If you look at the income statement of a manufacturing business, you will not fail to notice that it mentions “finished goods” under the Sales subheading. You will not find it in the income statement of trading businesses. This is because manufacturing businesses do not buy products at a low price and sell them at a higher price. Instead, they sell the products they make.
This makes accounting for manufacturing business slightly differently from accounting for trading business. Unlike other businesses, a manufacturing business uses raw materials to produce goods, which are then sold to market. All the ending balances resulting from the various activities must be properly valued before inclusion in the balance sheet. Thus, a great deal of accounting for manufacturing businesses involves the valuation of inventory and the cost of goods sold.
Types of inventories used
Manufacturing businesses use either a periodic inventory or a perpetual inventory system to track the number of units remaining in the inventory. This information is crucial for determining the value of the inventory.
Periodic inventory system
This system is easier to maintain, but it gives an accurate value only when a physical inventory count is conducted. Because of this, large manufacturers do not use this system as counting millions of items in the inventory is impractical.
Perpetual inventory system
This system gives an accurate value at any point in time as the changes to the inventory is updated into the system in real time; but requires rigorous record keeping and cycle counting to ensure a high level of accuracy. This is the recommended inventory system for most manufacturing businesses.
How the inventory valuation is done
The valuation of inventory involves the following activities:
Direct cost assignment
For the correct valuation of inventory, costs under various headings must be correctly assigned to the inventory. This is done using First-In First-Out (FIFO), Last-In First-Out (LIFO) or Weighted-Average Costing, whichever is appropriate.
Overhead cost assignment
The overhead costs under various heading are aggregated into several different cost pools and then allocated to the total number of units produced during the accounting period.
This testing is done to ascertain if the amounts at which inventory items recorded are higher than their market value. If they are, then the inventory values are lowered down to the market values. It is usually done at the end of an annual reporting period.
Cost of goods sold
The cost of goods sold is derived by adding purchases to the beginning inventory and then subtracting the ending inventory. The correct value of the cost of goods sold depends on how correctly direct cost assignment, overhead cost assignment and impairment testing were done. Additionally, any abnormal costs incurred are charged directly to the cost of goods sold, rather than recording them in the inventory, such as in the case of excessive scrap.
Thus, accounting for manufacturing businesses is much more detailed and time-consuming than other types of accounting. Manufacturing companies strive to reduce the workload by reducing the inventory at hand as soon as they can. Accounting for manufacturing can be rather complex so it will be a smart move to go for only the best accounting services in Singapore if you are looking to hire consultants.