Accounting for manufacturing businesses
/How to Account for a Manufacturing Business
The accounting for a manufacturing business deals with inventory valuation and the cost of goods sold. These concepts are uncommon in other types of entities, or are handled at a more simplified level. The concepts are expanded upon below.
Inventory Valuation
A manufacturing business must use a certain amount of raw materials, work-in-process, and finished goods as part of its production processes, and any ending balances must be properly valued for recognition on the company balance sheet. This valuation requires the following activities:
Direct Cost Assignment
Costs are assigned to inventory using either a standard costing, weighted-average cost, or cost layering methodology. See the standard costing, weighted-average method, FIFO, and LIFO topics for more information.
Overhead Cost Assignment
Factory overhead costs must be aggregated into cost pools and then allocated to the number of units produced during a reporting period, which increases the recorded cost of inventory. The number of cost pools should be minimized to reduce the amount of allocation work by the accountant.
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Impairment Testing
Also known as the lower of cost or market rule, impairment testing involves ascertaining whether the amount at which inventory items are recorded is higher than their current market values. If so, the inventory must be written down to the market values. This task may be completed at relatively long intervals, such as at the end of each annual reporting period.
Cost of Goods Sold Recognition
At its most basic level, the cost of goods sold is simply beginning inventory, plus purchases, minus ending inventory. Thus, the derivation of the cost of goods sold is really driven by the accuracy of the inventory valuation procedures that were just described. In addition, any abnormal costs incurred, such as excessive scrap, are not recorded in inventory, but instead are charged directly to the cost of goods sold. This calls for a detailed scrap tracking procedure. Also, costs may be assigned to specific jobs (known as job costing) and then charged to the cost of goods sold when the inventory items in those jobs are sold to customers.
Inventory Tracking
In addition, a manufacturing business must use either a perpetual inventory or periodic inventory system to track the number of units of inventory that it has on hand; this information is crucial for determining the valuation of inventory. The two inventory tracking systems are described next.
Perpetual Inventory System
Under the perpetual inventory system, an entity continually updates its inventory records in real time. To do this, it constantly updates an inventory database to account for received inventory items, goods sold from stock, items moved from one location to another, items picked from inventory for use in the production process, and items scrapped. Perpetual inventory is by far the preferred method for tracking inventory, since it can yield reasonably accurate results on an ongoing basis, if properly managed. The system works best when coupled with a computer database of inventory quantities and bin locations, which is updated in real time by the warehouse staff using wireless bar code scanners, or by sales clerks using point of sale terminals.
Periodic Inventory System
A periodic inventory system is a simplified system for calculating the value of an ending inventory. It only updates the ending inventory balance in the general ledger when a physical inventory count is conducted. Since physical inventory counts are time-consuming, few companies do them more than once a quarter or year. In the meantime, the inventory account in the accounting system continues to show the cost of the inventory that was recorded as of the last physical inventory count. This means that the inventory valuation in the accounting records will be inaccurate, except when a physical count is performed.
How to Reduce Inventory Paperwork
In summary, the accounting for manufacturing businesses is much more detailed than is required for a business that maintains no inventory. A company can reduce this workload by shrinking the amount of inventory on hand, encouraging suppliers to own some on-site inventory, employing supplier drop shipping, and other techniques that reduce the overall level of investment in inventory.