Chapter Four

Accounting for manufacturing business

Nature of manufacturing business:

A manufacturing business purchase raw materials, converts them into finished goods and sells them to
customers (wholesalers, retailers, end users). Examples include sugar factories, wood work companies,
cement factories, textile factories, paper and pulp processing firms, food complex factories. In
manufacturing firms the activities involved and the investment required are usually complex and extended
than the other types of business organizations.

Sound cost accounting system is critically important in a manufacturing business to compute cost of
finished goods manufactured during the period. Correct cost computation is important for both internal
decision making such as departmental evaluation and product pricing as well as external reporting
purposes.

Inventory accounts in manufacturing organizations

Transforming materials into finished products ready for sale requires a number of production and
production related activities. A manufacturing organization’s accounting system tracks these
activities as product costs flowing through the Materials Inventory, Work in Process Inventory,
and Finished Goods Inventory accounts.

 The Materials Inventory account shows the balance of the cost of unused materials.
 The Work in Process Inventory account shows the manufacturing costs that have been
incurred and assigned to partially completed units of product.
 The Finished Goods Inventory account shows the costs assigned to all completed products
that have not been sold.

Manufacturing Costs

The cost of a manufactured product includes the cost of materials used in making the product, as well as
the costs incurred in converting the materials into a finished product. For example, Legend Guitars uses
employees, machines, and other inputs to convert wood and other materials into the finished product,
guitars. The finished guitars the cost object, and the cost of the finished guitars includes direct materials
cost, direct labor cost, and factory overhead cost.

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Direct Materials Cost: Manufactured products convert raw materials into finished products. For
example, Legend Guitars uses raw materials such as wood, guitar strings, and guitar bridges and converts
them into a finished guitar. The cost of any material that is an integral part of the final guitar is classified
as a direct materials cost. Other examples of direct materials costs are the cost of electronic components
for a TV manufacturer, lumber for a furniture manufacturer, silicon wafers for a producer of
microcomputer chips, and tires for an automobile manufacturer.
As a practical matter, a direct materials cost must not only be an integral part of the finished product, but it
must also be a significant portion of the total cost of the product. For Legend Guitars, the cost of wood
used in the body and neck is a significant portion of the total cost of each guitar.
Direct Labor Cost: Most manufacturing processes need employees to convert materials into the final
product. For example, Legend Guitars uses employees to assemble guitars by gluing together the neck and
body and installing the guitar bridge and strings. The wages of each employee who is directly involved in
converting materials into the final guitar are classified as a direct labor cost. Other examples of direct
labor costs are carpenters’ wages for a construction contractor, mechanics’ wages in an automotive repair
shop, and machine operators’ wages in a tool manufacturing plant, and assemblers’ wages in a computer
assembly plant.
A direct labor cost must not only be an integral part of the finished product, but it must also be a
significant portion of the total cost of the product. For Legend Guitars, the wages of employees who
operate the saws and cutting machines and assemble the guitars make up a significant portion of the total
cost of each guitar.
Factory Overhead Cost Costs, other than direct materials cost and direct labor cost, that are incurred in
the manufacturing process are combined and classified as factory overhead cost. Factory overhead is
sometimes called manufacturing overhead or factory burden. All factory overhead costs are indirect
costs and include the costs of:
■ Heating and lighting the factory,
■ Repairing and maintaining factory equipment,
■ Property taxes,
■ Insurance, and
■ Depreciation on factory plant and equipment.
Factory overhead cost also includes materials and labor costs that do not enter directly into the finished
product. Examples include the cost of oil used to lubricate machinery and the wages of janitorial and

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supervisory employees. If the costs of direct materials or direct labor are not a significant portion of the
total product cost, these costs may be classified as factory overhead.
In Legend Guitars, the costs of sandpaper, buffing compound, and glue used in the assembly of guitars
enter directly into the manufacture of each guitar. However, because these costs are a small cost of each
guitar, they are classified as factory overhead. Other overhead costs for Legend Guitars would include the
power to run the machines, the depreciation of machines, and the salary of production supervisors
(including the vice president of production).
Product Costs and Period Costs: For financial reporting purposes, costs are often classified as either
product costs or period costs.

