In addition to normal accounting matters, businesses that manufacture products face additional accounting problems that retailers and distributors do not. Note that throughout this post, I use the term manufacture in the broadest sense: Automobile makers assemble cars, beer companies brew beer, automobile gasoline companies refine oil, and so on. Other companies manufacture the products that retailers sell — although the manufacturers may put private labels on the goods [which are common practice for grocery stores and other retailers]. This post focuses mainly on the accounting procedures used to accumulate the basic types of manufacturing costs. A manufacturer must know product cost in order to determine its cost of goods sold expense for the period and the cost of its inventory. This post explores certain unavoidable problems accountants face in determining product cost. To complete the picture, I will bring you for a short tour with Journal entries for manufacturing Cost. Enjoy!
A manufacturing business, first of all, must separate between its manufacturing costs and non-manufacturing costs. Manufacturing costs are the costs of production that are included in the determination of product cost. Non-manufacturing costs include marketing expenses and the general and administration expenses of the business, which are referred to as “period costs”.
Next, let’s have a look the basic types of manufacturing costs that go into the calculation of product cost.
Manufacturing costs consist of four basic types:
- Raw materials: What a manufacturer buys from other companies to use in the production of its own products. For example, General Motors buys tires from Goodyear (or other tire manufacturers) that become part of GM’s cars.
- Direct labor: Compensation of employees who work on the production line.
- Variable overhead cost: Indirect production costs that increase or decrease as the quantity produced increases or decreases. An example is the cost of electricity that runs a company’s production machines: If the business increases or decreases the use of those machines, the electricity cost increases or decreases accordingly.
- Fixed overhead cost: Indirect production costs that do not increase or decrease as the quantity produced increases or decreases. These fixed costs remain the same over a fairly broad range of production output levels.
Fixed manufacturing costs include:
- Salaries for certain production employees who don’t work directly on the production line, such as; vice presidents, production managers, safety inspectors, security guards, accountants, and shipping and receiving workers.
- Depreciation of production buildings, equipment, and other manufacturing fixed assets
- Occupancy costs, such as building insurance, property taxes, and heating and lighting charges
Note: Some manufacturers may merge the last two cost types [fixed and variable overhead cost] become just “Overhead cost”, so the manufacturing cost consisted of three types of manufacturing costs only.
Unlike a retailer that purchases products in a condition ready for resale, a manufacturer begins by purchasing the raw materials needed in the production process. Then the manufacturer pays workers to operate the production machines and equipment and to move the products into warehouses after they’re produced. All this work is done in a sprawling plant that has many indirect overhead costs. All these different production costs are funneled into ‘product cost“.
When manufacturing costs are incurred, they’re recorded in an inventory account — in particular, the work-in-process inventory account. I explain the use of this account in the section “Journal Entries for Manufacturing Cost” later in this post. Product costs are later recorded in the cost of goods sold expense when the products are sold. For example, a $760.00 product cost is the sum of four separate cost components — raw materials, direct labor, variable manufacturing overhead, and fixed manufacturing overhead. All four of the component costs must be correct to end up with the correct product cost.
Product costs are said to be capitalized because they’re viewed as a capital investment, which is an investment in an asset. Product costs aren’t recorded to expense until the products are eventually sold, at which time the appropriate amount of cost is removed from the asset account and recorded in the cost of goods sold expense account.
Costs that are charged to expense when they’re recorded are known as “period costs“. Marketing costs (such as advertising, sales personnel, or delivery of products to customers) are period costs. These selling costs are recorded as expenses in the period the costs are incurred. General and administrative costs (such as legal and accounting, compensation of officers, or information and data processing) are also period costs.
Period costs do not pass through an inventory account.
Separating Period and Product Costs
The distinction between period and product costs is very important. What if a business deliberately recorded some of its manufacturing costs as period costs instead of as product costs? Suppose that for the year just ended, a business recorded $2,400,000 of its manufacturing costs as marketing expenses. The $2,400,000 should have gone into inventory and stayed there until the products were sold. To the extent the products haven’t yet been sold at the end of the year, the business has understated the cost of its ending inventory and overstated its marketing expense for the year. Why would a business do this? To minimize its current year’s taxable income, that’s why.
Evidently many businesses were in the habit of misclassifying some costs as period costs [immediate expense deduction] instead of product costs. In response the IRS has laid down rules regarding what has to be treated as a manufacturing cost. Nevertheless, there are still many gray areas in which drawing a line between manufacturing and non-manufacturing costs is not entirely clear-cut.
In any case, a business should be consistent from period to period regarding how it classifies its manufacturing and non-manufacturing costs.
Wages paid to production line workers are a clear example of a manufacturing cost. Salaries paid to salespeople are a marketing cost and are NOT part of product cost. Depreciation on production equipment is a manufacturing cost, but depreciation on the warehouse in which products are stored after being manufactured is a period cost. Similarly, moving raw materials and partially completed goods through production process is a manufacturing cost, but transporting the finished products from the warehouse to customers is a period cost.
