Manufacturers take a unique approach to accounting because they don’t just ship, sell, and service goods – they create goods. Manufacturers also procure the raw materials and components necessary to build those goods, hire and pay the workers to assemble those goods, and, yes, ship and sell, store and move, provide services for those goods, and so much more. Manufacturing accounting also comes with its own set of challenges; different methods for determining production, labor, and inventory costs; different valuation methods for that inventory; and on and on.
This comprehensive guide to manufacturing accounting will look at the unique cost concepts used in manufacturing accounting, best practices for manufacturing accounting, and tips and features to consider when evaluating manufacturing accounting software. It will also explore how Rootstock Cloud ERP streamlines manufacturing accounting processes.
What is Manufacturing Accounting?
Manufacturers are, in many ways, are just like most businesses. They sell goods, employ people, use equipment and facilities, pay vendors, and receive money from customers. Where manufacturing accounting distinctly departs from the norm is in manufacturing costing.
Capturing the cost of manufactured goods requires unique considerations and methods. Manufacturing cost accounting systems then must capture the cost of manufacturing but be flexible enough for many different manufacturing methods, processes, and techniques
Think of what it costs to manufacture something simple, such as a toothpick. Wood is the raw material, but it must be received, processed, , and properly stored. Machinery is needed to convert large pieces of wood into toothpicks and add a coating to the wood. Workers then need to move and store the work-in-process goods. Packaging must be manufactured in-house or by a vendor, and the toothpicks then need to be boxed as finished goods and readied for shipment to customers. Workers also need to move those boxes onto trucks. All the while, the manufacturer must account for the cost of the wood, machinery, labor, electricity, and other overhead, and has yet to be paid for by a customer.
Yes, cost accounting for manufacturers is challenging. So, let’s dive in!
Common Challenges with Accounting for Manufacturing
Regardless if the manufacturer works in discrete manufacturing, distribution, or supply chain, manufacturing cost accounting is a unique challenge. Questions arise as to inventory valuation methods. Complex manufacturing processes can make it difficult to track and pinpoint costs, and allocating indirect costs correctly can be a guessing game. Reporting on these elements of manufacturing costs is also challenging, especially to meet the real-time, accurate and actionable data needs for production, management, customers, suppliers, and overall effective manufacturing business intelligence. It is the responsibility of the Accounting Department to address these challenges.
Accounting for Manufacturing Costs
The easiest place to begin is with accounting for manufacturing costs. There are incoming raw materials to purchase and store. These materials get consumed during production, and the finished goods may need to be inventoried in a warehouse until they can be shipped to a distributor, customer, or elsewhere. Finally, there is the cost of managing the manufacturing business and ensuring customers are paying for their goods and suppliers are getting paid for materials.
Total Manufacturing Cost
Determining the right costing methods for manufacturing depends on the type of manufacturing processes utilized. There are several common terms used in manufacturing accounting which can be defined to help better guide the accounting decisions and lead to a more accurate and timely calculation of total manufacturing cost.
Indirect Costs Versus Direct Costs
Manufacturing costs can be broadly separated into direct and indirect costs. Direct costs are traceable to a product, like the wood to manufacture toothpicks and the direct labor to cut the wood . Indirect costs are those costs required to run a manufacturing business but are not directly traceable to a product. Think of safety glasses, a facility’s security guard, and depreciation and utilities.
A good rule of thumb for determining if a cost is direct or indirect is to ask whether the cost increases as production increases. Direct costs are tied to production increases. Indirect costs are required whether a good is being produced or not.
Direct Materials Costs
Goods need to be produced from raw materials and components. When production increases, direct material costs increase, too. A manufacturer may produce those raw materials internally or purchase them from a supplier, but procuring raw materials is the first step. These are referred to as direct materials and are typically itemized in a streamlined bill of materials. They also need to be inventoried before products are manufactured.
Direct Labor Costs
Direct Labor Costs represent the wages, benefits, and insurance paid to the people who run equipment, assemble parts, and other roles that impact the production of goods. It is the direct cost of the labor required to produce a finished product.
A key consideration here for manufacturers is how labor costs are tracked for manufacturing accounting, especially where to draw the line between direct labor costs and overhead labor costs. Managers and maintenance workers are generally considered overhead labor. But what if a maintenance technician on the clock to repair a machine that has unexpectedly stopped production? And how would accounting handle a scenario where a manager pitches in to help a shorthanded production team? Manufacturing cost accounting has many gray areas, which is where manufacturing accounting software can be a big help.
Manufacturing Overhead Costs
Manufacturing overhead costs are also called indirect costs. Indirect costs are not directly connected to the production of the finished goods. Utilities, clerks, security guards, cleaning supplies, rentals, insurance, recruiters, and other costs are considered overhead. It’s critical to accurately determine direct costs and overhead costs because only direct costs are used to determine the value of inventories and gross profits.
