DDU, Department of Accounting & Finance Principles of Accounting I 2018

Chapter –Four
Accounting for manufacturing business enterprise
A manufacturing business purchases raw material, convert them in to finished goods and sell
them to customer (wholesalers, retailers, end users). In manufacturing firms the activities
involved & the investment required are usually complex and extended than the other types of
business organization. There are always more than one department to convert raw materials in to
finished products.
Manufacturing costs: there are three types of manufacturing costs
1. Direct material cost – these are the costs of the major ingredients that are incorporated as
part of the finished product. It is traceable to a certain product easily.
2. Direct labor costs – these are the costs of the human labor that are traceable to particular
product easily.
3. Manufacturing overhead cost – these are manufacturing costs other than the above two
categories. They are also called factory overhead cost, indirect manufacturing cost,
factory burden costs etc.
a. Indirect material cost –
b. Indirect labor cost-
Cost Classification
- Now consider some ways of classifying costs:
 Based on business function (R&D, Design, Production(manufacturing), Marketing,
Distribution, Customer service)
For purposes of contracting with government agencies design & R&D costs are
treated as product costs
 Based on financial statement presentation (capitalized, noncapitalized, inventoryable,
non-iventoriable: product vs. period)
 Based on assignment to cost object (direct vs. indirect)
 Based on whether or not the specified subunit can control or significantly influence the
cost(controllable cost, uncontrollable cost)
 Based on behavior in relation to cost driver (variable vs. fixed)
 Based on aggregation (total vs. unit)
 Based on economic characteristics of costs ( opportunity cost, sunk cost, incremental
cost, marginal cost)
Direct Costs and Indirect costs
- A key question in cost assignment is whether costs have a direct or an indirect relationship to
the particular cost object. The direct/indirect classification has no meaning unless one first
identifies the cost object to which the costs are to be related.
Direct Costs

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- Are costs related to a cost object and can be conveniently and economically traced (tracked)to
that cost object [product, department, etc.]. It is a cost used by a single cost object and would
be eliminated if the cost object is eliminated.
- Includes -the cost of materials specifically used in manufacturing a product or providing a
service. Examples are:
• the cost of the cans or bottles of Pepsi-colas,
• the cost of the metal frame and the lumber to make a chair;
• the cost of cloth and buttons used in manufacturing clothing’s,
• A supervisor's salary is a direct cost to the production department he or she is in charge of
or managing.
• Specific labor costs that can be identified with the work involved in manufacturing a
product or providing a service and other expenses that can be specifically identified with
a product or service.
- The term cost tracing describes the assignment of direct costs to the particular cost object.
Indirect Costs
- Are costs related (directly or indirectly) to a cost object but cannot be conveniently or
economically traced (tracked) to that cost object. Instead of being traced, these costs are
allocated to a cost object in a rational and systematic manner. The term cost allocation is used
to describe the assignment of indirect costs to a particular cost object.
- Indirect costs are also known as common costs--costs shared by more than one cost object.
- For example, the salaries of supervisors who oversee production of many different soft drink
products bottled at a Pepsi plant is an indirect cost of Pepsi-colas. Supervision costs are related
to the cost object (Pepsi-cola) because supervision is necessary for managing the production
and sale of Pepsi-colas. Supervision costs are indirect cost because supervisors also oversee the
production of other products such as 7-up. Unlike the cost of cans or bottles, it is difficult to
trace supervision costs to the Pepsi-cola line.
- Other examples include Electricity, Rent, Property taxes, janitors, factory supplies are
examples.
Factors affecting direct/Indirect cost classification
Several factors affect this classification
1. The materiality(relative importance) of the cost
o The larger the amount of a cost, the more likely that it is economically feasible to trace
that cost to a particular cost object, But if it is small, it should be classified as indirect
cost as it would not be economically feasible (cost>benefit). That is why minor items
such as nails and glue are treated as indirect costs.
2. Information gathering technology
o improvement in technology have enabled to treat more and more cost as direct costs,
which were previously treated as indirect costs.
e.g. many components parts display a bar code that can be scanned at every point in the
production process

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3. Design of operation
o Classifying a cost as direct is easier if a company's facility (or some part of it) is used
exclusively for a specific cost object, such as a specific product or a particular customer.
- The direct/indirect classification depends on the choice of the cost object. A specific cost may be
both a direct cost of one cost object and an indirect cost of another cost object. The definition
of a cost as direct or indirect changes if the cost object changes.
E.g Take a production department manager’s salary, if the cost object is the production
department, the salary is a direct cost because it canbetraced to the cost object. But if the
cost object is one of the many products manufactured in the production department, the
salary is an indirect cost because it can be allocated (but cannot be traced) to the cost
object.
- Generally, managers are more confident about the accuracy of direct costs of cost objects.
Indirect costs pose more problems.
Tracing versus Allocating Costs – Example
ABC, Inc. makes two products; bricks and play sand. The products are produced in two separate
facilities, and the plant supervisors work at both plants. Allocate rent and salaries based on
revenues.

