Accounting in manufacturing and trading companies
An automobile manufacturer, for example, buys steel, rubber, aluminum, plastic, etc., which is used to make motor vehicles that are sold to dealers (the trading company). These dealers, in turn, sell vehicles to the customer.
From an accounting point of view, the activities of manufacturing and trading companies are very similar, especially their management, sales, and financing activities. Therefore, accounting principles and most procedures can be applied to both manufacturing and trading. The main difference between the two is their cost accrual and costing method for (1) inventory valuation and (2) cost of goods sold calculation. The difference arises from the fact that trading companies buy finished goods, while manufacturers make the goods sold by traders.
The ‘accounting cost of goods manufactured’ item in the manufacturing company therefore corresponds to the ‘accounting cost of goods purchased’ item in the trading company. In both cases, these amounts represent the cost of finished products available for sale. The trading company, having purchased its goods in a ‘finished’ form, experiences little difficulty in determining their cost. The manufacturing company, on the other hand, has to account for the cost of turning raw materials into finished goods (also known as manufacturing costs).
In converting raw materials into finished products, the manufacturer uses labor, machinery, and equipment and also incurs other manufacturing costs such as energy consumption, machinery maintenance, etc. All of these costs must be added to the cost of raw materials to determine the cost of manufactured goods for any period.
Therefore, the accounting records of a manufacturing company must be expanded to provide for the recording of the various additional costs inherent to manufacturers.
The three largest elements of manufacturing costs are materials, labor, and manufacturing overhead. In accounting cost terminology, material and labor costs together are known as primary costs, while the accounting term conversion costs represents the combination of labor and manufacturing overhead costs.
By virtue of the nature of the activities of a manufacturing company, it will require more accounting accounts than a commercial company. The general ledger must contemplate aspects such as machinery and equipment, inventory, raw materials, work in process, finished products, etc. It is necessary to pay special attention to the different inventory accounts.
At any given time, a manufacturer will have different types of inventory on hand: inventory of materials ready to be used in the manufacturing process; partially finished products still in the manufacturing process; and finished products that must be shipped to distributors. Inventory ledger records and different inventory ledger accounts must be kept to determine the costs of each type of inventory at the end of a financial year. All three inventory accounts are asset accounts and are generally maintained in accordance with a perpetual accounting inventory system. In turn, they are control accounts supported by the corresponding subsidiary records.