POA SECTION 10

PART 1 Accounting for Manufacturing Organisations

What is the Manufacturing Process?

In the business world, some organisations choose to make/produce the product to sell instead of
buying the product from a supplier. These business entities are called Manufacturing
Organisations. The good that they create to sell goes through what is known as a Manufacturing
Process. A Manufacturing Process shows the steps or stages raw materials go through to be
transformed into finished products. In this Section, we will be learning how to take account of
the COSTS OR EXPENSES of the Manufacturing process at the end of an accounting period.
This accounting process aims to calculate the Production Cost of the Goods Manufactured
OR Cost of Production in the accounting period.

The Manufacturing Process is split into the following three Sections:

1. Prime cost or Direct cost (Variable Cost)
2. Overhead cost or Indirect cost (Fixed Cost)
3. Work in progress

Prime cost
Also known as Direct Costs or Variable Costs, these are costs directly related to the
manufacturing of the product's units.
The prime cost covers all the costs involved in physically making the products and other costs
that are directly related to the level of output. They are essential in the manufacturing of the
product.

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 POA SECTION 10
The three elements that comprise direct manufacturing cost are as follows:

● Direct Raw Materials – material, resources or ingredients directly associated with the
making of each unit of product.
● Direct labour – the workers that manufacture the products (A stitcher in a clothing
factory, a chef in a restaurant)
● Other direct costs (Patents, royalties, license)

Royalties
Royalties are included within the prime cost. These are costs paid to the owner of a copyrighted
process. Usually, a fee is paid for each product that uses this process, and therefore, the total
royalty cost will be directly proportional to the level of output. For example, Coca-Cola cannot
be bottled locally without payment of these fees.

FORMULA
Calculating Prime Cost = Cost of Direct Materials consumed + Direct Labour + Direct Expenses

$ $
Opening Stock of Direct Materials (Raw materials at the start) xxx
ADD: Purchases of Direct Materials (Raw Materials bought) xxx
ADD Carriage Inwards of Direct Materials (Transportation Cost of Raw Materials xxx
bought)
LESS Return Outwards of Direct Materials (xxx)
Cost of Direct Materials Available for use (Total Raw Materials readily accessible xxx
for production)
LESS Closing Stock of Direct Materials (Raw Materials not used in production) (xxx)
Cost of Direct Materials Consumed (Raw Actually used in production) xxx
ADD Direct Labour (Factory Wages) xxx
ADD Direct Expenses (Patents, Royalties) xxx
PRIME COST XXX

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Factory Overhead costs

Also known as Indirect cost. These are costs incurred in manufacturing a product, but they are
not specific or directly related to each product. This means that it cannot be directly traced to
making the products. This section includes all other expenses concerned with the production of
output but not in a direct manner. This means that if the level of production increases, then these
expenses may also increase but not by the same proportion. These are sometimes known as
indirect costs, factory overheads or indirect manufacturing costs. Common examples of overhead
costs would include:
● Factory rent.
● Indirect labour (Supervisor pay, Cleaners Pay, Forklift worker pay)
● Depreciation of factory plant and equipment
● Indirect materials
● Electricity (related to the Factory)
● Insurance for the Factory

Calculating Total Overhead Cost

$ $
Factory Overheads
Indirect Materials xxx
Indirect Labour (Supervisor, cleaner, forklift driver) LIST OUT INDIVIDUALLY xxx
Indirect Expenses (Percentage that belongs to the Factory) LIST OUT INDIVIDUALLY xxx
Depreciation on Factory machines and equipment LIST OUT INDIVIDUALLY xxx
Total Factory Overheads XXX

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NOTE WELL

Total Factory Overhead Cost (Indirect Costs) is added to Prime Cost to get TOTAL
MANUFACTURING COST.

$ $
PRIME COST Variable Cost XXX

ADD Factory Overheads

Indirect Materials xxx ADD
Indirect Labour (Supervisor, cleaner, forklift driver) xxx
Indirect Expenses (Percentage that belongs to the Factory ) xxx
Depreciation on Factory machines and equipment xxx
Total Factory Overheads Fixed Cost XXX
Total Manufacturing Cost Total Cost XXX

Total Manufacturing Cost differs from the Cost of Goods Manufactured or Produced during the
accounting period. This is because some goods started during the accounting period will only
partially finish or be completed by the end of the period. In addition, some partially completed
goods will be brought forward from the previous accounting period to be completed in this
accounting period. These are considered Work in Progress.