Product Units produced and Sold Sales price per unit

Bricks 2,000,000 tons $0.75
Sand 30,000 tons $90.00

The brick operation consumes 70% of the material purchased. The play sand uses the remaining
30%. Labor has an average cost of $10 per hour. The brick operation uses 21,000 labor hours.
The play sand operation uses 14,000 labor hours. The company pays all utilities on one bill that
goes to the headquarters. Headquarters allocates 50% of the utilities cost to each product.
Required: Show how revenue and cost are assigned to each product (cost object)

Solution:

Cost type Total cost bricks sands How assigned

Sales revenue $4,200,000 $1,500,00 $2,700,000 Traced
0
Materials 800,000 560,000 240,000 Traced
Labor 350,000 210,000 140,000 Traced
Supervisors 140,000 50,000 90,000 Allocated
Plant rent 700,000 250,000 450,000 Allocated
Total utilities 160,000 80,000 80,000 Allocated

Managers want to accurately assign costs to cost objects. Inaccurate product costs will mislead
managers about the profitability of different products; as a result, managers might promote
products that are not profitable while deemphasizing products that are profitable.
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Manufacturing and Nonmanufacturing Costs

- The costs associated with a manufacturing firm are separated into two broad categories. These
include manufacturing costs and nonmanufacturing (selling and administrative) costs. This
functional separation is important because each category of cost is treated differently in the
accounting records. Manufacturing costs are capitalized (recorded as asset) and expensed in the
form of cost of goods sold at time of sale. Nonmanufacturing costs are immediately expensed.
The different treatments are required to obtain proper matching.
Manufacturing Costs:

- Manufacturing is the process of converting materials into finished goods by using labor and
incurring other costs, generally called, manufacturing overhead. Manufacturing costs are costs
associated with the production of products.
- Three terms are widely used in describing manufacturing costs. In the following definitions,
“the cost object” refers to “work in process and then finished goods.”
1. Direct Material Costs
 Are the acquisition costs of all materials that eventually become part of the cost object
and that can be traced to the cost object in an economically feasible way.
 They must be a significant part of the finished good. For example the metal frame and
the lumber used in manufacturing a chair, steel in the manufacture of automobiles ,wires
for TV sets, and the buttons used in manufacturing clothing, costs of paper and ink for a
printer ,
 DMs do not include minor items such as nails or glue. Why? Because the costs of tracing
insignificant items do not seem worth than the possible benefit of precise product costs.
So, such items as supplies or indirect materials are classifies as FOH.

2. Direct labor Costs

 Include the compensation of all manufacturing labor who work directly in the production
process that can be traced to the cost object in an economically feasible way.
E.g. in a factory that makes chairs, wages of workers who cut and sand lumber and of
those who assemble the parts into finished chairs, wages of carpenters for a
construction company
 The labor must clearly be associated with a particular cost object, in order for the labor to
be called "direct labor."   An example would be a production supervisor in a factory with
multiple product lines. The supervisor would go from machine to machine inspecting the
different types of products to make sure there were not any defects.  Although the
supervisor did an important job, it was impossible to assign his time to any particular
product.  As a result, the inspector's labor was not considered direct labor.   
 In highly automated factories with a flexible workforce, there may be no direct labor
costs. Why? Because workers spend time on numerous products, which makes it
economically infeasible to physically trace any labor cost directly to specific products.

