BM2409

INTRODUCTION TO MANUFACTURING BUSINESS

Buy-Produce-Sell
Manufacturing is the most diverse of the three (3) business types in terms of activity. Aside from the buying
and selling activities, a manufacturing entity's production phase is unique, which complicates things further.
First, a manufacturing concern has to buy raw materials. Second, labor is procured and applied, and
other costs are incurred. Finally, the finished product is sold to customers.
The accounting for raw material purchases and customer sales is similar to that of a merchandising business.
Of course, there is the distinction that under a merchandising concern, purchased inventory is for sale without
modification, whereas accounting for sales to customers is substantially the same.
It should be mentioned that the above are just simplified descriptions of the general activities and sequencing
of a manufacturing concern's activities.
For deeper insight, complications may arise since making a product requires several raw materials. This means
the purchasing department will have to deal with different suppliers. When orders arrive, the receiving
department may have to inspect these several raw materials. Also, sufficient labor must be secured, especially
when a high-skilled and technical labor force is needed.
The majority of costs are incurred during the production stage. Close monitoring and proper cost accounting
are critical because costing directly impacts pricing. In a competitive industry, pricing is crucial. Forecasting
and budgeting are central to many of the activities listed above. All of these topics will be covered in your
higher accounting classes.

Elements of Manufacturing Costs

In broad terms, a cost is the amount of resources spent to achieve a specific object or objective.

Figure 1: Cost Classification

Source: Management Guru: The Essence of Management, 2014. Retrieved from https://www.managementguru.net/cost-
accounting/cost-classification/

08 Handout 1 *Property of STI

Page 1 of 9
 BM2409

Product Cost and Period Cost

Product cost includes all costs associated with acquiring and manufacturing a product. These are the costs
associated with the product from when it is manufactured until it is ready to be sold. Product costs are initially
assigned to inventory accounts (raw materials, work in process, finished goods) and then charged to expense
when sold. Product costs include direct material, direct labor, and factory overhead, also called inventory
costs.
All costs that are not product costs are classified under period cost. All non-manufacturing costs (selling and
administrative expenses) are treated as period costs and expensed as incurred.

Manufacturing Cost
1. Direct material – Raw materials are incorporated into the final product and thus become integral, with
their cost directly traceable to the finished product. Raw materials may be either direct or indirect.
Examples of direct materials include fingerprint readers in smartphone home buttons, ink tanks in printers,
and wood used for cabinets, the costs of which can be easily traced back to the finished product. Indirect
materials are raw materials that are relatively inexpensive and thus difficult to trace, typically due to small
amounts, such as binding glue used in books or thermal grease used in computer microprocessors.
2. Direct labor – Consists of labor costs that can be conveniently traced to the finished product. Examples
are direct labor workers’ salaries in Samsung’s computer assembly lines, the labor cost of electrical wiring
in construction, the salary of a shoemaker, etc.
3. Manufacturing overhead – This includes all manufacturing costs except direct materials and direct labor.
It is a catch basin cost classification, which means that anything that could not be conveniently traced or
classified as direct materials or direct labor falls under this category. Examples are maintenance and
insurance on manufacturing facilities, heating and lighting for a building, and depreciation of factory
machinery, among others.

Non-Manufacturing Cost
1. Selling Costs – Include all costs incurred in selling the company’s product, including costs to secure
customer orders, commissions to sales agents, recording costs for sales transactions, depreciation of
selling equipment, and delivery costs.
2. Administrative Costs—Include all costs associated with an organization's general management and
administration. Examples are administrative staff salaries, office fixtures depreciation, executive
compensation, and the like.

Prime Cost and Conversion Cost

Two additional cost categories are frequently used in discussions of manufacturing costs: prime cost and
conversion cost. The prime cost is the sum of the direct material and labor costs. Conversion cost is the sum
of direct labor and manufacturing overhead costs. Conversion cost refers to the direct labor and
manufacturing overhead costs incurred when converting materials into finished products.

08 Handout 1 *Property of STI

Page 2 of 9
 BM2409

Direct and Indirect Cost

If a cost is particularly traceable to a specific activity, it is a direct cost. It is also called a separable or traceable
cost. If the activity that causes its incurrence is stopped, the direct cost also ceases to be incurred. It is an
indirect cost if a cost is not particularly traceable to a specific activity but rather to several activities.

