Nature of Manufacturing Business

Merchandising
includes cost of merchandise purchased including the transportation cost of bringing merchandise to the business place.

Manufacturing
involves the conversion of raw materials into finished goods through the application of labor and various factory cost incidental to the production of products.

Manufacturing business makes major investments in physical facilities such as factory site, factory building and acquisition of various machinery and equipment to be use in the factory.

Chart of Accounts of Manufacturing Business

Acct No.
110 111 112 120 130 140 150 160 161 162 165 170 180 190 200 210 220 221 240 241 250 251

Acct No.
Assets: Cash in Bank Cash on Hand Petty Cash Accounts Receivable Allowance for Uncollectible Accounts Notes Receivable Short-term Interest Receivable Finished Goods Work in Process Raw Materials Supplies Prepaid Rent Prepaid Insurance Trading Securities Notes Receivable Long-term Land Building Accum. Depreciation Building Furniture & Fixtures Accum. Depreciation Fur. & Fix. Office Equipment Accum. Depreciation Office Equipment 310 320 321 330 340 350 360 370 380 390 400 410 420 430 440 Acct No. Owners Equity: 510 520 Owners, Capital Owners, Drawing Liabilities: Accounts Payable Notes Payable Short-term Interest Payable Accrued Salary Payable Accrued Rent Payable Bank Loans Payable Short-term Income Tax Payable Withholding Tax Payable SSS Contribution Payable PhilHealth Contribution Payable Pag-ibig Contribution Payable Insurance Payable Unearned Service Income Notes Payable Long-term Bank Loans Payable Long-term

Acct No.

Cost and Expenses:

Acct No.

Revenues:

810 811 812 813 814 815 820 830 840 850 860 870 880 890 900 905 910 920 930
940 950 960

Purchases Purchases returns Purchases allowances Purchases discounts Freight-in Cost of goods sold Salary Expense Rent Expense Utilities Expense Uncollectible Accounts Expense Advertising Expense Insurance Expense Taxes and Licenses Supplies Expense Interest Expense Freight-out Depreciation Expense Employees Benefits Expense Loss on Sale of Land (Building, Furniture & Fixture or Office Equipment) Unrealized Holding Loss Trading Sec Loss on Sale of Trading Securities Miscellaneous Expense

610 611 612 613 620 630 640 650

660

Sales Sales returns Sales allowances Sales discounts Interest Income Rent Income Dividend Income Gain on sale of Land (Building, Furniture & Fixture or Office Equipment) Unrealized Holding Loss Trading Sec

Operating Cycle of Manufacturing Business

Phase 1: Buy Raw Materials

Phase 4: Collect from customers

Phase 2: Processed raw materials to finished goods (Raw materials + direct labor + factory overhead)

Phase 3: Sell finished goods to customers

Cost Elements of Manufacturing Business

3 Types of Production Costs: 1. Raw Materials 2. Direct Labor 3. Factory Overhead

Raw Materials

Direct Labor

Factory Overhead
The cost of factory overhead is called as manufacturing overhead cost. It refers to all indirect materials, indirect labor and other miscellaneous items used in the making of a product. Examples are: used factory supplies salary of factory supervisors factory depreciation factory maintenance. As a rule, if a cost could not be classified as direct raw materials or direct labor, it is classified as factory overhead.

When the three elements of production cost are mixed, the following costs can be determined until a product is produced. 1.Manufacturing costs. This is the sum of the three (3) cost elements: direct materials, direct labor and factory overhead. This is sometimes referred to as production cost or factory cost. 2.Work-in-process. The portion of the total manufacturing costs that pertains to the goods under process which are not yet 100% completed at the end of the accounting period. 3.Cost of goods manufactured. The portion of the total manufacturing costs pertaining to the work which is 100% processed and completed, transferred to finished goods.