Product costs consist of the three elements of manufacturing cost: direct materials, direct labor, and
factory overhead. Period costs are generally classified into two categories: selling and administrative.
Selling expenses are incurred in marketing the product and delivering the sold product to customers.
Administrative expenses are incurred in the administration of the business and are not directly related to
the manufacturing or selling functions.

Product costing system

Cost accounting systems accumulate manufacturing costs for the goods that are produced. This product
cost information is used by managers to establish product prices, control operations, and develop financial
statements. In addition, the cost accounting system improves control by supplying data on the costs
incurred by each manufacturing department or process.
There are two principal types of product costing systems: job order costing and process costing systems.
a. Job costing: provides a separate record for the cost of each quantity of product that passes through
the factory. A particular quantity of product is termed a job. A job order cost system is best suited
to industries that manufacture custom goods to fill special orders from customers or that produce a
wide variety of products for stock. Manufacturers that use a job order cost system are sometimes
called job shops. The total cost of a job is the sum of direct materials, direct labor, and factory
overhead costs recorded in the job cost sheet for that particular job (N.B a job may be a single unit
or a number of units with the same nature. For instance 12 beds ordered by a single hotel may be
considered as one job by a wood work company.
b. Process costing system: Under a process cost system, costs are accumulated for each of the
departments or processes within the factory. A process system is best suited for manufacturers of
units of product that are not distinguishable from each other during a continuous production
process. Examples would be oil refineries, paper producers, chemical processors, aluminum
smelters, and food processors. This system is applicable where similar items are produced in bulk
in almost equal attention.
Manufacturing Business Transactions and Journal Entries
The manufacturing business has a number of unique transactions not found in a merchandising business.
These transactions as a whole all fall into the manufacturing costs category.
Basically, there are three types of manufacturing transactions:
1. Material
2. Factory labor
3. Manufacturing overhead

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The most common of these three types of transactions are the following:
1. Purchase of raw materials
2. Freight on material purchased
3. Material returns and allowances
4. Incurrence of direct factory labor
5. Incurrence of manufacturing overhead

Journal Entries for Basic Manufacturing Transactions

Transaction Journal Entry Debit Credit
1 10,000 units of material X were Material purchases 120,000
purchase for $12 per unit on account Accounts payable 120,000
2 Invoice to be paid on freight received Freight-in - materials 2,000
for material X,$2,000 Accounts payable 2,000
3 Damaged material X returned, $5,000 Accounts payable 5,000
Material returns 5,000
4 Factory workers/incurred/ paid in cash: Factory labor – Direct 200,000
Direct factory workers $200,000 Mfg. overhead Indirect labor 50,000
Indirect factory labor $50,000 cash 250,000
5 Other Manufacturing overhead costs to Manufacturing overhead 13,000
be paid for the month was as follows: Accounts payable 13,000
Factory utilities $5,000 (Factory utilities $5,000
Factory repairs and Repairs and main. $3,000
maintenance $3,000 Factory insurance $4,000
Factory insurance $4,000 Factory supplies $1,000)
Factory supplies $1,000
6 Depreciation on plant & equipment, Mfg. overhead –plant deprec. 2,000
$2,000 Allowance for 2,000
depreciation/Accumulated
depreciation

Financial statements of manufacturing companies

Balance Sheets: Merchandising and Manufacturing Compared

The balance sheet of a manufacturing business in terms of basic elements is identical to the balance sheet of a
merchandising business. The only difference is in one area, the current asset section. Instead of one inventory
account, the manufacturing business has three inventory accounts:

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 Merchandising Business Manufacturing Business
1. Assets 1. Assets
Current assets Current assets
Cash $ 50,000 Cash $ 50,000
Accounts receivable 30,000 Accounts receivable 30,000
Merchandise inventory 65,000 Inventory
Fixed assets $ 55,000 Work in process 25,000
$200,000 Materials 10,000
2. Liabilities Finished goods 30,000
Current liabilities $ 20,000 Fixed assets 55,000
Long-term liabilities 30,000 $200,000
3. Stockholders’ Equity 2. Liabilities
Paid-in capital 30,000 Current liabilities $ 20,000
Retained earnings 120,000 Long-term liabilities 30,000
$200,000 1. Stockholders’ Equity
Paid-in capital 30,000
Retained earnings 120,000
$200,000