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3. Indirect Manufacturing Costs (also called manufacturing overhead costs or

factory overhead costs ,factory burden)
 The generic term "overhead" can refer to all the costs in a company that are not direct
labor or direct material. But there is a distinction between overhead and manufacturing
overhead.
 Manufacturing overhead means the same thingall costs except direct labor and direct
materials.  The difference is that manufacturing overhead refers to those costs closely
related to the factory or production process and therefore excludes administrative and
selling expenses(e.g the president's salary, accountants, lawyers, interest expense,
advertising, marketing, secretarial staff, distribution costs, income taxes, etc, and any
other). 
 Manufacturing overhead costs are all manufacturing costs that are related to the cost
object but that cannot be traced to that cost object in an economically feasible way. You
cannot easily determine how much of these costs it takes to make one product. The total
dollars spent support the manufacturing of many products.
 Indirect cost of a cost object are divided into cost pools(a grouping of individual cost
items) and allocated to the cost object
 Usually subdivided into three categories:
i) Indirect materials-- the cost of materials of two types:
The cost of materials of two types:
a) Materials that are not physically incorporated in the product (such as the cost of
lathe blades in a furniture plant factory, supplies or operating supplies -cleaning
supplies, gloves, brushes, repair parts, light bulbs etc ). These are materials used
in production which do not end up as part of the finished product;
b) The cost of minor materials, even if they are physically incorporated in the
product (such as glue in manufacturing arm chairs, some paints and
lubricants oils, and greases, small amounts of wire, thread in sewing a suit).
These are materials used in small amounts in the mfg process that cannot easily
be allocated to specific products.
ii) Indirect labor
- The cost of compensating employees who are necessary for production (work in the
factory), but don’t actually transform the materials or assemble the product.
E.g. Wages of plant janitors, storeroom clerks, timekeepers, superintendents,
maintenance crew, factory foremen/supervisors, quality inspectors, cost
accountants, engineers, plant guards, wages of custodial personnel etc.
Note: For the above items, the company will incur costs for salaries, wages, Social Security and Medicare
taxes, unemployment compensation tax, worker compensation insurance, health insurance, holiday
pay, vacation pay, sick pay, pension or retirement plan, seminars and training, and perhaps more.
iii) Other mfg OH
-However, many costs are incurred so that the business can operate.

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E. g.Payroll taxes on factory wages, rent, depreciation, taxes, insurance on factory buildings and
machines, heat, light and power. Also includes service department costs, such as costs
incurred in the maintenance department or the engineering department, personnel, cafeteria.
Service departments are not directly related to the production of an item. Their function is
to provide services for other departments. A portion of the service department's cost should
be allocated to the production department and will become part of product cost(to be
discussed in cost and mgt accounting I). The portion not allocated to the production
department may be allocated to another service department or to a nonplant department,
such as the sales department, and will be an expense for that department for the current
period.
- Many of them relate to the physical plant (building, machinery and equipment)
- It is important to remember that these expenses must be on the factory facilities and not on the
administrative and selling offices in which case it will be nonmanufacturing costs.

 Note that precise classification of some costs in to one of these categories (DM, DL & FOH)
may be difficult and judgment may be required in the classification process.
Nonmanufacturing Costs
- In addition to DM, DL and FOH, all manufacturing companies also incur costs associated with
the other value chain functions (R & D, design, marketing, distribution, and customer service).
Most firms’ financial statements report these costs as selling and administrative expenses. In
short, these costs do not become a part of the reported inventory cost of the manufactured
products.
Selling Costs:
• The costs associated with selling the product are Selling Costs. These include sales salaries
and commissions, payroll tax sales salaries, advertising, delivery expenses (Freight Out),
depreciation on store equipment, stores and their related fixtures and equipment etc .
Warehouse costs and people who move inventory are period costs.
General and Administrative Costs
• Viewed as the core of necessary costs to manage the entire firm.
• This includes costs that are part of the administrative arm of the business, provided these
costs can't be traced directly or indirectly to the manufacturing function.
E.g Officers' salaries expense, office salaries expense, payroll tax expense – administrative,
office supplies and expense, Bad debt expense, depreciation on office buildings and
eqts, Insurance, and Property Tax on executive headquarters, Advertising Expense
etc

- Theoretically, if there are future benefits associated with a cost, the cost should be capitalized
as an asset rather than expensed. Certainly there are some future benefits associated with costs
such as research and development, training, market promotion and advertising.
- However, these costs are expensed as incurred because it is difficult if not impossible to relate
them to the future benefits. As a result, these costs are referred to as period costs.