The unsold finished goods, unfinished goods-inprocess and unused raw materials at the end of the period are inventories, which should be reported as part of the current assets of the business. The ending inventories of each type of business are compared as follows:
MERCHANDISING
1. Merchandise inventory (Unsold merchandise at the end of the period)

MANUFACTURING
1. Finished goods inventory (unsold) 2. Work-in-process inventory (incomplete) 3. Raw materials inventory (unused) 4. Factory supplies inventory
(unused)

Comparative Cost Flow

The comparative cost flow of merchandising and manufacturing business could be outlined as follows:
MANUFACTURING MERCHANDISING Merchandise beginning Add (Deduct) Net purchases Purchases Freight-in Purchase discount Pxxx xxx (xxx) (xxx) (xxx) xxx Pxxx xxx Pxxx Direct materials, beginning Pxxx Add (Deduct) Net purchases Purchases Freight-in Purchase discount Purchase allowances Purchase returns Total direct materials for use Less: Unused raw materials at the end of the period Direct materials used Add: Direct labor Factory overhead Total manufacturing costs Add: work-in-process, beg. Total work-put-in-process Less: work-in-process, end Total costs of goods manufactured Add: finished goods, beg. Total finished goods for sale Less: finished goods, end Cost of goods manufactured and sold Pxxx xxx Pxxx xxx (xxx) (xxx) (xxx) Pxxx

Purchase allowances
Purchase returns Total goods available for sale Less: Unsold merchandise at the end of the period Cost of goods sold

xxx Pxxx

xxx Pxxx
xxx Pxxx xxx Pxxx xxx

The Cost of Sales can be described as Cost of Goods Sold for a merchandising business since the items purchased are already the final product sold. On the other hand, it is described as the Cost of Goods Manufactured and Sold for manufacturing firms because the items purchased are converted into finished products before they are sold.

Pxxx xxx Pxxx xxx

Pxxx

ASSETS IN THE BALANCE SHEET

EXPENSE IN THE INCOME STATEMENT

Raw Materials WORK-IN-PROCESS INVENTORY

Factory Overhead: Indirect Materials Indirect labor Factory depreciation and other factory expenses

FINISHED GOODS INVENTORY

Direct Labor

Cost of goods sold

Prime Cost and Conversion Cost

The cost elements of a manufacturing firm could be combined and formed as (1) prime costs and (2) conversion costs. 1. Prime Costs consist of direct materials and direct labor used to make the product . This cost is called prime cost or direct cost because the primary materials and main labor are combined in making the product.

2. Conversion Costs includes the costs of direct labor and all indirect costs.
This is called conversion cost because the direct labor and overhead costs transform the raw materials to finished goods. Indirect manufacturing cost is also called manufacturing overhead or factory overhead cost.

The Cost of Goods Manufactured and Sold The cost of goods manufactured and sold account is generally used to describe the merchandise sold by a manufacturing business. The schedule of cost of goods manufactured and sold is presented as follows (all amounts assumed):

VALROX Manufacturing Schedule of Cost of Goods Manufactured and Sold For the Year Ended December 31, 200x Raw materials used: Beginning raw materials inventory Add: Net raw materials purchases Raw materials purchases Freight-in Gross raw materials purchases Less: Purchase discounts Purchase returns Purchase allowances Total raw materials available for use Less: Ending raw materials inventory Direct labor Factory overhead Total manufacturing cost Add: Work in process, beginning Total cost of goods in process Less: Work in process, ending Total cost of goods manufactured Add: Finished goods, beginning Total finished goods available for sale Less: Finished goods, ending Cost of goods manufactured and sold

P 70,000 P 200,000 5,000 205,000 P2,500 1,500 1,000

5,000

200,000 P 270000 20,000 P250000 400,000 150,000 P800000 100,000 P900000 150,000 P750000 50,000 P800000 150,000 P650000

Cost versus Non-Cost System

The accounting for manufacturing activities may be done using either Cost System or Non-Cost System.