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 POA SECTION 10
Work-in-progress.
These are partly completed goods (unfinished goods) that were started during the manufacturing
accounting period but not yet completed at the end. Opening Work in Progress is added to Total
Manufacturing Costs, and Closing Work in Progress is subtracted from Total Manufacturing
Costs. This result will be the Production Cost of the Goods Manufactured.

$ $
Total Manufacturing Cost XXX
Add Opening Work in Progress xxx
xxx
LESS Closing Work in Progress (xxx)
Cost of Production OR Production Cost of goods XXX
manufactured

NB: The Cost of Production is transferred into the Income Statement. It is ADDED to Opening
stock (of Finished Goods) to obtain the Cost of Goods Available for Sale.

There are three types of Stock (inventory) in a Manufacturing Organisation.

1. Direct Material Inventory – Raw material or ingredients (Manufacturing Account)

2. Work in progress Inventory – Unfinished/incomplete goods (Manufacturing Account)
3. Finished Goods Inventory – Completed goods (Income Statement)

Finding the Cost of Production per unit

The following formula is used to calculate the production cost for each unit of the goods that is
manufactured.

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛

Cost of Production per unit = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑈𝑛𝑖𝑡𝑠 𝑃𝑟𝑜𝑑𝑢𝑐𝑒𝑑

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Format for the Manufacturing Account

Name of the Business

Manufacturing Account for the year ended (Day Month Year)
$ $
Opening Stock of Direct Materials xxx
ADD: Purchases of Direct Materials xxx
ADD Carriage Inwards of Direct Materials xxx
Cost of Direct Materials Available for use xxx
LESS Closing Stock of Direct Materials (xxx)
Cost of Direct Materials Consumed xxx

ADD Direct Labour (Factory Wages) xxx

ADD Direct Expenses (Patents, Royalties) xxx
PRIME COST XXX

ADD Factory Overheads

Indirect Materials xxx
Indirect Labour (Supervisor, cleaner, forklift driver) xxx
Indirect Expenses (Percentage that belongs to the Factory) xxx
Depreciation on Factory machines and equipment xxx
Total Factory Overheads XXX
Total Manufacturing Cost XXX

Add Opening Work in Progress xxx

xxx
LESS Closing Work in Progress (xxx)
Cost of goods manufactured/ total cost of production c/d XXX

The Income Statement and the Balance Sheet of the Manufacturing

Organisation
The Income Statement (Trading, Profit and Loss Account) for a Manufacturing Organisation is
the same as that of a Sole Proprietorship. However, since it is an organisation that produces its
products and does not purchase them for resale, there is no need to calculate NET purchases. The
Computation for net purchases will be replaced with the Cost of Production. The Balance Sheet
is also the same. However, since the Manufacturing Organisation has three (3) categories of
stock, ALL three will be accounted for in the Current Assets Section.

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Name of the Business

Income Statement for the year ending (Date, Month and Year)

$ $ $
Sales Revenue xxx
LESS Sales Returns (Return Inwards) (xxx)
Net Sales xxx
LESS Cost of Goods Sold:
Opening Stock of Finished goods xxx
ADD Cost of Production xxx
Cost of goods available for sale xxx
LESS Closing Stock of Finished Goods (xxx)
Cost of Goods sold (xxx)
Gross Profit xxx
ADD: Discounts Received xxx
Rent Received xxx
Bad Debts Recovered xxx
Decrease in Provisions for Doubtful debts xxx
Commissions Received xxx
Donations Received xxx
xxx
LESS Expenses:
Discounts Allowed xxx
Rent Expenses xxx
Repairs xxx
Bad Debts xxx
Increase in Provisions for doubtful debts xxx
Depreciation xxx
Wages and Salaries xxx
Interest Expense xxx
Commissions Paid xxx
Stationery used xxx
Fuel/petrol/gas xxx
Miscellaneous xxx
Carriage outwards xxx
General Expenses xxx
Total Expenses (xxx)
NET PROFIT/NET LOSS XXX

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Name of the Business

Balance Sheet as at (Date Month and Year)

$ $ $
Cost Accumulated NBV
Depreciation
FIXED ASSETS
Land xxx
Building or Premises xxx
Equipment and Machinery xxx (xxx) xxx
Motor vehicles xxx (xxx) xxx
TOTAL FIXED ASSETS xxx