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Material and cost flows (manufacturing companies)

There are 3 types of inventories in a manufacturing business enterprise.
1. Raw materials inventory –
2. Work in process inventory-
3. Finished goods inventory-

Manufacturing costs consists of direct material, direct labor, and manufacturing overhead.
The product costing system used by companies employ several manufacturing accounts. As
production takes place, all manufacturing costs are added to the work- in-process inventory
accounts. Work in process is partially completed inventory. A debit to the account increases
the cost-based valuation of the asset represented by the unfinished products. As soon as
products are completed, their product costs are transferred from Work-in-Process Inventory
to Finished-Goods Inventory. This is accomplished with a credit to Work in Process and a
debit to Finished Goods. During the time period when products are sold, the product cost of
the inventory sold, which is an expense of the period in which the sales occurred. A credit to
finished goods and a debit to cost of goods sold completes this step. Cost of goods sold is
closed into the income summary account at the end of the accounting period, along with all
other expenses and revenues of the period.(see exhibit 3-7)
Exhibit 3-7 : Material and cost flow manufacturing companies

Work in process inventory finished goods inventory

Direct material cost

Direct labor cost product cost is transferred
Mfgover head cost when product is transferred

Product cost are transferred when product is sold

Cost of goods sold income summary

Expense closed to I/s

At the end of year

Cost Accounting System in Manufacturing Business

There are two principal types of costing system:
A. Job costing – is a costing system also called job order costing where the cost of each
independent and discrete will be determined. The jobs are most often performed based on
customer order & the cost of each job is accumulated in a separate record called job cost
sheet. The total cost of job is the sum of direct material, direct labor and factory

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overheadcost recorded in the job cost sheet for that particular job. Job may be a single
unit or a number of items with same nature.
B. Process costing – is accosting system where costs are accumulated in each processing
department. This system is applicable in a factory where similar items are produced in
bulk almost with equal attention. Some of the companies which use this system are sugar
factories, cement factories, textile factories, food complex companies etc. for example a
company has three processing department such as cutting, assembly and finishing
department. The goods that are fully processed in the first department will transfer to the
next department & will be finished goods when leaving the last department. The cost of
each department will be the sum of direct material, direct labor and factory over head cost
incurred in it until items are transferred to the next department or are completed and total
cost is the sum of costs in each processing department.
Eg.Mirt garment factory manufactures various types of clothes for children. The factory
has three department, cutting, assembly and finishing departments. In January 1998 the
company has manufactured 2000 shirts & the costs incurred in each department were as
follows

Cutting Assembly finishing

Direct material cost Br,12800 Br, 3200 Br, 1000
Direct labor cost 5000 20,000 5000
Factory over head cost 3000 8000 2000
Required : the cost of each department
Determine the total cost & cost per unit of items produced
Solution:
Cost of each department= direct material + direct labor + FOH
Cutting department= 12,800+ 5000+30000 = 20,800
Assembly department = 3200 +20,000+ 8000 = 31,200
Finishing department = 1000 +5000 +2000 = 8,000
Total cost ------------------------------------ 60,000
Cost per unit = 60,000/2000 = Br,30
1. As direct materials and direct labor are used in production department A, these costs are
added to the Work-in Process inventory account for Department A. Overhead is applied
using predetermined overhead rate. The POR is determined in the same way in job order
and process costing.

Work-in Process: Production Department A xxx

Raw Materials xxx
Wage Payable xxx
Manufacturing overhead applied xxx

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2. When production department A completes its work on some units of product, these units
of product are transferred to production department B. The costs assigned to these goods
are transferred from the Work-in Process Inventory account for department A to work-in
Process inventory account in department B, the costs assigned to those partially
completed products are called transferred-in costs1.
Work-in Process: Production Department B xxx
Work-in Process: Production Department A xxx
3. Direct material and direct labor are used in production department B, and manufacturing
overhead is applied using POR.
Work-in Process: Production Department B xxx
Raw Materials xxx
Wages Payable xxx
Manufacturing overhead applied xxx
4. Goods are completed in production department B and transferred to the finished goods
warehouse.
Finished-Goods xxx
Work-in Process: Production Department B xxx
5. Goods are sold
Cost of Goods Sold xxx
Finished-Goods xxxx
Illustration of work sheet for a manufacturing enterprise
Use of worksheet is optional. The worksheet is not part of the basic accounting records.
Worksheets assist with only a portion of the accounting cycle. The procedures for preparing a
work sheet for manufacturing enterprise are similar to those used for merchandising enterprise.
The addition of a pair of columns to summarize the manufacturing operation is the major
difference. These columns allow for one more step in the classification of the data.
Nature of a manufacturing firm
Three different inventory accounts are maintained by a manufacturing firm:
1. Raw materials inventory
2. Work in process inventory and
3. Finished goods inventory
These are reported into the current asset section of the balance sheet at the end of the period. In
general, cost flows for manufacturing enterprises.

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Raw materials work in process finished goods Costs of goods sold (this when
the goods are sold). .