1. Cost System maintains detailed perpetual records of the cost of raw materials, work-in-process and finished goods inventory. This system provides an updated information about manufacturing costs which serves as helpful guide for price decision-making.
2. Non-cost system determines the cost of goods manufactured based on the periodic actual physical count of ending inventory for materials, work-in-process, and finished goods, converting these into value using the adapted cost method (FIFO or weighted average). This chapter discusses the manufacturing accounting using the non-cost system.

Under the non-cost system, the manufacturing cost should be summarized in manufacturing account which basically includes the following postings:
Direct Raw Materials Debit Credit 1. Beginning 4. Purchase return Inventory 5. Purchase discounts 2. Purchases 6. Manufacturing 3. Freight-In Summary
Direct Labor Debit 1. Actual payroll paid 2. Accrued payroll Credit 3. Manufacturing summary
Manufacturing Summary Debit Credit 1. Work-in-process, 5. Work-in-process, beginning end (per account) 2. Direct raw materials used 3. Direct Labor 4. Factory overhead 6. Transferred to Finished goods (per account)

Work-In-Process Debit Credit 1. Manufacturing Summary

Factory Overhead Debit Credit 1. Actual payroll, indirect 2. Accrued payroll, indirect 3. Factory utilities 7. Manufacturing 4. Taxes/Insurances Summary 5. Depreciation Factory 6. Factory supplies

Finished Goods Debit Credit 1. Beginning Inventory 2. Manufacturing Summary Finished goods sold

Notes: 1. The cost of goods manufactured and sold, computed as follows: Finished goods, beginning Pxxx Add: Transferred to finished goods xxx Total Pxxx Less: Finished goods inventory,end xxx Cost of goods manufactured and sold Pxxx

Cost of Goods Manufactured and Sold Debit Credit 1. Finished goods sold

2. The appropriate journal entry for the finished goods inventory end would be

Finished goods, end Income summary

xxx xxx

The debit to finished goods end represents the item to be reported in the SFP, while the credit to income summary is the finished goods end to the income statement representing a reduction of the cost of finished goods sold during the period.

Transactions Related to Manufacturing Process

Business transactions of manufacturing firms are generally similar to the merchandising firm except that a merchandising firm doest not produce goods. The accounting for the production of goods includes the following pro-forma entries ( comparing periodic non-cost accounting system from perpetual cost accounting system):

Transactions Related to Manufacturin Process

Business transactions of manufacturing firms are generally similar to the merchandising firm except that a merchandising firm does not produce goods. The accounting for the production of goods includes the following pro-forma entries (comparing periodic non-cost accounting system from perpetual cost accounting system):

Transactions Related to Manufacturing Process

Accounting for Materials:
1. Purchased raw materials, P105,000 & factory supplies, P20,000. Non-Cost System
Purchases Factory Supplies Accounts Payable 105 000 20 000 125 000

VS

Cost System
105 000 20 000 125 000

Raw Materials, Inty. Factory Supplies Accounts Payable

2. Returned defective raw materials to vendor, P5,000. Non-Cost System

Accounts Payable Purchase Returns 5 000 5 000

VS

Cost System
5 000 5 000 Raw materials, inty.

Accounts Payable

3. Paid the accounts payable less P2,000 cash discount. Non-Cost System
Accounts Payable Cash Purchase Returns 120 000 118 000 2 000

VS

Cost System
120 000 118 000 2 000 Cash Raw materials, inty.

Accounts Payable

4. Issued raw materials, P97,000 & factory supplies, P20,000 for factory use.
Non-Cost System
No entry

VS

Cost System
97 000 20 000 97 000 20 000

WIP - Raw Materials WIP - Overhead Raw materials, Inty. Factory Supplies

5. Returned excess raw materials to storeroom, P2,000.

Non-Cost System
No entry

VS

Cost System
2 000 2 000

Raw materials, Inty. WIP Raw materials

Note : WIP means work-in-process

6. Closed raw materials cost accounts (assume raw materials beginning is P2,000).
Non-Cost System
Raw materials, Inty. - end WIP Raw materials Purchase returns Purchase discounts 5 000 95 000 5 000 2 000 No entry

VS

Cost System

Raw materials, Inty. - beg.