CURRENT ASSETS
Stock or Inventory
Raw Materials xxx
Work in progress xxx
Finished Goods xxx
Total Inventory xxx
Debtors or Accounts Receivable xxx
Less Provisions for Doubtful Debts (xxx)
Net Debtors xxx
Bank xxx
Cash xxx
Stationery xxx
Prepaid Expenses xxx
Accrued Revenues xxx
TOTAL CURRENT ASSETS xxx

LESS CURRENT LIABILITIES

Creditors or Accounts payable xxx
Bank Overdraft xxx
Prepaid Revenues xxx
Accrued Expenses xxx
TOTAL CURRENT LIABILITIES (xxx)
Working Capital xxx
Capital Employed XXX
Financed by
Opening CAPITAL xxx
ADD Net profit xxx
LESS Drawings (xxx)
Closing Capital xxx
LONG TERM LIABILITIES
Mortgage/long-term loan, Bank loan xxx
XXX

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 POA SECTION 10

PART 2 Cost Principles

What is Costing?
This is the process of estimating all costs involved in production and calculating the total cost of
production or the total cost of running the business.

Why is Costing Important?

◍ Operations Managers will know precisely how much it costs to produce units of output.
◍ Assist in identifying when cost savings can be made.
◍ Used for decision-making purposes. (Pricing decisions, Make or buy decisions, Sell or
process further decisions)

Cost Plus pricing

According to an article written by Steven Bragg (2017), “Cost plus pricing is a cost-based
method for setting the prices of goods and services.”
In this method, we calculate the total cost of producing a single unit of the good or service and
add an additional amount called a markup to create a profit margin. This markup can be an
amount given or a percentage of the total unit cost of production.

CP = $400 Profit 50% ($200) SP (400 + 200) $600

Selling Price – Cost Price = Profit ( Mark up)

Advantages Disadvantages
◍ Easy to calculate. ◍ Does not take competition into
◍ Profits are assured account.
◍ May miss profits

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Mark up Pricing

Figure 1: Scan me

Advantages Disadvantages
◍ Enables vendors to calculate profits easily. ◍ Does not take competition into
account.
◍ Requires little information as information on demand
and costs might not always be available. ◍ Provides incentive for inefficiency.

◍ Reduces the cost of decision-making. ◍ Includes sunk costs rather than just
using incremental costs.
◍ Provides how fair prices can be easily found

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Absorption Costing
AKA Total Costing or Full Costing

This is a process that uses Fixed and Variable costs to calculate cost units. In other words, it
absorbs all costs associated with producing a product, whether direct or indirect.

Total Cost = Variable Cost + Fixed Cost OR

Total Cost = Direct Cost + Indirect Cost OR
Total Cost = Prime Cost + Factory Overheads

Points to note:

1. Variable Costs/Direct Costs/Prime Costs

⮚ Costs that change with changes in the level of output produced.
⮚ It is straightforward to trace these Cost items to a unit of product/output in the
production process because they are directly associated with a cost unit.

2. Fixed Costs/Indirect Costs/ Factory Overheads

⮚ Costs that do not change regardless of the level of output produced.
⮚ As these costs do not change (remain constant in total) with the level of output
produced, it is difficult to trace, associate, or assign an amount to a cost unit.

Advantages of Absorption Costing Disadvantages of Absorption Costing

◍ Accounts for all production costs
◍ Absorption costing also provides a
company with a more accurate picture
of profitability
◍ Not Useful for Comparison of Product
Lines
◍ Absorption costing does not help with
Operational efficiency as it fails to
provide as good an analysis of cost
and volume, especially if fixed costs
account for a large part of the cost of
production

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Definition of Terms
(Randal et al., 2012, p.242)

Term Meaning
Absorption This is the addition of (Factory) Overheads to Prime Cost to arrive at the
Cost of Production.
Cost Units One unit of production or output
Cost Centres An Entity to which cost can be attributed (assigned)
Allocation The distribution of cost-to-cost centres when the costs are not traceable to
these entities.
Apportionment The distribution of cost-to-cost centres when the costs were undertaken for
the benefit of the business as a whole

Bases of Cost Apportionment

Since allocating indirect cost /Factory overheads to a cost unit is challenging, they are
apportioned using an Overhead Absorption Rate (OAR). According to Randal et al. (2012), OAR
is “… a predetermined value of overhead in a cost centre that is added to Variable Cost to arrive
at Total Cost per unit of output produced.” This means that OAR is a per-unit overhead rate
assigned to a cost unit, making it easier to calculate the Total Cost per unit under Absorption
Costing.