Cost of finished products consists of three manufacturing cost elements:

 Direct materials costs
 Direct labor costs and
 Manufacturing overhead
The following unadjusted trial balance was prepared by Addis manufacturing company
accountant in the first pair of columns of the work sheet for the year ended Dec.31,1990.
Statement of Cost of Finished Goods Manufactured format
The cost of goods completed during an accounting period is summarized in a statement of cost of
finished goods manufactured. We can take from the manufacturing columns of the worksheet.
Name of the company
Statement of Cost of Finished Goods Manufactured
For the year ended xx, xxx
Direct material used:
Raw material beginning------xx
Raw material purchases-------xx
Less: raw material purchases ending—(xx)
ending—(xx)
Direct material used------------------xx
Direct labor----------------------------xx
Factory overhead----------------------xx
overhead----------------------xx
Manufacture cost for the period------------xx
Add: beginning work in process----------------------xx
process----------------------xx
Total work in process-------------------------------xx
Less: ending work in process------------------------------- (xx)
Cost of finished goods manufactured------------------------------------------xx

Work sheet for Mehariw manufacturing enterprises

The same purposes that were mentioned for a merchandising business are also obtained from
work sheet of Mehariwmanufacturing firm during 2012.

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Mehariw shoe factory

Unadjusted Trial Balance
On Dec.31, 2012
Accounts Dr. Cr.
Cash 14400
Raw materials inventory 8000
Work in process inventory 25000
Finished goods inventory 11200
Prepaid factory insurance 4550
Factory supplies 6700
Office supplies 1750
Machinery 75000
Acc.deprc. machinery 28125
A/payable 4420
Mahriew capital 56605
Sales 170550
Raw materials purchased 451000
Fright on RM purchased 1000
Direct labor 19000
Indirect labour 8400
Factory utilities 2100
Delivery expense 9000
Office salaries expense 27200
Sales salaries expense 13200
Advertising expense 9000
Miscellaneous gen. expense 16000
Total 259700 259700

Additional information:
a. Raw material inventory at Dec.31,2012 was Br.2,500
b. Work in process inventory at Dec.31,2012 was Br.3,100
c. Finished goods inventory at Dec.31,2012 was Br.2,000
d. Unexpired portion of prepaid factory insurance at Dec.31,2012 was Br. 50
e. Factory supplies on hand at Dec.31.,2012 total was Br.700
f. Office supplies on hand at Dec.31.2012 total was Br.50
g. Accrued direct labor and indirect labor were Br.500 and Br.100,respectively at Dec.31.,2012
h. Machinery was being depreciated for the last 15 years on straight-line basis.
Required:
a. Prepare the work sheet for Mehariw shoe factory
b. Prepare statement of cost of goods manufactured
c. Prepare income statement
d. Pass the adjusting and closing entries.

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Mehariw shoe factory

Work sheet
For the year ended Dec.31, 2012

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Account title Trial balance Adjustments Manufacturing statement Income statement Balance sheet
Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr. Dr. Cr.
Cash 14,400 14400
Raw material in. 8,000 a)2,500 8000 2500
Work in process in. 2,500 b)3100 2500 3100
Finished goods in. 11,200 c)2000 11200 2000
Prepaid factory insur. 4,550 d)4500 50
Factory supplies 6,700 e)6000 700
Office supplies 1,750 f)1700 50
Factory machinery 75,000 75000
Accum.Dep.-Mach. 28,125 h)1875 30000
Account payable 4,420 4420
Mehariw capital 56,605 56605
Sales 170,550 170,550
Raw material purch. 45,100 45,100
Freight on RMP 1,000 1000
Direct labor 19,000 g)500 19500
Indirect labor 8,400 g)100 8500
Factory utilities 2,100 2100
Delivery expense 9,000 9000
Office salaries exp. 27,200 27200
Sales salary exp. 13,200 13200
Advertising exp. 9,000 9000
Miscellany.exp. 1,600 1600
Total 259,700 259,700
Income summary c)11200 2000 11200 2000
Manufacturing sum. a,b,)8000 2500+3 10,500 5600
+2500 100
Factory insur..exp. d)4500 4500
Factory supp.exp. e)6000 6000
Accrued wage pay. g)600 600
Office supp.exp. f)1700 1700
Dep.exp-machinery h)1875 1875
Total 43,975 43,975 99,075 5,600
Cost of FGs manufa. 93,475 93,475
Total 99,075 99,075 166,375 172,550 97,800 91,625
Net income 6,175 6,175
172,550 172,550 97,800 97,800

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