Purchases

2 000
105 000

Accounting for Labor: 7. Paid payroll of factory: Direct workers, P100,000; Supervisor, P20,000; Janitor, P3,000.
Non-Cost System
Direct Labor
Indirect Labor Cash

VS

Cost System
100 000
23 000 123 000

100 000
23 000 123 000

WIP, Direct Labor

WIP, Factor Overhead Cash

8. Closed direct labor cost account.

Non-Cost System
WIP Direct Labor Direct Labor 100 000 100 000

VS

Cost System
No Entry

Accounting for Factory Overhead

9.Recorded other factory overhead expenses: Depreciation of factory machine, P12,000; Paid factory insurance expense, P4000 and miscellaneous factory expense, P1,000.
Non- Cost System
Depreciation expensefactory Insurance expensefactory Miscellaneous expense4,000 12,000

VS

Cost System
17,000

Work-in-process, FOH Accum. Depreciationfactory machine Cash

12,000 5,000

factory
Accum. Depreciationfactory machine Cash

1,000

12,000 5,000

10. Summarized factory overhead accounts.

Non- Cost System Manufacturing overhead summary factory supplies Indirect labor Depn expense factory Insurance expense - factory Miscellaneous expense - factory 1,000 4,000 60,000 20,000 23,000 12,000 No entry

VS

Cost System

11. Closed factory overhead

Non- Cost System Work-in-process, FOH Manufacturing overhead summary 60,000
60,000

VS

Cost System

No entry

Accounting for Cost of Goods Manufactured and Sold

12. Recorded 80% goods completed.

Non- Cost System *Cost of goods

VS

Cost System

Cost of goods

Manufactured

196,000

Manufactured

196,00 0
76,000 80,000
40,000

WIP Raw materials WIP Direct labor WIP - FOH

76,000 80,000 40,000

WIP Raw materials WIP Direct labor WIP FOH

13. Closed cost elements of cost of sales (assuming that finished goods - beginning, P20,000 and finished goods ending, P10,000)
Non- Cost System
Cost of goods Manufactured and sold 206,000

VS

Cost System

Cost of goods Manufactured and sold

206,000

*Finished goods, end Finished goods, beg Cost of goods manufactured

10,000

Finished goods, end 20,000 Finished goods, beg Cost of goods 196,000 manufactured

10,000

20,000

196,000

14. Closed revenue and cost of sales to income summary (assuming that the total sales is P400,000).
Non- Cost System
Sales Cost of goods manufactured and sold Income summary
400,000

VS
Sales 206,000 194,000

Cost System
400,000

Cost of goods manufactured and sold Income summary

206,000 194,000

Cost Accumulation Procedures

Process Costing Job Order Costing

Process Costing
Is a system applicable to continuous process of production of the same or similar (i.e. homogenous) goods. There is no need to determine the costs of the different groups of products because the product is uniform. Thus, each processing department becomes a cost center.

Job Order Costing

Is a system of allocating costs to group of unique products. It is applicable to the production of customers specified products. Each job becomes a cost center from which costs are accumulated. A subsidiary record called a JOB ORDER SHEET is needed to keep track of all unfinished jobs (work-in-process) and finished jobs (finished goods).

Distinction between Process Costing and Job Order Costing

Process Costing
1. Homogenous units pass through a series of similar process. 2. Costs are accumulated by processing department.

Job Order Costing

1. Unique jobs are worked on a time period. 2. Costs are accumulated by individual job order.

3. Unit costs are computed by dividing 3. Unit costs are determine by dividing the individual processing departments the total costs on the job cost sheet by costs by the equivalent units of the number of units on the job. production.

