De La Salle University

ACTBFAR – Basic Financial Accounting and Reporting

M.J ESPIRITU

Accounting for Manufacturing

What is Manufacturing?
Manufacturing is transforming inputs into outputs using tools and processes. A manufacturer or a
manufacturing concern would be involved in the selling of outputs which it had processed.

Key Characteristics of a Manufacturing Concern

To be profitable, the following are some key characteristics of a manufacturing concern:
1. Productivity: Productivity is defined as a measure of efficiency of a person, machine, or
manufacturing unit completing the task in converting inputs into outputs, while efficiency is
defined as doing things right the first time at the lowest possible cost. A higher productivity
would translate to higher profit due to more output (higher sales) or less input (lower cost)
or both.
2. Quality control: If final product does not meet customer requirements, then either the
company incurs more costs to rework and redesign the product in order to satisfy
customers or it loses sales due to non-purchase by customers. Thus, it is important that a
manufacturing concern produces quality outputs through implementation of quality
control measures.
3. Good design: An output is of quality if it meets customer expectations. One of the
dimensions of quality is design, the other being conformance to specifications. A product
with good design is one that meets customer expectations and usually stands out among
its competitors. Thus, good product design leads to more revenues due to greater
customer demand.
4. Cost effectiveness: Effectiveness is defined as doing the right things. This allows the
company to avoid unnecessary costs to be incurred thus making it more profitable.

Types of Manufacturing
In general, there are three types of manufacturing method and these are as follows:
1. Make-to-stock (MTS): This is the traditional type of manufacturing wherein the
production strategy is based on forecasts of customer demand and therefore company presents its
customers with the final product.
2. Make-to-order (MTO): Also known as made-to-order or build-to-order, this is the type of
manufacturing wherein the production strategy is based on customer order.
3. Make-to-assemble (MTA): Also known as assemble-to-order (ATO), this is the type of
manufacturing wherein company makes available the inputs while the customer decides on the final
output. It is a mix of make-to-stock, wherein the company keeps an inventory of its inputs based on
forecasted demand, and make-to-order, wherein assembly does not happen until customer order is
received.
 Cost Concepts and Classifications

Cost is the monetary measure of resources given up in order to achieve a particular objective. It is
the amount of cash or cash equivalent paid or committed to be paid in the future for goods and
services expected to bring about current or future benefit.

Classifications of Cost

There are several cost classifications and some of these are identified below:

1. As to traceability to cost object:

a. Direct cost: This refers to cost that is economically feasible to be traced to the cost
object. A cost object, or cost objective, is anything to which you want to measure and
assign or simply know the cost of. A cost object can be a product, product line,
department, customer segment, or geographic region, among others.
b. Indirect cost: This refers to cost that is not economically feasible to be traced to the
cost object, thus the assignment of cost is usually done through allocation.

Illustrative Example. #1: Classify the following costs as (D) direct costs or (ID) indirect costs in
relation to a specific product.

Glue in book production Indirect

Factory supplies Indirect
Wood in making furniture Direct
Training and development Indirect
Machine maintenance Indirect
Leather in manufacturing shoes Direct
Supervisor's salary Indirect
Depreciation of factory equipment Indirect
Direct labor Direct

2. As to reporting purposes:
a. Product cost: This refers to cost that forms part of the product, thus the cost of unit unsold
is presented under inventory section in the statement of financial position while the cost of
unit sold is presented under cost of sales section in the income statement.
b. Period cost: This refers to cost that is expensed immediately in the period it is incurred,
thus the entire cost is presented under operating expenses section in the income
statement.
 3. As to cost behavior: Cost behavior refers to how cost changes given changes in activity
level.
a. Fixed cost: This refers to cost which when expressed as a total amount, does not change
with changes in activity level.
b. Variable cost: This refers to cost which when expressed as a total amount, changes in
direct proportion to changes in activity level. This means that total costs increase as activity
levels increase or that total costs decrease as activity levels decrease.

Examples:

• Total variable cost varies in direct proportion to changes in the level of activity. For
example, your long distance telephone bill may be based on how many minutes your talk—
the total bill varies with the number of minutes used.
• Total fixed cost is constant within the relevant range. In other words, fixed costs do not
change for changes in activity that fall within the “relevant range.” For example, your
monthly basic telephone bill probably is a set amount and does not change based on the
number of calls you make.

