The income statement for merchandising and manufacturing companies differs primarily in the reporting of the cost of the merchandise (goods) available for sale and sold during the period.
In this lecture, we will learn how to prepare the income statement for a manufacturing company. In a manufacturing company, there is a need to prepare a manufacturing account, statement of production or a cost sheet, before proceeding ahead to prepare the income statement. In fact, the income statement literally remains the same except that the cost of goods manufactured is transferred to a trading account to be treated as finished goods (at par with purchases). That means the company that carries on manufacturing activity besides trading activity, generally prepare:
- Manufacturing account (statement of production)
- Trading and profit and loss account (Income statement)
- Balance sheet (position statement)
The purpose of preparing a manufacturing account is to show: (1) cost of materials consumed, productive wages, direct and indirect expenses of production; resulting in (2) cost of finished goods produced.
Manufacturing account is debited with: opening stock of raw materials + purchase of raw materials during the year – closing stock of raw materials to get ‘raw materials consumed’ debited with productive wages and expenses to get ‘prime cost’ debited with factory expenses to get factory cost; debited with work in progress in the beginning – work in progress at the end of the year and the sale of scrap if any to get the cost of production. The total cost of production is credited to the manufacturing account by giving a debit to the trading account.
Some manufacturing companies prefer to transfer finished goods from factory to warehouse at a marked up price. This is arrived at by adding a certain pre-set margin (called Manufacturing Profit) to the Production Cost. When preparing the Income Statement, it is the enhanced Cost of Production, which is taken into account to compute the Cost of Goods Sold. The reason for this practice is two-fold:
- Goods are transferred to Trading Account at a value which the business would have paid had these goods been bought from other manufacturers instead of manufacturing itself. This ensures that the Trading Account shows a more realistic gross trading profit or loss.
- The Manufacturing Profit, i.e. the excess of transfer value of goods manufactured over their actual production cost, represents the savings the company is making by manufacturing the goods itself instead of buying them from outside.
The methods for arriving at the rate to be used for marking up the production cost are beyond the scope of our discussion in this article. However, given the rate for marking up the production cost; the
accounting treatment would be as follows:
Debit Manufacturing Account
Credit Profit & Loss Account
with the amount of markup added to production cost, i.e. the manufacturing profit.
The effect of the above entry would be to increase the production cost, thereby reducing the gross profit disclosed by the Trading Account. At the same time, by crediting the Profit and Loss Account by the amount of manufacturing profit, the figure of net profit is kept unaffected.
Basic facts as for the example given in Trading account of a manufacturing concern. Now assume that finished goods are transferred from factory to warehouse at production cost plus a 10% manufacturing profit. Show the relevant statements.