𝑃𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑 𝑇𝑜𝑡𝑎𝑙 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡

Formula to Calculate OAR = 𝐵𝐴𝑆𝐸 𝑓𝑜𝑟 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐴𝑏𝑠𝑜𝑟𝑏𝑡𝑖𝑜𝑛

BASES (usually used in for CSEC) When it can be used

Machine Hours If Production is Capital Intensive
Labour Hours If Production is labour-intensive

Other Bases

⮚ Direct Material Cost

⮚ Direct Wages
⮚ Cost Units

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 POA SECTION 10
Let us calculate the Total cost per unit.

Haganezka Sword Factory creates the best katanas for Demon Slayers all
over the world. On January 22nd 2022, a job order came in to recreate a
sword for Tanjiro. The following information was taken from the books of
Haganezka Sword Factory.
Variable Cost per unit $800 Total Labour hours: 2000 hours
Total Overhead Cost $440 000 Total Machine hours 250 hours

Overhead is apportioned to Total Cost using Labour hours. Haganezka Sword Factory uses three
(3) labour hours to produce one katana.

Workings
Step 1 – Calculate OAR
𝑃𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑 𝑇𝑜𝑡𝑎𝑙 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑐𝑜𝑠𝑡
OAR = 𝐵𝐴𝑆𝐸 𝑓𝑜𝑟 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝐴𝑏𝑠𝑜𝑟𝑏𝑡𝑖𝑜𝑛
$440 000
= = $220 per labour hour
2000 ℎ𝑜𝑢𝑟𝑠

Step 2 – Calculate Overhead Cost per unit

Overhead Cost per unit = $220 x 3 hours = $660

Step 3 – Calculate Total Cost per unit

Total cost per unit = Variable Cost per unit + Fixed Cost (Overhead Cost) per unit
Total cost per unit = $800 + $660 = $1460 per unit

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Part 3 Inventory Valuation

Importance of Inventory Valuation.

⮚ Determine the value of Current assets by determining the value of Closing Stock.
⮚ Determine the value of the cost of goods sold, gross profit and net profit. (By extension)
⮚ Incorrect stock value affects the value of current assets, current year’s profit, and profit of the
subsequent years.

Methods of Inventory Valuation

There are three methods for evaluating stock.

1. First in First out (FIFO)
2. Last in First out (LIFO)
3. Average Cost (AVCO)

IAS and CA 2006 do not accept LIFO as an allowable valuation method.

1. FIFO
This method assumes that the oldest stock on hand will be sold first. It is commonly used with
perishables and goods with a short shelf life.
2. LIFO
This assumes that the most recent stock on hand will be sold first. Mass-produced items that are
identical in nature (pencils and rulers) can be valued in this way.
3. AVCO
The objective of the AVCO method is to arrive at an average cost price based on all of the
purchases. Each time stock is purchased, a new average is calculated. Stock is sold is issued at the
last calculated average price.

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Name of Business
Stock Valuation Card

Date Purchases IN Sales OUT Balance

Units Cost $ Value $ Units Cost $ Value $ Units Cost $ Value $
Year
Month Day

Perpetual process – after every transaction, a NEW balance is found.

The first balance represents your Opening Stock, and the Last Balance represents your Closing
Stock.

Points to note

● When recording the balance after purchasing, record the PREVIOUS BALANCE FIRST,
then record the amount purchased. It helps you to separate old stock from new stock.
● The selling price is NOT recorded on a stock card!!! The stock card records ONLY
COST PRICE! Use the method of valuation to figure out the cost price of the goods that
were sold.
● Selling price will be used to calculate total sales in the income statement (trading
account)

Preparing the Income Statement (Trading Section using information from the
stock card)
Name of Business
Trading Account for the year ending (Day, Month, Year)
$ $
Sales (Total units sold X Selling price) XXX
Less Cost of Sales:
Opening Stock (opening units X Cost price) XXX
Add Purchases (Total Purchased X Cost price) XXX
Less Closing Stock (Last Balance Value calculated from the (XXX)
valuation method used)
Cost of Goods Sold (XXX)
Gross Profit XXX

⮚ FIFO gives the highest profit (High-value closing stock)

⮚ LIFO gives the lowest profit (Low-Value closing stock)
⮚ AVCO gives a profit between FIFO and LIFO. (Average value of closing stock)
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