Accounting in the Manufacturing Industry

Business

ACCOUNTING IN THE MANUFACTURING INDUSTRIES

What is a standard cost system?

A standard cost system is an accounting method used in manufacturing to establish predetermined costs for producing goods, including materials, labor, and overhead. These costs serve as benchmarks against which the actual costs incurred during production are compared. Using a standard cost system improves cost control, facilitates planning and budgeting, and streamlines performance evaluation.

Key Components of a Standard Cost System

  • Standard Direct Material Cost
  • Standard Direct Labor Cost
  • Standard Manufacturing Overhead

Application of Standard Costing in Manufacturing

  1. Setting Standards: In the initial phase, companies set standard costs based on historical data, market analysis, or engineering estimates. These standards are meant to reflect the most efficient operating conditions.
  2. Recording Transactions: During production, actual costs (materials, labor, and overhead) are recorded separately from standard costs. This allows for comparison and analysis at the end of the period.
  3. Variance Analysis: Variances arise when there are differences between the standard and actual costs. These variances are analyzed to determine the causes and make operational adjustments:
  • Material Price Variance
  • Material Usage Variance
  • Labor Rate Variance
  • Labor Efficiency Variance
  • Overhead Variances
  1. Corrective Actions: Based on variance analysis, management can take steps to control costs more effectively. For example, if labor efficiency variance is unfavorable, they might investigate inefficiencies in the production process or revise labor standards.
  2. Performance Evaluation: Managers use the variances to evaluate the performance of different departments, teams, or individual employees, helping to incentivize efficiency and cost savings.

HOW TO MANAGE AND ACCOUNT FOR RAW MATERIAL, WORK IN PROGRESS AND FINISHED INVENTORY

  1. Raw Material Inventory: This includes all the materials that are purchased but not yet used in the production process.

Management of Raw Material Inventory

  • Inventory Control Systems : Manufacturing companies often use inventory management systems like Enterprise Resource Planning (ERP) or Material Requirement Planning (MRP) systems to track the quantity of raw materials in stock, automate reordering, and prevent overstocking or stockouts.
  • Just-In-Time (JIT) Inventory : Some manufacturers use JIT to reduce holding costs, only purchasing raw materials when needed for production.

Accounting for Raw Material Inventory:

  • Initial Recording : Raw materials are recorded at their purchase cost, including freight, taxes, and any handling charges. These are entered as assets on the balance sheet under the "Inventory" account.
  • Inventory Valuation Methods: Common methods used for raw materials include:

      First-In, First-Out (FIFO)

      Last-In, First-Out (LIFO)

      Weighted Average Cost

              Journal Entry Example for Purchase of Raw Materials:

Debit: Raw Material Inventory

Credit: Accounts Payable (or Cash)

  1. Work-in-Progress (WIP) Inventory: WIP includes partially completed products that are still in the production process.

Management of WIP Inventory

  • Production Tracking : WIP is tracked through different stages of production using tools like job order costing or process costing systems.
  • Job Order Costing: Costs are assigned to specific production batches or jobs.
  • Process Costing: Costs are assigned to production processes in continuous manufacturing environments.

Accounting for WIP Inventory

  • Cost Allocation
  • Direct Materials
  • Direct Labor
  • Manufacturing Overhead

Journal Entry Example for Moving Costs to WIP:

Debit: Work-in-Progress Inventory

Credit: Raw Materials Inventory (for materials used)

Credit: Wages Payable (for direct labor)

Credit: Manufacturing Overhead (for allocated overhead costs)

  1. Finished Goods Inventory: Finished goods include completed products that are ready for sale but not yet sold.

    Management of Finished Goods Inventory:

  • Storage and Warehousing
  • Demand Planning : Finished goods inventory levels are managed based on sales forecasts to avoid overproduction or stockouts.
  • Inventory Turnover : Monitoring the turnover ratio helps manufacturers understand how quickly finished goods are sold and replenished.

   Accounting for Finished Goods Inventory

  • Cost of Goods Manufactured (COGM): Once production is complete, the accumulated costs in WIP (direct materials, labor, and overhead) are transferred to the finished goods inventory.
  • Cost of Goods Sold (COGS): When finished goods are sold, their costs are transferred from finished goods inventory to COGS on the income statement, reducing inventory on the balance sheet.

Journal Entry Example for Transferring to Finished Goods

Debit: Finished Goods Inventory

Credit: Work-in-Progress Inventory (for the total cost of completed goods)

Journal Entry Example for Recording COGS Upon Sale

Debit: Cost of Goods Sold (COGS)

Credit: Finished Goods Inventory

Handling spoilage and defective products in manufacturing accounting is essential for maintaining accurate cost records and properly reporting financial performance. Spoilage refers to materials or products that are unusable or do not meet quality standards, while defective products are items that can be reworked or repaired.

  • Normal Spoilage : refers to the expected or unavoidable waste or loss of materials that occurs during a manufacturing process, even when operations are carried out efficiently under normal conditions. It is considered a natural part of production and is often factored into the overall cost of goods. Included in the cost of production and allocated across good units.
  • Abnormal Spoilage : refers to the waste or loss of materials, products, or resources that occurs unexpectedly and exceeds the normal, anticipated level of spoilage in a manufacturing process. Unlike normal spoilage, abnormal spoilage is considered avoidable and typically results from inefficiencies, errors, accidents, equipment malfunctions, or unforeseen events. Treated as a loss and recorded separately to highlight inefficiencies.
  • Defective Products : refer to items that do not meet a company's required quality standards or specifications. These products contain faults, flaws, or imperfections that make them unsuitable for sale or use in their intended form. Defective products can arise from various stages of production, including design, manufacturing, or handling processes. If normal, rework costs are added to production costs; if abnormal, rework costs are recorded as a loss.

Cost of Goods Manufactured (COGM):

  COGM represents the total cost incurred to manufacture products during a specific period. It includes direct materials, direct labor, and manufacturing overhead costs.

The formula for COGM:

COGM=Total Manufacturing Costs + Beginning WIP Inventory − Ending WIP Inventory\text

Where:

Total Manufacturing Costs = Direct Materials Used + Direct Labor + Manufacturing Overhead

Cost of Goods Sold (COGS):

COGS represents the cost of the finished goods that were sold during the period. It includes the cost of goods manufactured and adjustments for finished goods inventory.

The formula for COGS:

COGS=Beginning Finished Goods Inventory + COGM − Ending Finished Goods

Where:

  • Beginning Finished Goods Inventory: The value of the inventory of finished goods at the start of the period.
  • Ending Finished Goods Inventory: The value of the inventory of finished goods at the end of the period.
  • COGM: The total cost of goods manufactured during the period (calculated above).