Hey, welcome to edX world and this video series on IGCSE accounting. Today's topic that we're going to cover is manufacturing account. I have received a lot of requests from many students to cover this topic.
So I decided to cover this topic today. So first we understand why do we have to prepare a manufacturing account. Some important terms related to a manufacturing business because it makes us easy to prepare a manufacturing account after that.
Then the meaning and calculation of prime cost and the factory overheads, understand the format of manufacturing account and also understand in detail these steps in preparation of the manufacturing account. If you want to practice more questions on this topic and learn theory for this topic, then you can consider buying our course for just $99 that will give you access until June 2021. First, why do we have to prepare manufacturing account see a manufacturing business is involved in production of goods and services. Unlike the trading business that just buys goods and services. So in a trading business, if I tell you to find out the cost of the goods that have been purchased, it's very simple. Just find out how much were they purchased from the supplier.
But in a manufacturing business to produce the goods, so many expenses have to be incurred on the factory floor. So we prepare a manufacturing account to calculate the cost of production of the finished goods, the goods that the manufacturing business is producing. And what is the ultimate use of this? See, in a trading business, we find out gross profit by taking into account the purchases in the cost of sales. But in a manufacturing business, goods are mainly manufactured, produced in-house.
And hence, we need to find out the cost of production of the finished goods. Rarely, you would also find that manufacturing businesses purchase goods from outside suppliers for resale. And hence, you will also see cost of goods purchased in the income statement for such businesses.
But mainly, it is the cost of production of finished goods that will... help you calculate the cost of sales and eventually the gross profit. Some important accounting terms that you need to know before we go ahead in this chapter material cost.
So our main cost in any manufacturing business is the material cost material cost means the raw material cost. Now raw material cost can be divided into direct material cost and indirect material cost. What is the direct material cost? The direct material cost or cost of raw materials that can be directly identified to and charged to a unit of production meaning what raw materials purchase that directly go in the production process and form part of the finished products for example wood used by a furniture manufacturer directly goes in the manufacturing of the furniture again in an electronic business electronic manufacture the chipsets directly go in the production of the electronics form a part of the electronics and hence again direct material cost and so on the other type of material cost is indirect material cost.
Now, these are also raw materials purchased for the factory, but they do not directly form a part of the finished product. They are necessary to ensure smooth functioning of the factory, but not directly in the production of finished goods. And hence, they are indirect material cost. Example, now machines require diesel or fuel.
They are also raw materials, but not directly associated with the end product and hence indirect material. Similarly, cleaning consumables that may be used. to clean the factory again indirect material and so on. The other major cost in any manufacturing business would be obviously labor cost. Labor cost is the wages and salaries paid to people working in the factory that can also be divided into direct labor cost and indirect labor cost.
Now direct labor cost means wages or salaries paid to people who directly engaged in the production of the end product who are working on the machines producing the product and the wages of such people can be associated with the production of the product. You can say that this much wages have been paid for one unit of the product. Example obviously wages of factory workers were directly engaged in the production activity.
Indirect labor wages or salaries paid to anyone else in the factory working for the factory but not directly on the production of a product. For example, the best example would be wages paid to a factory supervisor whose job is to supervise the production of many products. but he's not directly engaged in the production of a product or wages paid to a factory cleaner who is cleaning in general the entire factory floor.
Now apart from material and labor all other expenses come under other cost okay so other cost can also be divided into other direct cost and other indirect cost. Other direct cost means all direct costs other than material and labor that have to be incurred for production of a unit of product that that are directly associated with a unit of product. For example, royalty paid when a unit of product is produced.
You cannot produce without incurring the royalty cost. And finally, we have all other indirect costs that are also costs incurred in the factory, but they cannot be directly identified with the product. So any other costs that have not been covered above in the material labor and other direct expenses will fall under other indirect cost.
So examples of costs that would be covered under this category could be depreciation on your factory assets, your insurance on factory assets, your rent, electricity charges, and so on. Having understood the different types of course, now let us understand how our prime cost and factory overheads calculated. So we've seen that our mainly cost are divided into material cost, labor cost and other cost. Each one of them further divided into direct indirect cost, direct material, indirect material, direct labor, indirect labor and other direct expenses and other indirect expenses.