Cost Flow in a Manufacturing Business (Manufacturing Inventory Accounts)

Product Cost Period Cost

Costs Purchase of Raw Direct Labor Manufacturing Selling and

Materials Overhead Aministrative

Statement of Materials Work in Process Finished Goods

Financial Position Inventory Inventory Inventory

Statement of
Profit or Loss Cost of Goods
Sold

Selling and
Aministrative
Expenses

Figure 2: Cost Flow in a Manufacturing Business

Distinct to a manufacturing business are the three (3) inventory categories:

1. Materials Inventory—This account shows the balance of the cost of unused materials purchased but not
yet used in the production process.
2. Work in Process Inventory—This account displays the manufacturing costs incurred and allocated to
partially completed product units. Therefore, it represents the costs associated with manufacturing the
unfinished product.
3. Finished Goods Inventory—This account shows the costs assigned to all completed products that have
not been sold. It shows the cost of the complete and ready-for-sale product.
A manufacturing cost flow is the flow of direct materials, direct labor, and manufacturing overhead through
these inventory accounts and into the Cost of Goods Sold account.
Well-defined manufacturing cost flows are the foundation for accurate product costing, inventory valuation,
and financial reporting. They supply all the information necessary to prepare the statement of cost of goods
manufactured and compute the cost of goods sold.
JOURNAL ENTRIES AND T-ACCOUNTS
Purchase of Raw Production of Goods Product Sale of the Product
Materials Completion
Activity Purchase and receipt Processing and Finished products Sale and shipment of
of raw materials conversion of raw are completed and finished products to
moved to customers

08 Handout 1 *Property of STI

Page 3 of 9
 BM2409

Purchase of Raw Production of Goods Product Sale of the Product

Materials Completion
materials by using direct the storage area
labor and overhead awaiting sale.
Journal Raw materials xxx Work in process xxx Finished goods xxx Cost of goods sold xxx
Accounts payable Factory overhead Control xxx Work in process Finished Goods xxx
Entry xxx Raw materials xxx
xxx

Work in process xxx

Factory overhead control xxx
Salaries & Wages payable
xxx

Work in process xxx

Applied FOH
xxx
T-
Account

Schedule of Cost of Goods Manufactured

This schedule shows how much direct materials, direct labor, and manufacturing overhead remain in the Work
in Process and how much of these cost elements are transferred from Work in Process to Finished Goods.
To illustrate, take the following as an example:
Jose Corporation has provided the following data concerning June’s manufacturing operations.
Sales P375,000
Purchases of raw materials 30,000
Direct labor 58,000
Manufacturing overhead applied to work in process 87,000
Underapplied overhead 4,000
Selling expenses 45,000
Administrative expenses 35,000

Inventories
Beginning Ending
Raw materials P12,000 P18,000
Work in process 56,000 65,000
Finished goods 35,000 42,000

08 Handout 1 *Property of STI

Page 4 of 9
 BM2409

The Schedule of Cost of Goods Manufactured is a combination of three separate computations. First is
determining how much direct materials have been put into the process. Observe the following equation:

Raw Beginning Raw Purchases of Ending Raw

materials = materials + Raw materials - materials
used in inventory inventory
production

For Jose Corporation, the beginning raw materials inventory is P12,000, plus P30,000 in purchases of raw
materials, less the ending raw materials inventory of P18,000. This equals the raw materials used in
production, which is P24,000.

Remember that direct and indirect materials are sourced from the same inventory account - Raw Materials
Inventory. As a result, if indirect materials were used and are already included in the manufacturing overhead
account, they must be deducted from the P24,000 to calculate the direct materials used in production.

Second, the total manufacturing cost would be computed.

Total Applied
manufacturing = Direct materials + Direct labor + Manufacturing
cost overhead

For Jose Corporation, direct materials used in production is P24,000, add the direct labor cost of P58,000, and
add the applied manufacturing overhead of P87,000. The total manufacturing cost, in this case, is P169,000.

Third, the cost of goods manufactured itself would be computed.

Cost of Goods Total Beginning WIP Ending WIP

Manufactured = Manufacturing + Inventory - Inventory
Cost

For Jose Corporation, the total manufacturing cost of P169,000, added to the beginning work in process of
P56,000 and deducted from the ending work in process of P65,000, would give us the cost of goods
manufactured of P160,000.