Income Statement for a Manufacturing Company

The major difference in the income statements for merchandising and manufacturing businesses is in the
reporting of cost of products sold during the period. A merchandising business purchases merchandise
(products) in a finished state for resale to customers. The cost of products sold is called the cost of
merchandise sold, which we described and illustrated in earlier chapters. A manufacturer makes the
products it sells, using direct materials, direct labor, and factory overhead. The cost of the product sold is
generally called the cost of goods sold. For a manufacturer, the total cost of making and finishing the
product is called the cost of goods manufactured. This is very similar to the cost of merchandise available
for sale in a merchandising business.

The income statement of manufacturing companies is supported by a statement of cost of goods

manufactured, which provides the details of the cost of goods manufactured.

To illustrate the flow of manufacturing costs to the income statement for Legend Guitars, assume the
following data for 2008:
Inventories January 1 December 31
Materials $65,000 $35,000
Work in process 30,000 24,000
Finished goods 60,000 62,500

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Materials purchased during the year $100,000
Direct labor incurred in production 110,000
Factory overhead incurred in production:
Indirect labor $24,000
Depreciation on factory equipment 10,000
Factory supplies and utility costs 10,000
Total 44,000
Selling expenses 20,000

Administrative expenses 15,000

Sales366, 000

The cost of goods manufactured is determined by first computing the cost of direct materials used in the
year as follows:
Materials inventory, January 1, 2008 $ 65,000
Add: Materials purchased during the year 100,000
Cost of materials available for use $165,000
Less: Materials inventory, December 31, 2008 35,000
Cost of direct materials used in production $130,000

The total manufacturing costs incurred during the year of $284,000 is determined as follows:

Direct materials used during the year $130,000

Direct labor 110,000

Factory overhead 44,000

Total manufacturing costs incurred during the year $284,000

To determine the cost of goods manufactured during the year, the beginning work in process inventory of
$30,000 is added to the total manufacturing costs incurred during the year of $284,000 to yield the total
manufacturing costs of $314,000. The ending work in process of $24,000 is then deducted to determine
the cost of goods manufactured during the year as follows:

Work in process inventory, January 1, 2008 $ 30,000

Total manufacturing costs incurred during the year 284,000

Total manufacturing costs $314,000

Less work in process inventory, December 31, 200824,000

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Cost of goods manufactured during the year $290,000

Legend Guitars
Income Statement
For the Year Ended December 31, 2008
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ……………$366,000
Cost of goods sold:
Finished goods inventory, January 1, 2008 . . . . . . . . . . . . . . . . . .60,000
Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . . . . . . .290,000
Cost of finished goods available for sale . . . . . . . . . . . . . . . . . . .350,000
Less finished goods inventory, December 31, 2008 . . . . . . . . . . .62500
Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ……………….$287000
Gross profit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ………………78500
Operating expenses:
Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000
Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .15000
Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . …………………….35000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ……………..$43000

Legend Guitars
Statement of Cost of Goods Manufactured
For the Year Ended December 31, 2008
Work in process inventory, January 1, 2008 . . . . . . . ……………………………..$30,000
Direct materials:
Materials inventory, January 1, 2008 . . . . . . . . . . . $ 65,000
Purchases . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000
Cost of materials available for use……………… $165,000
Less materials inventory, December 31, 2008 . . . . . 35,000
Cost of direct materials used in production. . …………………$130,000
Direct labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …………110,000
Factory overhead:
Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 24,000
Depreciation on factory equipment . . . . . . . . . . ....10,000
Factory supplies and utility costs . . . . . . . . . . . . . . .10,000
Total factory overhead . . . . . . . . . . . . . . . . . . . . ……………………… 44,000
Total manufacturing costs incurred during the year……………………………………
284000
Total manufacturing costs . . . . . . . . . . . . . . . . . . . . . …………………………………$314000
Less work in process inventory, December 31, 2008 24000
Cost of goods manufactured…………………………………………………………...$290,000

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 Adjusting and closing entries for a manufacturing business

