transfer of finished goods to trading account at more than cost of production

It is fairly common for a manufacturing business to transfer finished goods from the
manufacturing account to trading account at a value which exceeds production cost.
This policy might be adopted for the following reasons:

(a) The business may wish to allocate its gross profit between manufacturing and
trading operations so that the extra profit earned as a consequence of making its
own products (rather than buying them in) is clearly identified.
(b) The business may sell a mixture of manufactured goods and bought-in goods. In
this case it is desirable to transfer manufactured goods between manufacturing
and trading at their market value so that the trading account is prepared on a
consistent basis.

The mark-up applied to production cost is shown in the manufacturing account as

manufacturing profit. In precisely the same way as the gross profit on trading is
calculated in the trading account and then credited to the profit and loss account, the
profit on manufacturing is calculated in the manufacturing account and then credited to
the profit and loss account.

Sample Example Ltd

Manufacturing Account for the year ended 31.12.07
$ $
Direct Raw Materials:
Inventory (Stock) at 1.1.07 xxxx
(+) Purchases of raw materials xxxx
(+) Carriage on raw materials xxxx
xxxx
(-) Inventory (Stock) at 31.12.07 (xxxx)
Raw material consumed/ used xxxx
(+) Direct labour /Manufacturing wages xxxx
(+) Direct expenses (Royalties/ License fee) xxxx
Prime cost xxxx
(+) Factory overheads (Indirect costs)
Indirect materials xxxx
Indirect labour xxxx
Indirect expenses xxxx xxxx
xxxx
(+) work-in-progress at 1.1.07 xxxx
xxxx
(-) work-in-progress at 31.12.07 (xxxx)
Cost of Production xxxx
(+) Factory Profit (20% of cost of production) xxxx
Cost of goods Transfer to Trading Account xxxx

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AL WADI INTERNATIONAL SCHOOL ACCOUNTING GRADE-12 NOTES

Sample Layout of
Trading and profit and Loss Account
For the year ended 31.12.07
$000 $000
Sales xxxx
(-) Cost of sales:
Inventory (Stocks) of finished goods (1.1.07) xxx
Transfer of finished goods xxx
xxx
(-) Inventory (Stocks) of finished goods (31.12.07) (xxx)
Cost of sales xxxx
Gross profit xxxx
(-) Operating Expenses:
Selling and distribution expenses xxx
Administration expenses xxx
(xxxx)
Net profit on Trading xxxx
(+) Factory Profit xxx
(-) Unrealised Profit on closing stock of F.G (xxx)
Net profit xxxx

Profits / Losses on manufacturing:

Firm producing their own goods usually do so because they can make them more
cheaply than they can buy them from outside. The difference between costs of
manufacturing and cost of bought in goods is a factory profit, or profit on
manufacturing and increases the profits of the firm. The difference between the
manufacturing profit and Gross profit on trading is important and the two must be
kept separate until they are aggregated in the profit and loss account. If cost of
production exceeds the cost of similar bought in goods, a factory loss results.

Treatment of profits / losses on manufacture

In manufacturing account:
Add factory profit to cost of production
Deduct factory loss from cost of production

In profit and loss account:

Add factory profit to net profit on trading
Deduct factory loss from net profit on trading

Elimination of unrealized manufacturing profit from unsold stocks of finished

goods:
The Prudence Concept requires that profit shall not be anticipated before it is
realized. If the valuation of closing inventory (stock) of finished goods includes an
element of factory profit, this unrealized profit must be eliminated in the profit and
loss account and balance sheet by making an appropriate provision.

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AL WADI INTERNATIONAL SCHOOL ACCOUNTING GRADE-12 NOTES

The entries to be made for the annual adjustment to the provision are as
follows:

Increase in provision:
Debit profit and loss account
Credit provision for Unrealised profit account with the amount of the increase

Decrease in provision:
Debit provision for Unrealised profit account
Credit profit and loss account with the amount of the decrease

In balance sheet : deduct provision from stock of finished goods

Provision for Unrealised Profit Account

$ $
Balance c/d xxxx Balance b/d xxxx
(balancing figure) (opening balance)
Profit & Loss A/C xxxx
(increase in provision)
xxxx xxxx
Balance b/d xxxx

Balance sheet extract :

Statement of financial position (extract) as at 31.12.07

$000 $000
Current Assets:

Inventory(Stocks)-Direct materials xxx

Work-in-progress xxxx
Finished goods xxxx
(-) Provision for Unrealised Profit (xxx) xxx