4. The cost of production report provides the detail for the work-inprocess account for each processing departments.

4. The job cost sheet provides the detail for work-in-process account.

Job Order Costing

Job Order Costing

Assumptions: Raw materials are recorded under perpetual inventory system. Total materials issuance for the period based on store requisition slip, patrol costs per payroll summary, and cash voucher and payable voucher for supplies is as follow:
Total Direct raw materials Direct labor Indirect labor Factory supplies Status at the end of accounting period P1,500,000 950,000 475,000 75,000 P3,000,000 JOB ORDERS 001 002 003 P1,300,00 800,000 350,000 50,000 P2,500,000 Completed P100,000 100,000 85,000 15,000 P300,000 In process P100,000 50,000 40,000 10,000 P200,000 In process

Journal entries
1. To record the costs incurred
GENERAL LEDGER Date (a) Description Work-in-process - materials Work-in-process - direct labor Work-in-process - indirect labor Work-in-process - factory supplies Raw materials Cash Accounts payable Page number Debit 1,500,000 950,000 475,000 75,000 200

Credit

1,500,000 1,425,000 75,000

Note: individual subsidiary ledger for each job order is maintained; hence the above entries affecting the work-in-process accounts are posted in the general ledger and subsidiary ledger.

2. To record the completed job order 001

GENERAL LEDGER Date Description Page number Debit 2,500,000 200 Credit 2,500,000

(b)

Cost of goods manufactured Work-in-process Job 001

3. Supposing that Job Order 001 was billed at P3,125,000 (using perpetual inventory system), the journal entries would be:
GENERAL LEDGER

Date
(c)

Description
Accounts receivable Sales To record billing for job order 001. Cost of goods manufactured and sold Cost of goods manufactured To record cost of goods sold Sales Cost of goods manufactured and sold Income summary To close revenue and cost of goods sold

Page number Debit 3,125,000

200 Debit 3,125,000

(d)

2,500,000 2,500,000

(e)

3,125,000 3,125,000

Just-in-time is a manufacturing model based on the philosophy that storing inventory is a non-value added activity that a company should try to reduce or eliminate. Hence, the best decision is to maintain zero or minimal inventories. This manufacturing model implies that products should be produced when needed in the quantities needed by customers , so there is little need for workin-process or finish goods inventories. In addition, raw materials should arrive when needed, in the quantities needed for production.

a pull system, that is production is determined by customer demand , and the need for raw materials is determined by production. Accordingly, manufacturing firms that adopt this model use the backflush costing system, which is described as follows:

JIT is

1. The amount of raw materials purchased , direct labor used, and manufacturing overhead applied on the cost of goods sold account for the period will expensed during the same period.

2. At the end of the period, if any inventory remains on hand, it is

necessary to make an entry for the adjustment of the cost of goods sold account to reflect the cost of the remaining inventory. 3. The cost of the ending inventory , whether it is a raw material, work-in-process, or finished goods, is recorded in a current asset account called raw and in-process inventory. This accounting method eliminates the need for separate raw materials, work-in-process and finished goods inventory accounts, so is saves record-keeping time and cost.

Illustration:
Japan company incurs the ff. cost in connection with the production of a product named Kamukhamo:

Raw materials purchased Direct labor used Manufacturing overhead applied

P 100,000 150,000 50,000

At the end of the period the cost of Kamukhamo still-in-process is P10,000 and there are 5,000 raw material still unused. The journal entries of the above JIT production activities using backflush accounting would be:

GENERAL JOURNAL
Page Number 100

Date a)

Description Cost of goods sold Accounts payable To record the purchase of Inventory on acount Cost of goods sold Accrued wages payable To record the labor used in production. Cost of goods sold Factory overhead To record the overhead applied to production

Debit 100,000

Credit

The recording of raw materials, labor and overhead is eliminated because the products are presumed to be in accordance with the customers demand.