Illustrative Example #2: Tell whether the following items are Product/Period and
Variable/Fixed
A. Tomatoes used in the manufacture of Heinz ketchup
B. Administrative salaries of executives employed by Southwest Airlines
C. Wages of assembly-line workers at a Ford plant
D. Marketing expenditures of the Los Angeles Dodgers baseball club
E. Commissions paid to Coca-Cola's salespeople
F. Straight-line depreciation on manufacturing equipment owned by Dell Computer
G. Shipping charges incurred by Office Depot on out-going orders
H. Speakers used in Sony home-theater systems
I. Insurance costs related to a Mary Kay Cosmetics' manufacturing plant

4. As to types of inventory in a manufacturing concern:

a. Raw materials inventory: This refers to cost of materials, whether direct or indirect, which
remain unused as of reporting date. Raw materials refer to resources used as inputs in the
production process for conversion into finished goods.
b. Work-in-process inventory: This refers to cost of partially-completed goods which remain
on-hand as of reporting date.
c. Finished goods inventory: This refers to cost of completed goods which remain unsold as
of reporting date.
 Financial Statements for Manufacturing Concern

Financial statements represent the output of financial reporting.

The objective of financial statements is to provide financial information about the reporting entity’s
assets, liabilities, equity, income, and expenses that is useful to users of financial statements in
assessing the prospects for future net cash inflows to the reporting entity and in assessing
management’s stewardship of the entity’s economic resources

A reporting entity is defined as “an entity that is required, or chooses, to prepare financial
statements. It can be a single entity or a portion of an entity or can comprise more than one entity.
A reporting entity is not necessarily a legal entity”

A complete set of financial statements includes the following:

(1) Statement of financial position,
(2) Statement of comprehensive income,
(3) Statement of changes in equity,
(4) Statement of cash flows, and
(5) Notes comprising significant accounting policies and other explanatory information.

Financial Statements: Manufacturing versus Merchandising

Statement of Financial Position

A. For Merchandising – Inventory for Merchandise are the unsold items of the purchase
merchandise also known as “Merchandise Inventory”.

Current assets:
Cash and cash equivalents (Note __) XX
Trade and other receivables (Note__) XX
Financial Assets through Profit or Loss (Note __) XX
Merchandise Inventory (Note __) XX
Prepaid expenses (Note __) XX
Total Current Assets XX

B. For Manufacturing: As of reporting date, it is possible for a manufacturing concern to still

have unused materials, unfinished products, and unsold products. Thus, its statement of
financial position normally includes a separate line item for inventories.

Current assets:
Cash and cash equivalents (Note __) XX
Trade and other receivables (Note__) XX
Financial Assets through Profit or Loss (Note __) XX
Inventories (Note __) XX
Prepaid expenses (Note __) XX
Total Current Assets XX
Inventories for manufacturing include:
• Raw materials inventory: This refers to cost of materials, whether direct or indirect, which
remain unused as of reporting date. Raw materials refer to resources used as inputs in the
production process for conversion into finished goods.
• Work-in-process inventory: This refers to cost of partially-completed goods which remain
on-hand as of reporting date.
• Finished goods inventory: This refers to cost of completed goods which remain unsold as
of reporting date.

Income Statement

Similar to a merchandising concern, a manufacturing concern also observes a traditional multi-step

format for external reporting purposes. The difference between the two income statements lies in
the cost of sales computation.

Functional form (See Sample below)

Note
Net Sales 1 XX
Cost of Sales 2 (XX)
Gross Profit XX
Other Income XX
Total Income XX
Operating Expenses
Distribution Cost 3 (XX)
General and Administrative Expenses 4 (XX)
Finance Cost (XX)
Net Income (Net Loss) XX

A. Cost of Sales Presentation for Merchandising

Merchandise Inventory, beginning XX

Add: Net Purchases* XX
Total Goods Available for sale XX
Less: Merchandise Inventory, ending (XX)
Cost of Sales XX

• Where Net Purchases is equal to Purchases + Freight In – Purchase returns and allowances –
Purchase Discounts
 B. Cost of Sales Presentation for Manufacturing

The following is a detailed computation of cost of sales, which is commonly known as the Schedule
of Cost of Goods Manufactured and Sold and shown as a supporting note or schedule to cost of
sales in the income statement:

Direct Materials used XX

Direct Labor XX
Manufacturing Overhead XX
Total Manufacturing Cost XX
Add: Work-in Process, beginning XX
Cost of Work put into process XX
Less: Work-in Process, ending (XX)
Cost of Goods Manufactured XX
Add: Finished Goods, beginning XX
Cost of Goods Available for Sale XX
Less: Finished Goods, ending (XX)
Cost of Sales XX
MANUFACTURING COST CLASSIFIED
Total manufacturing costs is the sum of costs of all resources consumed in the process of making
a product. The manufacturing cost is classified into three categories: direct materials cost, direct
labor cost and manufacturing overhead.