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AL WADI INTERNATIONAL SCHOOL ACCOUNTING GRADE-12 NOTES

Provision for unrealized profit

If finished goods are transferred from manufacturing at a value which exceeds

production cost, the transfer value of the closing inventory of finished goods will include
an element of unrealized profit. This unrealized profit must be eliminated from the profit
and loss account and the stock of finished goods must be shown in the balance sheet at
cost value. The usual procedure for dealing with this situation is as follows:

(a) The opening and closing inventory of finished goods are shown in the trading
account at transfer value.
(b) The closing inventory of finished goods is shown in the balance sheet at transfer
value, less a provision for unrealized profit. The amount of this provision is equal
to the amount of manufacturing profit included in the transfer value of the
inventory.
(c) When a provision for unrealized profit is first established, the amount of the
provision is debited to the profit and loss account. In subsequent accounting
periods, only the increase or decrease in the provision is debited or credited to
the profit and loss account. The accounting treatment of a provision for
unrealized profit is very similar to that of a provision for doubtful debts.

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AL WADI INTERNATIONAL SCHOOL ACCOUNTING GRADE-12 NOTES

Worked Example:

The following balances have been extracted from Makeit & Co.’s trial balance at 31
December 2004.
$000 $000
Inventory (Stock) at 1 January 2004:
Direct materials 10
Work in progress 38
Finished goods 40

Purchases (direct materials) 140

Carriage inwards 24
Direct wages 222
Direct expenses (patent royalties) 46
Indirect materials 45
Indirect labour 72
Rent: Factory 100
Offices 90
Heating, lighting and power: Factory 45
Offices 35
Sales 1 300
Administration salaries and wages 175

Further information:

1. Inventory (stock) at 31 December 2004 was as follows.

$000
Direct materials 18
Work in progress 20
Finished goods 60

2. Depreciation is to be provided on fixed assets as follows.

$000
Factory building 20
Factory machinery 36
Office equipment 24

3. Factory profit is to be calculated at 15% on cost of production.

Required:

Prepare the Manufacturing, Trading and Profit and Loss Account for the year ended 31
December 2004.

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AL WADI INTERNATIONAL SCHOOL ACCOUNTING GRADE-12 NOTES

Answer:
Makeit & Co
Manufacturing, Trading and Profit and Loss Account
For the year ended 31 December 2004
$000 $000
Direct materials Inventory (stock) at 1 January 2004 10
Purchases 140
Carriage inwards 24
174
Less stock at 31 December 2004 (18) 156
Direct labour 222
Direct expenses 46
Prime cost 424
Indirect materials 45
Indirect labour 72
Rent of factory 100
Heating, lighting and power 45
Depreciation: factory 20
Machinery 36 318
742
Work in progress 1 January 2004 38
Work in progress 31 December 2004 (20) 18
Factory cost of finished goods 760
Factory profit (15%) 114
Transferred to Trading Account 874
Sales 1 300
Cost of sales
Inventory (Stock) of finished goods at 1 January 2004 40
Transferred from factory 874
914
Inventory (Stock) of finished goods at 31 December 2004 60 854
Gross profit 446
Wages and salaries 173
Rent of office 90
Heating and lighting 35
Depreciation of office equipment 24 322
Net profit on trading 124
Add factory profit 114
Less Unrealised profit on closing stock of finished goods
(60-40)x15/115 3 111
Net profit 235

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AL WADI INTERNATIONAL SCHOOL ACCOUNTING GRADE-12 NOTES

Statement of Financial Position (Balance sheet) extract :

Balance Sheet (extract) as at 31.12.2004

$000 $000
Current Assets:

Inventory(Stocks)-Direct materials 18
Work-in-progress 20
Finished goods 60
(-) Provision for Unrealised Profit (8) 90

SUMMARY:

 The function of a manufacturing account is to calculate the production cost of

completed goods. The manufacturing account shows both direct and indirect
manufacturing expenses.
 A manufacturing business might transfer finished goods to the trading account at
value exceeding cost. If any such goods remain in stock at the end of an
accounting period, it is necessary to provide for the element of unrealized profit
which is included in their valuation.
 The method of treatment of this provision is very similar to that of the provision
for doubtful debts.
 If factory profit has been added then make sure you add it again at the end of the
profit and loss account - to cancel out of the effect of increasing production cost.
 It is the change in the provision of unrealised profits that will appear in the profit
and loss account!
 The full provision for unrealised profits will be deducted from finished goods on
the balance sheet.

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