Manufacturing Businesses

A manufacturing account is an accounting statement prepared by manufacturing businesses to determine the total cost of goods produced during an accounting period. It is prepared before the statement of profit or loss and acts as a detailed working to calculate one key figure: the production cost of finished goods. This figure then replaces 'Purchases' in the trading section of the statement of profit or loss.

The manufacturing account is structured to build up the cost in logical stages. It starts with direct costs (Prime Cost), adds indirect factory costs (Factory Overheads), and finally adjusts for goods that are only partially completed (Work in Progress).

Manufacturing Account for the year ended [date]

Distinguishing between direct and indirect costs is fundamental to manufacturing accounting. Prime Cost is the total of all costs that can be directly traced to the units being produced. It represents the core expenditure on the product itself.

Prime Cost = Direct Materials Consumed + Direct Labour + Direct Expenses

Factory Overheads (also known as indirect manufacturing costs) are all other costs incurred in the factory that are necessary for production but cannot be directly traced to a single unit. Examples include the factory manager's salary, rent for the factory building, and depreciation of machinery.

Some businesses choose to treat their manufacturing department as a separate 'profit centre'. To do this, they transfer the finished goods from the factory to the sales department at a price that includes a profit. This is known as the transfer price, and the profit element is the factory profit or manufacturing profit.

Transfer Price = Production Cost of Finished Goods + Factory Profit

Why would a business do this? There are several reasons:

1. Performance Evaluation: It allows the business to assess the efficiency and profitability of the manufacturing operation separately from the sales operation.
2. Comparison: The transfer price can be compared with the price of buying the same goods from an external supplier, helping management make informed sourcing decisions.
3. Motivation: It can motivate the factory manager to control costs and improve efficiency, as their department's 'profit' is being measured.

This is a critical concept. When goods are transferred at a profit, but some of these goods remain in closing inventory at the end of the year, the profit included in their value is 'unrealised'. According to the prudence concept, we cannot recognise profit until goods are sold to an external customer. Therefore, we must remove this unrealised profit from our accounts.

This is done by creating a Provision for Unrealised Profit (PUP). This provision reduces the value of closing inventory in the Statement of Financial Position and also reduces the overall profit in the Statement of Profit or Loss. It ensures that inventory is valued at the lower of cost or net realisable value from the business's perspective.

PUP = Value of Closing Inventory of Finished Goods (at transfer price) × Profit Margin

The figure for 'Production cost of finished goods' (or 'Transfer Price' if factory profit is included) from the manufacturing account replaces 'Purchases' in the cost of sales calculation. The factory profit itself is added to the gross profit, and then the adjustment for the change in PUP is made.

Adjusted gross profit calculation

The key difference for a manufacturer appears in the Current Assets section under 'Inventories'. Instead of just one inventory figure, there will be three: Raw Materials, Work in Progress, and Finished Goods. The Finished Goods inventory must be shown at its cost to the business, which is the transfer price less the Provision for Unrealised Profit.