A. DIRECT MATERIALS USED

Direct Materials are the traceable matter used in manufacturing a product. It is the cost of the raw
materials and components used to create a product. The formula in getting the direct materials is
below:

Raw Materials Inventory, beginning XX

Add: Raw materials purchases XX
Less: Raw Materials Inventory, end (XX)
Direct Materials Used XX

B. DIRECT LABOR COSTS

Direct labor costs are the wages or salaries paid to employees who physically produce products. In
other words, these expenses are the costs paid to workers who make the products that
manufactures sell.

C. MANUFACTURING OVERHEAD COST

Manufacturing overhead comprises of indirect materials, indirect employee cost and indirect
expenses which are not directly identifiable or allocable to a cost object. Overheads may defined
as the aggregate of the cost of indirect material, indirect labor and such other expenses including
services as cannot conveniently be charged directly to specific cost units.

Examples of Manufacturing Overhead: Indirect Materials, Indirect Labor, Factory utilities, Factory
Depreciation, Factory Supervisor Salaries, Factory insurance or any cost related to factory except
direct materials and direct labor.
PRIME AND CONVERSION COSTS
In cost accounting, the term for the sum of the direct materials and direct labor is prime cost.
Prime cost reflects the primary source of costs of units in production. The total of direct labor and
manufacturing overhead is often called conversion costs. Conversion cost indicates the costs
required to convert the raw materials into finished products.

Direct Materials + Direct Labor = Prime Cost

Direct Labor + Manufacturing Overhead = Conversion Cost

See Chart of Cost for a Manufacturing Company

Illustrative Example #3: Eastside Manufacturing produces small electric engines. Identify
the following costs as direct materials (DM), direct labor (DL), manufacturing overhead (MOH), or a
period cost (PC). Also indicate whether the cost is variable (V) or fixed (F) with respect to behavior.

A. Commissions paid to salespeople

B. Straight-line depreciation on the factory building
C. Salary of the plant supervisor
D. Wages of the assembly-line workers
E. Machine lubricant used in production activities
F. Engine casings used in production activities
G. Advertising placed in trade journals
H. Lease payments for the president's automobile
I. Property taxes paid on the factory facilities
APPLICATION:

Illustrative Example #4: ASSUMERA Manufacturing had the following data for the period just
ended:

Work in process, Jan. 1 P 21,000

Work in process, Dec. 31 40,000
Finished goods, Jan. 1 70,000
Finished goods, Dec. 31 61,000
Direct materials used 126,000
Direct labor 260,000
Factory depreciation 80,000
Sales 945,000
Advertising expense 52,000
Factory utilities 27,000
Indirect materials 19,000
Indirect labor 35,000

Required:
A. Calculate ASSUMERA’s Cost of Goods Manufactured.
B. Calculate ASSUMERA’s Cost of Goods Sold.

Answer:
A. Direct materials used P126,000
Direct labor 260,000
Manufacturing overhead:
Factory depreciation 80,000
Factory utilities 27,000
Indirect materials 19,000
Indirect labor 35,000
Total manufacturing costs P547,000
Add: Work in process, Jan. 1 21,000

Cost of Work put into process P568,000

Deduct: Work in process, Dec. 31 40,000

Cost of goods manufactured P528,000

B. Finished goods, Jan. 1 P 70,000

Add: Cost of goods manufactured 528,000
Goods available for sale P598,000
Deduct: Finished goods, Dec. 31 61,000
Cost of goods sold P537,000
 Illustrative Example #5: DIKANIYAMAHAL Company had the following inventory balances at
the beginning and end of the year:

January 1 December 31
Raw material P 50,000 P 35,000
Work in process 130,000 170,000
Finished goods 280,000 255,000

During the year, the company purchased P100,000 of raw material and spent P340,000 on direct
labor. Other data: manufacturing overhead incurred, P450,000; sales, P1,560,000;selling and
administrative expenses, P90,000; income tax rate, 30%.

Required:
A. Calculate cost of goods manufactured.
B. Calculate cost of goods sold.
C. Determine DIKANIYAMAHAL’s net income.

