CHAPTER FOUR

ACCOUNTING CYCLE FOR MANUFACTURING BUSINESS

1. Introduction to manufacturing and non-manufacturing costs

A manufacturing company incurs both manufacturing costs (also called product costs) and
nonmanufacturing costs or expenses (also called selling and administrative expenses). In the
illustration below you can see the difference between manufacturing and nonmanufacturing costs
and their classification:

Illustration 1: Manufacturing vs. nonmanufacturing costs

2. Manufacturing costs and their classification

Manufacturing costs are the costs that a company incurs in producing a product.

1. Direct materials
2. Direct labor
3. Factory (or manufacturing) overhead

2.1. Direct materials as a type of manufacturing costs

Direct materials are raw materials that become an integral part of the finished goods.

Direct materials should be distinguished from indirect materials (part of overhead costs), Direct
materials always have a variable nature. Direct labor as a type of manufacturing costs
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Almost any production plant or factory requires employees to operate equipment, move raw
materials from the warehouse to equipment, and so on. These employees are directly involved in
the production process and the cost of their remuneration and benefits represents direct labor:

Direct labor is the cost of wages to be paid to individuals who work on specific products or in
other words, the cost of wages of employees who are directly involved in converting raw
materials into finished goods.

Usually direct labor is a variable cost. In most situations the amount of direct labor required is
directly correlated with the amount of finished goods produced.

Direct materials and direct labor, when added together, represent the prime cost. Direct
materials and direct labor are called prime costs because they are directly (physically,
"primarily") associated with the finished goods production.

2.3. Factory overhead as a type of manufacturing costs

Factory overhead is any manufacturing cost that is not direct materials or direct labor.

Factory overhead can have variable or fixed nature, depending on whether overhead changes in
direct proportion with production volumes. The following are some examples of factory
overhead costs:

Illustration 2: Examples of fixed and variable factory overhead costs

Variable Factory Overhead Fixed Factory Overhead

Examples Examples
 Electricity  Depreciation
 Heating  Property taxes
 Water  Property insurance
 Indirect Materials  Salaries for non-
 Indirect Labor production employees

Most items in the table above are self-explanatory, so they don't require further explanation,
while indirect materials and labor may benefit from further explication.

Indirect materials are materials that are (a) not an integral (physical) part of the finished goods,
or (b) a minor part of the finished goods to be economically traced to the finished good or have a
very small physical association with the finished product.

Indirect labor is the cost of production employees who are involved in the manufacturing
process, but do not work on a specific product. For example, wages of custodians, maintenance
people, supplies room supervisors, etc. are considered indirect labor.

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Direct labor and factory overhead, when added together, represent the conversion cost. Direct
labor and factory overhead are called conversion costs because they are involved in converting
raw materials into finished goods.

Illustration 3: Inventory at different manufacturing stages

When materials (both direct and indirect) are purchased, they are recorded in the Raw Materials
Inventory account. For example, during March 20X9 Friends Company purchased $2,000 of
paint, $7,000 of plastic and metal parts, and $500 of light bulbs on account ($2,000 + $ 7,000 +
$500 = $9,500). The journal entry to record the purchase is as follows:

1) Purchase of raw materials:

Account Titles Debit Credit

Raw Materials Inventory 9,500
Accounts Payable 9,500

Going back to our Friends Company example, assume that in March 20X9 the company used
$1,000 of paint and $4,000 of plastic and metal parts for a total of $5,000.

The journal entry to record this inventory consumption is posted as follows:

2) Use of direct raw materials in production:

Account Titles Debit Credit

Work-in-Process Inventory 5,000
Raw Materials Inventory 5,000

For example, during March 20X9 Friends Company finished producing valves with the
manufacturing cost of $8,600 and posted the following the journal entry to transfer these costs to
the Finished Goods Inventory account:

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3) Transfer finished goods from work-in-process:

Account Titles Debit Credit

Finished Goods Inventory 8,600
Work-in-Process Inventory 8,600

To continue our example, let's assume that during March 20X9 Friends Company sold on account
valves costing $7,900, and the sales price were $15,000. The $7,900 represents the Cost of Goods
Sold (COGS). The journal entry to record the cost of goods sold is presented below

4) Record cost of goods sold:

Account Titles Debit Credit

Cost of Goods Sold (COGS) 7,900
Finished Goods Inventory 7,900

5) Record sales revenue:

Account Titles Debit Credit

Accounts Receivable 15,000
Sales Revenue 15,000

4.8. Cost of goods manufactured and cost of goods sold

As we noted earlier, when finished goods are sold, their cost is called the cost of goods sold
(COGS). The cost of goods sold is based on the cost of goods manufactured (COGM).

Refer to the illustrations below showing how COGS and COGM are determined:

Illustration 4: Formula for cost of goods manufactured (COGM)

(+) Beginning Balance of WIP

Inventory
(+) Direct Materials
(+) Direct Labor
(+) Factory Overhead
(–) Ending Balance of WIP Inventory
(=) Cost of Goods Manufactured

Illustration 18: Formula for cost of goods sold (COGS)

(+) Beginning Balance of FG

Inventory
(+) Cost of Goods Manufactured
(–) Ending Balance of FG Inventory
(=) Cost of Goods Sold

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