Schedule of Cost of Goods Sold

The Cost of Goods Sold is an expense account. It is recognized in the period incurred. It is commonly the largest
expense account of most firms.

The Schedule of Cost of Goods Sold displays how much direct materials, direct labor, and manufacturing
overhead remain in the Finished Goods inventory and how much of these cost elements are transferred from
the Finished Goods to the Cost of Goods Sold account.

Unadjusted Beginning FG Cost of Goods Ending FG

Cost of = Inventory + Manufactured - Inventory
Goods Sold

08 Handout 1 *Property of STI

Page 5 of 9
 BM2409

Continuing our illustration for Jose Corporation, beginning finished goods of P35,000, added to the P160,000
cost of goods manufactured, less ending finished goods of P42,000, results in an unadjusted cost of goods sold
of P153,000.

Such cost of goods sold is said to be unadjusted since it is before the closing of any under or overapplication
of manufacturing overhead. Closing the P4,000 underapplied overhead will finally bring us to the adjusted cost
of sales/cost of goods sold of P157,000.
Jose Corporation
Statement of Cost of Goods Manufactured
For the month ended June 30, 2023

Beginning raw materials P12,000

Add: Purchases of raw materials 30,000
Raw materials available for use 42,000
Deduct: Ending raw materials 18,000
Raw materials used in production 24,000
Direct labor 58,000
Applied manufacturing overhead 87,000
Total manufacturing cost 169,000
Add: Beginning work in process 56,000
Total work in process 225,000
Deduct: Ending work in process 65,000
Cost of goods manufactured P160,000

Josue Corporation
Statement of Cost of Goods Sold
For the month ended June 30, 2023

Beginning finished goods P35,000

Add: Cost of goods manufactured 160,000
Cost of goods available for sale 195,000
Deduct: Ending finished goods 42,000
Unadjusted cost of goods sold 153,000
Add: Underapplied overhead 4,000
Adjusted cost of goods sold P157,000

Comparison of Statements of Profit or Loss and Statement of Financial Position

Service Business Merchandising Business Manufacturing Business
Statement of Profit or Service Revenue PXXX Sales PXXX Sales PXXX
Less: Cost of Services XXX Less: Cost of Sales* XXX Less: Cost of Sales* XXX
Loss Gross Income XXX Gross Income XXX Gross Income XXX
Less: Operating Expenses XXX Less: Operating Expenses XXX Less: Operating Expenses XXX
Operating Income PXXX Operating Income PXXX Operating Income PXXX
# #
Beginning Inventory PXXX Beginning FG Inventory PXXX
Add: Net Purchases XXX Add: Cost of goods manufa. XXX
Cost of GAFS PXXX Cost of GAFS PXXX

08 Handout 1 *Property of STI

Page 6 of 9
 BM2409

Comparison of Statements of Profit or Loss and Statement of Financial Position

Service Business Merchandising Business Manufacturing Business
Less: Ending inventory XXX Less: Ending FG Inventory XXX
Cost of Sales* PXXX Cost of Sales* PXXX
Statement of Financial No inventory account One inventory accounts: Three inventory accounts:
Merchandise inventory Raw Materials Inventory
Position (Inventory (bought ready for sale) Work in Process Inventory
Accounts) Finished Goods Inventory

Also, a statement of profit or loss can be prepared for Jose Corporation as follows:

Jose Corporation
Statement of Profit or Loss
For the month ended June 30, 2023

Sales P375,000
Less: Cost of goods sold 157,000
Gross income/Gross profit P218,000
Less: Operating expenses:
Selling expenses 45,000
Administrative expenses 35,000 80,000
Net income P138,000

Comprehensive Illustration
Bien Company of Alcala, Pangasinan, is a family-owned enterprise that makes bamboo crafts for the North
Luzon market. The company sells its bamboo crafts through an extensive network of commission agents who
receive a percentage of their sales. The company usually transacts with customers, employees, and suppliers
on account.

The company uses a job-order costing system in which overhead is applied to jobs based on direct labor costs.
Its predetermined overhead rate is based on a cost formula that estimated P330,000 manufacturing overhead
for an estimated P200,000 direct labor pesos activity level.

