Some firms may manufacture or produce goods rather than buy due to savings in operational costs. (i.e. it is cheaper to produce the goods rather than buy). Due to additional costs involved in the production process, additional information is reported in the final accounts. These firms incur manufacturing cost. Therefore in addition to the preparation of trading profit & loss A/c and balance sheet, they also prepare manufacturing account to show the manufacturing costs.
The purpose of the manufacturing account is to report all the costs incurred in producing goods. The costs incurred in the manufacture are classified as either direct or indirect.
Direct costs /prime costs
These are costs that one can easily identify in the product or which one can easily associate with the product. Direct costs are further divided into the following categories:
- Direct materials These are the cost of raw materials which one can directly identify in product e.g. wheat in breach, cloth in clothes e.tc.
- Direct Labour This is labour costs which is directly associated with a product e.g. wages of a machine operator or wages of a machine operator or wages of labourers directly involved in product process e.g. sorting out materials, mixing etc.
- Direct expenses These are expenses which are directly incurred in the process of manufacture of a product e.g royalties paid to the owner of a machine or to the owner of a quarry land where minerals are extracted.
Note The total of direct materials, labour and expenses make up prime cost.
Indirect costs overheads
These are costs not easily identified in a product or associated with it. They are divided into: –
- Indirect materials These are costs raw materials which one cannot easily identify with a particular product e.g. salt/sugar in bread, buttons in clothes, bolts in furniture etc.
- Indirect Labour This is labour cost which is not easily associated with a product e.g. salary of a foreman or supervisor. Because such a person is supervising several production floors his/her services cannot be associated with one single production process.
- Indirect expenses These are expenses which can’t be directly associated with the product e.g. insurance of factory machines, buildings, rent, water, power & lighting, depth of machines, Other examples include; rent for the factory, depreciation of plant and machinery used in production
Note The totals of indirect materials, indirect labour and indirect expenses are refereed to as factory costs overheads.
Work in progress (W-I-P) These are materials, labour and overheads which are in the process of manufacture. W-I-P can either be opening W-I-P or closing W-I-P. The manufacturing account shows the factory cost of goods produced that will be shown in the
trading account in place of purchases.