Keep in mind that production overhead will be distinct from overhead calculations for other departments.
Product costs—not production costs—measure the total cost of producing a product, including both direct costs and indirect costs. Continuing the toothpick example, the cost of the wood, labor, equipment cleaning supplies, security guard, and electricity all add up to the total product cost used for manufacturing accounting.
Production costs—not product costs—are the total of the direct materials, direct labor, and manufacturing overhead costs associated with producing a specific product or batch of products. Many manufacturers also differentiate manufacturing accounting production costs by specific product or product line, or by project, or by customer order to further determine product and customer costs and profitability.
Inventory covers the raw materials, partially completed goods, or other goods that have been manufactured but have not yet been sold. Manufacturing accounting must capture these costs, including the cost of raw materials and the cost of production. It becomes even more challenging if products are partially assembled and then inventoried or scrapped in production and sent through a rework process.
Unit of measure is critical when determining the cost of a manufactured item. For example, if a purchasing manager procures wire by the foot, an inventory clerk monitors storage by the spool, and the production manager tracks usage by the inch, problems can quickly arise. Cost accounting processes might miss the different units of measure, resulting in inaccurate reports, cost analyses, and forecasts. This is an area where manufacturing accounting software can ensure consistency and accuracy.
A new forklift might cost $75,000, but it won’t be worth that same amount after 3 years. Eventually, it will be decommissioned after it has lived its useful life and have a value of zero or a minimal salvage value. Depreciation is a way to financially account for the decrease in value of a physical asset over time.
There are three primary methods for manufacturing accounting depreciation:
- Straight-line depreciation, where the value of an item is depreciated an equal amount over each year of its useful life.
- Declining balance depreciation, where the value of an item is depreciated quickly at first and then more slowly as it reaches end-of-life.
- Sum of the years depreciation, where the asset’s depreciable amount is calculated using a depreciation factor unique to each year.
Operating costs for a manufacturer or distributor usually cover material and production costs, commonly referred to as the cost of goods sold (COGS), plus the costs to run the business, such as sales, general, and administrative (SG&A) costs. Operating costs in manufacturing include things like travel expenses, office supplies, maintenance, salaries, utilities, taxes on production facilities, and more. Operating costs can be variable or fixed.
Variable costs are termed as such because they vary according to the amount of goods produced. Variable costs in manufacturing go up as production increases and down as production decreases. The cost of wood, production labor, and packaging are all variable costs for toothpick production example.
Fixed costs in manufacturing are not related to production volumes and must be paid whether or not production is active. A security guard is a fixed cost, as is the cost of the real estate and factory facility, insurance, and other costs required to run a manufacturing business. Learn more about automating fixed costs and assets.
Calculating Cost of Goods Manufactured (COGM) and Cost of Goods Sold (COGS)
There is much nuance in the world of manufacturing accounting. Although the cost of goods sold (COGS) is a common measure, the cost of goods manufactured (COGM) may also be considered. COGM brings the time inventory is held into the manufacturing accounting costs equation. Here’s the primary difference:
- COGM captures only the costs of goods manufactured and put into inventory either as a finished good or a work in progress. COGM can be expresses as follows:
COGM = beginning inventory value + manufacturing costs – ending inventory value
- COGS captures the manufacturing costs of all goods sold plus sales and administrative costs. COGS can be expresses as follows:
COGS = beginning finished goods inventory value + COGM – ending finished goods inventory value
What’s important to recognize is how inventory valuations and methods impact COGS and COGM for accounting for manufacturing. Since financials are reported periodically, inventory levels will change over time and impact COGS and COGM. For example, in February, a manufacturer may produce 1,000 widgets but only sell 925 widgets. In that case, finished goods inventory levels rose by 75 boxes but inventories of incomplete items may or may not have been changed.
Inventory valuation represents the costs of goods manufactured but not sold. Inventoried items can represent a significant portion of the deferred costs associated with manufacturing as inventory may be waiting to be packaged and shipped to customers. Work in process (WIP) units also require accurate costing for those units that are not yet finished.
Costing Methods for Inventory
Manufacturing costs and inventory valuation can be calculated via several methods. These different methods can impact inventory costs and COGS as raw material prices or markets fluctuate, especially for longer manufacturing processes.
1) First in, First Out (FIFO)
FIFO accounting for manufacturing inventory considers the first units received into inventory are the first ones sold. Think of a storage area that is filled from the rear with the most recently manufactured units, but shipments are taken from the front. The cost of the most recently sold unit is based on the oldest set of raw materials purchased.