At the beginning of 2023, the inventory balances were as follows:

Raw materials P25,000

Work in process 10,000
Finished goods 40,000

During the year, the following transactions were completed:

a. Raw materials purchased on account, P275,000.
b. Raw materials requisitioned for use in production, P280,000 (materials costing P220,000 were charged
directly to jobs; the remaining materials were indirect).
c. Cost for employee services were incurred as follows:

08 Handout 1 *Property of STI

Page 7 of 9
 BM2409

Direct labor P180,000

Indirect labor 72,000
*Sales commissions 63,000
Administrative salaries 90,000
*paid in cash
d. Paid rent for the year was P18,000 (P13,000 of this amount related to factory operations, and the
remainder related to administrative activities)
e. Utility costs incurred in the factory, P57,000
f. Paid advertising expenses, P140,000
g. Depreciation recorded on equipment, P100,000. (P88,000 of this amount was on equipment used in
factory operations; the remaining P12,000 was on equipment used for administrative activities)
h. Manufacturing overhead cost was applied to jobs.
i. Goods that had cost P675,000 to manufacture according to their job cost sheets were completed.
j. Sales on account for the year totaled P1,250,000. The total cost to manufacture these goods,
according to their job cost sheets, was P700,000.

Requirements:
1. Prepare journal entries to record the transactions for the year.
2. Prepare T-accounts for the three (3) inventory categories: Factory Overhead Control and Applied
Factory Overhead. Post relevant data from your journal entries to these T-accounts. Do not forget to
enter the beginning balances in your inventory accounts. Compute an ending balance in each account.
3. Is Manufacturing Overhead underapplied or overapplied for the year? Prepare a journal entry to close
any under or overapplied overhead to the Cost of Goods Sold.
4. Calculate net income by preparing a Statement of Profit or Loss for the year.

A Raw materials 275,000

Accounts payable 275,000

B Work in process 220,000

Factory overhead control 60,000
Raw materials 280,000

C Work in process 180,000

Factory overhead control 72,000
Commission expense 63,000
Salaries expense 90,000
Cash 63,000
Salaries and wages payable 342,000

D Factory overhead control 13,000

Rent expense 5,000
Cash 18,000
E Factory overhead control 57,000
Accrued utilities payable 57,000

08 Handout 1 *Property of STI

Page 8 of 9
 BM2409

F Advertising expense 140,000

Cash 140,000
G Factory overhead control 88,000
Depreciation expense 12,000
Accumulated depreciation 100,000

H Work in process 297,000

Applied factory overhead 297,000
(P330,000/200,000=1.65 X P180,000)

I Finished goods 675,000

Work in process 675,000

J Accounts receivable 1,250,000

Sales 1,250,000
Cost of goods sold 700,000
Finished Goods 700,000

Notes on the foregoing journal entries:

A. The usual entry is used to record purchases of raw materials on the account.
B. Out of the P280,000 requested materials, P220,000 is direct materials and, therefore, enters the Work in
Process account. The remaining P60,000 is actual factory overhead incurred and, therefore, debited to the
Factory Overhead Control account.
C. Direct labor is debited to Work in Process; indirect labor is the actual overhead incurred and, therefore,
debited to Factory Overhead Control. Sales commission and administrative salaries are period costs and
are expensed as incurred.
D. P13,000 is the actual factory overhead, and the balance is operating expenses.
E. Factory-related utility costs are factory overhead. Enter the Factory Overhead Control account.
F. The usual recording of advertising expense is a period cost.
G. The portion relating to factory overhead is debited to Factory Overhead Control, and the portion
pertaining to operating expense is depreciation expense.
H. As mentioned in earlier discussions, the applied overhead enters the product cost. The application rate is
computed by dividing a budgeted cost (P300,000) by a budgeted activity (in this case, the activity is in
direct labor pesos of P200,000). The rate is then applied (multiplied) to the actual level of activity
(P180,000 direct labor pesos).
I. This entry transfers the cost of the completed units from the work-in-process inventory to the finished
goods inventory.
J. The first entry records sales on the account. The second entry transfers the cost of the units sold from
the finished goods inventory to the cost of goods sold.

References
Reyno, F., & Reyno, D. (2021). Financial Accounting and Reporting (Part One). Reyno Publishing House.

08 Handout 1 *Property of STI

Page 9 of 9