Answer:
A. Direct materials used:
Raw materials, Jan. 1 P 50,000
Add: Purchases 100,000
Raw materials available for use P150,000
Deduct: Raw material, Dec. 31 35,000
Raw material used P 115,000
Direct labor 340,000
Manufacturing overhead 450,000
Total manufacturing costs P 905,000
Add: Work in process, Jan. 1 130,000
Cost of work put into Process P1,035,000
Deduct: Work in process, Dec. 31 170,000
Cost of goods manufactured P 865,000

B. Finished goods, Jan. 1 P 280,000

Add: Cost of goods manufactured 865,000
Cost of goods available for sale P1,145,000
Deduct: Finished goods, Dec. 31 255,000
Cost of goods sold P 890,000

C. Sales revenue P1,560,000

Less: Cost of goods sold 890,000
Gross margin P 670,000
Less: Selling and administrative expenses 90,000
Income before taxes P 580,000
Income tax expense (P580,000 x 30%) 174,000
Net income P 406,000
 Illustrative Example #6: The following selected information was extracted from the 2020
accounting records of KAILANGANKITA Products:

Raw materials used P284,000

Direct labor 178,000
Indirect labor 35,000
Selling and administrative salaries 250,000
Building depreciation* 330,000
Other selling and administrative expenses 80,000
Other factory costs 620,000

Seventy percent of the company's building was devoted to production activities; the remaining
30% was used for selling and administrative functions.

KAILANGANKITA’s beginning and ending work-in-process inventories amounted to P306,000 and

P245,000, respectively. The company's beginning and ending finished-goods inventories were
P450,000 and P440,000, respectively.

Required:
A. Calculate KAILANGANKITA’s manufacturing overhead for the year.
B. Calculate KAILANGANKITA’s cost of goods manufactured.
C. Compute the company's cost of goods sold.

Answer:
A. Indirect labor P 35,000
Building depreciation (P330,000 x 70%) 231,000
Other factory costs 620,000
Manufacturing Overhead P 886,000

B. Raw material used P 284,000

Direct labor 178,000
Manufacturing overhead (see answer A) 886,000
Total manufacturing costs P1,348,000
Add: Work in process, beg. 306,000
Cost of Work put into process P1,654,000
Deduct: Work in process, end. 245,000
Cost of goods manufactured P1,409,000

C. Finished goods, beg. P 450,000

Add: Cost of goods manufactured 1,409,000
Cost of goods available for sale P1,859,000
Deduct: Finished goods, end. 440,000
Cost of goods sold P1,419,000
 COST ACCUMULATION SYSTEM

The basic objectives of cost accounting is the determination or accumulation of a product’s cost for
inventory valuation.

The following systems maybe used in accumulating a product’s cost (input Measurement Basis)

1. Actual Cost system (Historical) - Assigns actual costs to direct materials, direct labor, and
manufacturing overhead
2. Normal Cost System - Commonly used, computes total manufacturing costs based on
actual costs of direct materials and direct labor, and applied manufacturing overhead cost.
3. Standard cost system - Assigns standard or budgeted costs to all manufacturing costs.

Product Costs Actual Normal Standard

Direct Materials Actual Actual Standard
Direct Labor Actual Actual Standard
Manufacturing Overhead Actual Predetermined Standard

Predetermined Manufacturing Overhead

The primary purpose of overhead rate is to charge a fair share of overhead cost to each costs. The
common bases are as follows:
• Direct Labor costs
• Direct Labor hours
• Direct material costs
• Machine hours
• Units of Production

Illustrative Example #7: To illustrate the computation procedures for each basis, assume the
following budgeted data for the year:
Manufacturing overhead ₱100,000
Number of Units of Production 25,000
Direct Material costs ₱500,000
Machine Hours 10,000
Direct Labor Hours 40,000
Direct Labor Costs ₱250,000

1. Compute for the predetermined manufacturing overhead based on the direct labor costs.
Manufacturing overhead ₱100,000
Direct Labor Costs ₱250,000

Predetermined Manufacturing overhead is 40% of direct labor costs (100,000/250,000)

2. Compute for the predetermined manufacturing overhead based on the direct labor hours.
Manufacturing overhead ₱100,000
Direct Labor Hours 40,000

Predetermined Manufacturing overhead isP2.5 per direct labor hour (100,000/40,000)

 3. Compute for the predetermined manufacturing overhead based on the direct material
costs.
Manufacturing overhead ₱100,000
Direct Material costs ₱500,000

Predetermined Manufacturing overhead is 20% of direct material costs (100,000/500,000)

4. Compute for the predetermined manufacturing overhead based on Machine hours.

Manufacturing overhead ₱100,000
Machine Hours 10,000

Predetermined Manufacturing overhead is P10 per machine hour (100,000/10,000)

5. Compute for the predetermined manufacturing overhead based on Units of Production

Manufacturing overhead ₱100,000
Number of Units of Production 25,000

Predetermined Manufacturing overhead is P4 per unit (100,000/25,000)

NORMAL VS ACTUAL COST SYSTEM

To differentiate the two cost systems,

1. Actual Cost system (Historical) - Assigns actual costs to direct materials, direct labor, and
manufacturing overhead
2. Normal Cost System - Commonly used, computes total manufacturing costs based on
actual costs of direct materials and direct labor, and applied manufacturing overhead cost.