End-of-period adjusting and closing entries must be made to record:

1. Transfer of materials inventory balance to cost of goods manufactured
2. Transfer of beginning material purchases to cost of goods manufactured
3. Transfer of materials freight-in to cost of goods manufactured
4. Transfer of manufacturing overhead incurred to cost of goods manufactured
5. Recording of ending balance of material inventory
6. Transfer of cost of goods manufactured account to cost of goods sold account
7. Transfer of finished goods account balance to cost of goods sold account
8. Recording of ending finished goods inventory
Example: the trial balance of Mahrew Shoe factory at December 31. 2002 shows the following account
balance before adjusting entries are journalized and posted.

Mahrew shoe factory

Trial Balance
December 31,2002
Account title Debit Credit
Cash 14400
Raw materials inventory 8000
Work in process inventory 2500
Finished goods inventory 11200
Prepaid factory insurance 4550
Factory supplies 6700
Office supplies 1750
Machinery 75000
Accum. Depreciation machinery 28125
Accounts payable 4420
Mahrew, capital 56605
Sales 170,550
Raw material purchases 45100
Freight on RM purchases 1000
Direct labor 19000
Indirect labor 8400
Factory utilities 2100
Delivery expenses 9000
Office salaries expense 27200
Sales salaries expense 13200
Advertising expense 9000
Miscellaneous expense 1600

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 Total 259,70 259,700
0

The necessary data for making adjustments and updating ledger accounts are as follows
a. Raw materials inventory at December 31,2002 was Br2,500
b. Work in process inventory at December31,2002 was Br3100
c. Finished goods inventory at December 31, 2002 was Br2000
d. Unexpired portion of prepaid factory insurance at December 31,2002 was Br50
e. Factory supplies on hand at December 31, 2002 was Br700
f. Office supplies on hand at December 31, 2002 was Br50
g. Accrued direct and indirect labor were Br500 and Br100 respectively at December
31,2002
h. Machinery was being depreciated for the last 15 years on straight line basis.
Required:
1. Prepare the statements of cost of goods manufactured
2. Pass the adjusting entries
Adjusting entries
Date Description Debit Credit
Dec 31,2002 Manufacturing summary 10500
Raw material inventory jan1,2002 8000
Work in process inventory jan.1,2002 2500
(To eliminate beginning balances)
Dec 31,2002 Raw material inventory,dec.31 2500
Work in process inventory,Dec.31 3100
Manufacturing summary 5600
(Updating the manufacturing inventory accounts)
Dec 31,2002 Income summary 11200
Finished goods inventory, jan1 11200
(to eliminate the beginning balance of fin.goods inventory)
Dec 31,2002 Finished goods inventory,Dec31 2000
Income summary 2000
(to update the finished goods inventory account)
Dec 31,2002 Factory insurance costs 4500
Prepaid factory insurance 4500
(To record the insurance costs expired)
Dec 31,2002 Factory supplies cost 6000
Factory supplies 6000

Dec 31,2002 Direct labor 500

Indirect labor 100
Accrued wags payable 600
Dec 31,2002 Factory depreciation costs 1875
Accumulated depreciation 1875

Dec 31,2002 Office supplies expense 1700

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 Office supplies 1700

II. Closing entries

a. Close manufacturing cost accounts

Manufacturing summary………………….88575
Raw materials purchases……………………………………..45100
Freight on raw material purchased…………………………..1000
Direct labor……………………………………………………19500
Indirect labor………………………………………….……….8500
Factory utilities………………………………………….……..2100
Factory insurance…………………………………….………..4500
Factory supplies……………………………………….……….6000
Factory depreciation costs…….………………………….…….1875
b. Closing revenue accounts
Sales …………………………………….170550
Income summary……………………………….170550
c. Closing expenses
Income summary………………………….155175
Office salaries expense………………………….27200
Sales salaries expense………………………….13200
Delivery expense………………………………..9000
Advertising expense…………….………………9000
Office supplies expense………………………...1700
Miscellaneous expense……….…………………1600
Manufacturing summary……..……………….93475
d. Closing the income summary account
Income summary……………………….6175
Mahrew capital………………………………6175

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