Essentially, product cost stops at the end of the production line — but every cost up to that point is a manufacturing cost.
A manufacturer must design and implement a cost accounting system to determine the cost of every product it manufactures and sells. The business must track the costs of all raw materials that go into the production process and the costs of all production line labor (which may involve hundreds or thousands of operations). Furthermore, the business has to determine and allocate many indirect manufacturing costs to the various products it manufactures. Tracking and allocating these costs is a very challenging task, to say the least.
Journal Entries for Manufacturing Cost
When a retailer or wholesaler purchases products, it debits [increases] an inventory account. The cost of the products is held in an inventory account until the products are sold. At that time, the appropriate amount of cost is removed from the inventory account and charged to cost of goods sold. The amount of the cost removed from inventory is determined by which cost of goods sold method is used, such as FIFO or LIFO. In contrast to retailers and wholesalers, a manufacturer has to make more entries to get to its cost of goods sold expense.
Note: A business may manufacture hundreds or thousands of products, but in the example, Company X manufactures and sells only one product. I expect the example is realistic yet avoids the clutter of too much detail.
Let’s go through with journal entry procedure through the following illustrative Company X, a manufacturing example:
Company X purchased $27,325,000 of raw materials during the year, which is slightly more than the cost of materials released into the manufacturing process. Therefore, its inventory of raw materials increased during the year. The business has a good credit rating, and purchased all its raw materials on credit: Its raw materials purchases during the year are shown in the following entry:
[Debit]. Raw Materials Inventory = $27,325,000
[Credit]. Accounts Payable = $27,325,000
When raw materials are released from inventory storage into the manufacturing process, the cost is charged to a particular job order or to a particular department. The transfers of raw materials to production during the year are shown in the following entry:
[Debit]. Work-in-Process Inventory = $25,800,000
[Credit]. Raw Materials Inventory = $25,800,000
The work-in-process inventory account is a special account used by manufacturers to accumulate the costs of products working their way through the production process. These products aren’t ready for sale until the production process is completed. At that time, an entry is made to move the product cost out of this temporary holding account into the finished goods inventory account — see the entry later [the second to last entry].
The company’s direct labor costs consist of all elements of compensation earned by its production line workers. The largest part of the compensation of production line workers is paid in cash, but payroll taxes are withheld and fringe benefit costs are also recorded in various liability accounts. In the following entries I use “Accrued payables“ as the generic title for various liability accounts used to record costs incurred by the business that are paid at a later time. The direct labor costs of the business during the period are shown in the following entry:
[Debit]. Work-in-Process Inventory = $15,000,000
[Credit]. Cash = $xx,xxx,xxx
[Credit]. Payroll Taxes Payable = $x,xxx,xxx
[Credit]. Accrued Payables = $x,xxx,xxx
The bulk of the company’s variable manufacturing overhead costs are paid in cash over the course of the year, but two liability accounts — accounts payable and accrued payables — are involved in recording many of these costs. The business’s variable manufacturing overhead costs for the year are shown in the following entry:
[Debit]. Work-in-Process Inventory = $8,400,000
[Credit]. Cash = $x,xxx,xxx
[Credit]. Accounts Payable = $xxx,xxx
[Credit]. Accrued Payables = $xxx,xxx
Most of the company’s indirect fixed manufacturing overhead costs for period are paid in cash during the year, but many involve liability accounts for unpaid manufacturing costs— such as the two shown in the following entry. Also, “depreciation” is a major fixed overhead cost, so the accumulated depreciation account is credited in recording the depreciation cost component of fixed manufacturing overhead costs. The business’s fixed manufacturing overhead costs for the year are shown in the following entry:
[Debit]. Work-in-Process Inventory = $42,000,000
[Credit]. Cash = $xx,xxx,xxx
[Credit]. Accumulated Depreciation = $x,xxx,xxx
[Credit]. Accounts Payable = $x,xxx,xxx
[Credit]. Accrued Payables = $x,xxx,xxx
When the manufacturing process is completed products are moved off the production line to the warehouse. The appropriate amount of product cost is removed from the work-in-process inventory account and entered in the finished goods inventory account. The transfers of products from the production line to the finished goods warehouse during the year are shown in the following entry:
[Debit]. Finished Goods Inventory = $91,200,000
[Credit]. Work-in-Process Inventory = $91,200,000
Note: In these entries, I assume that there was no work-in-process at the beginning or end of the year. This assumption would be accurate, for instance, if the business shut down its manufacturing activity for a week or two at the end of the year to permit a fumigation of the plant or to give workers a holiday vacation. The entries would be more involved if there was work-in-process inventory at the start and end of the year.
Recording the cost of products sold during the year is shown in the following entry:
[Debit]. Cost of Goods Sold = $83,600,000
[Credit]. Finished Goods Inventory = $83,600,000