Product Costs Actual Normal

Direct Materials Actual Actual
Direct Labor Actual Actual
Manufacturing Overhead Actual Predetermined

The only difference is that Overhead cost for actual is the actual costs incurred while with Normal
Cost system is the predetermined overhead (applied).

Illustrative Example #8: Huxtable charges manufacturing overhead to products by using a

predetermined application rate, computed on the basis of machine hours. The following data
pertain to the current year:
Budgeted manufacturing overhead: P480,000
Actual manufacturing overhead: P440,000
Budgeted machine hours: 20,000
Actual machine hours: 16,000
Determine the overhead cost applied to production:
The predetermined rate is P480,000/P20,000 = P24 per machine hour. Under normal cost system,
the overhead applied to production is 16,000 hours X 24 per hours = P384,000.
What will happen to the actual costs if normal system is used? What will happen to the
difference of actual costs vs applied costs?

• Actual costs > Applied Costs – The overhead appears to be underapplied. Meaning under
normal system, applied costs is below than the actual costs.
• Actual costs < Applied Costs - The overhead appears to be overapplied. Meaning under
normal system, applied costs is higher than the actual costs.

Illustrative Example #9: Maher, Inc., applies manufacturing overhead at the rate of P60 per
machine hour. Budgeted machine hours for the current period were anticipated to be 80,000;
however, a lengthy strike resulted in actual machine hours being worked of only 65,000. Budgeted
and actual manufacturing overhead figures for the year were P4,800,000 and P4,180,000,
respectively. Overhead is ______.

Actual 4,180,000
Applied (60 X 65,000) 3,900,000
Underapplied overhead 280,000

Illustrative Example #10: Carlson charges manufacturing overhead to products by using a

predetermined application rate, computed on the basis of labor hours. The following data pertain
to the current year:
Budgeted manufacturing overhead: P1,800,000
Actual manufacturing overhead: P1,632,000
Budgeted labor hours: 50,000
Actual labor hours: 48,000
Overhead is ______.

Budgeted manufacturing overhead 1,800,000

Budgeted labor hours 50,000
Predetermined rate 36

Actual hours 48,000

Applied rate 36
Applied Overhead cost 1,728,000

Actual Overhead cost 1,632,000

Applied Overhead cost 1,728,000
Overapplied Overhead cost (96,000)
How should the Overapplied and underapplied be treated in Accounting?

At the end of the year, the balance in manufacturing overhead account (over or under-applied
manufacturing overhead) is disposed off by either allocating it among work in process, Finished
Goods and Cost of Goods Sold accounts or transferring the entire amount to cost of goods sold
account.

• Transferring the entire amount to Cost of Goods Sold.

o Under-applied – add to get the adjusted Cost of Goods Sold
o Over-applied – deduct to get the adjusted Cost of Goods Sold

Illustrative Example #11: For Cases above, assume that Cost of Goods Sold is P3,200,000. What
is the Adjusted cost of Goods Sold at year end?

Illustrative #6 Illustrative #7
Cost of Goods Sold 3,200,000 Cost of Goods Sold 3,200,000
Underapplied Overhead 280,000 Overapplied Overhead (96,000)
Adjusted Cost of Goods Sold 3,480,000 Adjusted Cost of Goods Sold 3,104,000

Illustrative Example #12: Fletcher, Inc., disposes of under- or overapplied overhead at year-end as
an adjustment to cost of goods sold. Prior to disposal, the firm reported cost of goods sold of
P590,000 in a year when manufacturing overhead was underapplied by P15,000. If sales revenue
totaled P1,400,000, determine (1) Fletcher's adjusted cost of goods sold and (2) gross margin.

Cost of Goods Sold 590,000

Underapplied Overhead 15,000
Adjusted Cost of Goods Sold 605,000

Sales Revenue 1,400,000

Adjusted Cost of Goods Sold (605,000)
Gross Profit 795,000

• Allocating to WIP, Finished Goods and Cost of Goods will be discussed in advanced
cost accounting courses.

REFERENCES:
Dela Cruz, A.L.C., Rabo, J.S., & Tugas, F.C. (2019). Basic financial accounting and
reporting.

Price, J., Haddock, M., & Farina, M., (2018). College Accounting, 15h ed. McGraw-
Hill Education.

__END___
MJ ESPIRITU