100,000 Accordingly, the cost of goods

b)

150,000

sold account is immediately debited upon requisition of the basic manufacturing costs. This is accordance with the principle 150,000 that the cost of finished goods should be expensed at the period of production.
At the end of the production period, the raw material unused and the work-in-process are adjusted in the raw and inprocess inventory account. The cost of goods sold, net of raw and in-process inventory at the end of the period is actually the amount of the total cost of goods manufactured and sold.

c)

50,000 50,000

d)

Raw and in-process inventory Cost of goods sold To record raw materials and work-in-process inventory

15,000 15,000

Cost of Goods Sold Debit Direct Materials 100,000 Credit Raw and in-process

Account No.16

15,000

Direct Labor
Factory Overhead

150,000
50,000 300,000 285,000 Raw and In-Process Inventory Debit Cost of goods sold 15,000
Account No. 18

Credit

Activity-Based Costing System

(ABC SYSTEM)

Activity-Based Costing (ABC) System

Activity-based costing uses more than one predetermined overhead rate to assign overhead costs for each activity utilized in production. Accordingly, this method ensures that the amount of overhead assigned represents the resources consumed. When companies use an activity-based costing(ABC) system, they first assign estimated manufacturing overhead costs to activity level called cost pools. A cost pool is a group of costs that change in response to the same cost driver. Cost Drivers measure activity in the conversion cycle and are assumed to cause the change of conversion cycle cost. A good example of cost driver is the number of hours used for a particular type of activity.

The following activity-based costing overview facilitates an understanding of the concept:

ACTIVITY-BASED COSTING OVERVIEW
Types of Costs Depreciation Property taxes Utilities Insurance Activity Level Facility sustaining Types of Activities Owning buildings Occupying buildings Using buildings Maintaining buildings Example of Cost Drivers Number of square feet Number of square feet BTUs of heat produced Number of square feet

Product sustaining

Testing products Designing products Maintaining products inventory Using specialized machinery

Testing costs* Design costs* Carrying costs* Depreciation

Number of tests required Number of hours of design time Number of parts required No. of specialized processes required

Batch related

Ordering parts Setting up machines Handling materials Requisitioning parts Cutting/drilling units Assembling units Painting units Inspecting units

Ordering costs* Setup costs* Moving costs* Requisition cost Power costs Indirect labor Indirect material Rework costs*

Number of orders placed Number of setups required Number of moves required Number of requisition made Number of machine hours Number of labor hours Direct materials cost Number of units reworked

Unit related

*Includes the salaries and wages of those individuals involved in the acitivity.

Illustration Assume the following costs and cost drivers of the cost pools of New Products Manufacturing Company:

Predetermined overhead rates:

Cost drivers Building costs Development costs Costs assigned Total cost driver P400,000 P200,000 100,000 sq. ft. 20,000 hours Cost driver per unit P4 per square foot P10 per development hour

Product testing costs

Setup and inspection Machine usage costs

P 30,000
P150,000 P 50,000

30 quality test
150 production runs 10,000 machine hours

P1,000 per test

P1,000 per production run P5 per machine hour

Assuming that during the period, the production of New Products Manufacturing Company actually required the following resources to produce Kamukhamo products: 3,000 square feet of building space 2,000 hours of development time 10 quality tests 150 production runs 1,000 machine runs Using the predetermined overhead rates, the manufacturing overhead is applied to the production, as follows:
Building costs: (P 4x 3,000 sq.feet) Development costs: (P10x 2,000 devt.hours) Product testing costs: (P1,0000x10 quality tests) Setup and inspection costs: (P1,000x150 production runs) Machine usage costs: (P5x1000) Total Manufacturing overhead applied in the period = P 12,000 = 20,000 = 10,000 = 150,000 = 5,000 = P 197,000

The appropriate journal entry to reflect the applied manufacturing overhead costs for the period would be:
GENERAL JOURNAL Page 100 Number Debit 197,000

Date Descriptions a) Work-in-process inventory Kamukhamo Factory overhead Building Factory overhead Development Factory overhead Testing Factory overhead Setup and inspection Factory overhead Machining To record applied manufacturing overhead for The period

Credit 12,000 20,000 10,000 150,00 0 5,000