So if I take a total of all the direct cost, direct material, labor and other direct cost, what I get is prime cost and If I take a total of all the other indirect cost, material, labor and other expenses, what I get is factory overheads. When I take a total of my prime cost and factory overheads, that's where I get my cost of production of my finished goods, which was the ultimate aim of preparing the manufacturing account. Now let's see how to calculate the cost of production of the finished goods using the format of manufacturing account.
So if I see the format of manufacturing account looks confusing. So many row items here. Students may find it difficult to remember in this order. So let's understand each step very logically so that it becomes easy for you to remember this format for the exam.
Let's start with the first one. The first one is where you have to calculate the raw material consumed. Now if you pay attention here, they're talking about raw material consumed and not raw material purchased.
So let's say you've purchased 100 tons of raw material in this year, but used only 50 tons in the production process. The remaining 50 tons forms a part of the closing inventory of raw materials. Can I take the entire 100 tons as cost of production of finished goods? No, because they've not been consumed or used in the production. So what I have to do is I have to subtract the closing inventory of raw materials at the end of the year from my raw material cost.
And at the same time, add the opening inventory of raw materials because those raw materials were actually consumed in this year in the production activity. So add the opening and subtract the closing inventory of raw material. Other than that, that's it.
Other adjustments are common, like obviously purchase returns of raw material have will have to be deducted from the purchases of raw material. And carriage paid or carriage invert on raw materials is an integral part of the raw material cost itself. So when I start with my opening inventory of raw material, add the net purchases of raw material and subtract the closing inventory of raw material, what I get here is my raw material consumed or cost of raw material during the year.
My second step is to arrive at the prime cost. Already seen that prime cost is a total of direct material labor and other direct cost. I've already calculated my direct material cost consumed on top to that I will add my direct labor during the year direct labor cost for the year. Direct labor cost would be cost of factory workers, factory operatives, and other direct expenses like royalty.
When I take a total of the three, what I get is the prime cost. Another important part of the manufacturing account which has to be clearly shown in your solution. Once you get a prime cost to that you add your factory overheads.
Factory overheads would be all your indirect material, indirect labor and other indirect expenses. So the total of them would be called the factory overheads. Example, your rent, your factory rent, your factory heat and lighting, your electricity, your insurance, factory depreciation.
So once I get my factory overheads Once we arrive at the prime cost and the factory overheads, we can take a total of that to arrive at the cost of production. But is that finally final cost of production of finished goods? Not necessary because whatever costs have been incurred during the year, a part of it at the end of the year, it's possible that it's not yet completed and hence forms a part of the work in progress.
Now, in the income statement, when we transfer cost of production, we can only transfer cost of production of finished goods because the revenues that we record, or the opening and closing inventories that we record in the income statement are always of finished goods. And hence we have to find the cost of production of finished goods. So can I say that whatever costs have been incurred during the year but at the end have not yet been completed into finished goods and but are yet in work in progress can be subtracted.
And hence I have less work in progress at the end closing work in progress. But this closing work in progress next year becomes a part of the finished goods because they are completed in the next year and And hence I have add opening work in progress. So the net amount of opening and closing work in progress will be adjusted.
Finally, we will arrive at the cost of production of finished goods. So once this is arrived at cost of production of finished goods, this can be taken to the income statement to finally calculate the gross profit. Now if I look at my manufacturing account, and understand it stepwise, it becomes very simple, I don't have to mug up the entire format. It's very logical to start from your direct material, add all your other direct costs arrive at the prime cost where at factory overheads ends. Step by step, finally calculate the cost of production of finished goods.
I have not solved any question for this chapter because I feel it is important to understand the format. Once you understand the format in a very logical way, you can solve any type of question. Still, if you have a doubt in any question, any particular item that you come across when solving questions, you have a doubt, you can always post your comments below. I will make sure I'll reply to them, clear all your doubts. If you've enjoyed the video, please.
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