2) Last in, Last Out (LIFO)
LIFO accounting for manufacturing inventory considers the most recent units entered into inventory as the next units sold. Think of a storage area that is filled from the front with the most recently manufactured units and shipments are also taken from the front. The cost of the most recently sold unit is based on the most recent set of raw materials purchased.
3) Weighted Average Cost (WAC)
WAC accounting uses the average cost of all units in inventory and is updated every time a new purchase is made. The updated average cost is used to value the remaining inventory. WAC is easier for manufacturing cost accounting and can smooth out fluctuations in costs or selling prices.
Production Costing Methods
Manufacturing accounting must track all costs associated with doing business. But production is unique to the manufacturing industry, so accountants must consider how production costs are determined and evaluated. As with most costing methods for manufacturing, there is more than one to choose from.
1) Job Order Costing
Job order costing for manufacturing is desirable for manufacturers who produce customized or variable goods. Each customer might receive unique versions of products using different raw materials or options, so costs are determined for each job order.
2) Process Costing
Process costing for manufacturing is generally used by manufacturers who produce standardized goods using similar or the same processes. Each customer receives identical or similar products manufactured using identical or similar processes.
3) Activity-Based Costing
Activity-based costing (ABC) accounts for the overhead and indirect costs used to manufacture a product. It uses units of work, or activities, to determine the cost of manufacture. If the toothpick shaper employee makes $50 per hour and can shape 1,000 toothpicks per hour, then the activity-based cost of the shaping operation is $0.05 per toothpick. Adding up the ABC of all operations provides the total ABC for a finished good.
Best Practices for Improving Manufacturing Accounting
Manufacturing accounting is a unique and challenging process. There is much to learn and many decisions to make along the way, but it is a critical task for manufacturers.
To help improve and ease accounting for manufacturing, here are 5 best practices for inventory and production cost accounting methods.
1. Allocate Indirect Costs Accurately
Manufacturing accounting teams can work to ensure that indirect costs are allocated appropriately and accurately. Different production costing methods discussed earlier in this article can have significant impact on how the business operates and financial results are interpreted. Determine which costing methods for manufacturing produces the most accurate calculations and the most opportunity for growth. Also consider unique situations, such as when employees purchase items for production using a company credit card. These costs must be correctly allocated to the right job or product or order, and manufacturing accounting software might be a big help.
2. Streamline the Production Process
Streamlining and removing inefficiencies from production processes can ease the calculations required in cost accounting. Costs can be lowered when waste is eliminated, or unnecessary steps are removed from operations. Reviewing the production methods used, and the associated costs, can help pinpoint areas of production where manufacturing costs are too high.
3. Implement Real-Time Inventory Tracking
A real-time inventory tracking system can minimize the manual accounting tasks common in properly valuing inventory. Implementing real-time inventory tracking can also improve planning, pricing, shipping, and the overall customer experience. Deploying a modern manufacturing planning engine can also ensure sufficient inventory is available to meet the demands of the business but that excess inventory is not causing undue strain on the business. Rootstock has purpose-built features for real-time inventory management for manufacturers.
4. Implement Real-Time Costing of Components and Finished Goods
Real-time costing for components and finished goods can provide more accurate insights for manufacturers. This improves manufacturing costing and accounting with features to integrate data, highlight costs, and evaluate overall business health on a continuing basis. Rootstock Financials provides manufacturing accounting software for full financial visibility, analysis, and reporting for accounting and finance teams.
5. Adopt an Advanced Manufacturing Accounting Software
Advanced manufacturing accounting software is a must-have for modern manufacturers and the manufacturing accounting teams responsible for tracking business financials. Manufacturers demand powerful, intuitive financial reporting with customizable dashboards to monitor costs, profitability, cash flow, and financial health in real-time. They need it handle manufacturing business complexities like subsidiaries and foreign currencies, manage credit card transactions from customers and by employees, and generate reports based on any dimension to deliver real-time, actionable data to decision makers. Rootstock Financials is an ideal solution for manufacturing accounting, and so much more.
Rootstock Financials is an All-in-One Manufacturing Accounting System
Accounting and Finance track and guide the financial health of manufacturing operations, but these teams can’t be effective when relying on slow, manual spreadsheets and struggling with incomplete data from disconnected systems. Rootstock manufacturing accounting software brings accounts receivable, accounts payable, and general ledger together to provide real-time financial insights for manufacturers. Rootstock Financials also offers:
- Full audit trail capabilities from the general ledger back to the source transaction.
- Internal controls and approvals tailored to any manufacturer’s specific needs.
- Ability to analyze and monitor financials in real-time, allowing Finance to react quickly to fluctuations in trends, results, actual vs. forecast, and more.
- A single source of truth to manage complete business process and results on one platform, from sales and customer service to supply chain and procurement, and, of course, manufacturing accounting.