Inventory are the products that we buy or make to then sell in our business. Manufacturing is the process of making the inventory ourselves from raw materials (rather than buying it from another business to then on-sell to your customer). It can be a complicated process and certainly the proper accounting for the costs can be daunting, but this blog is going to take you through it.
Let us start with the basic manufacturing cost terminologies. With these building blocks, you will be able to build on your understanding of this area of your business. This will help you categorise the expenses for your bookkeeping and accounting, report more accurately for the ATO, and for yourself.
Check out our other blog here on Inventory in general. This is a good blog to read first for some foundation knowledge.
These all have a value to you and should be reflected on your books, in the Balance Sheet. These also come at a cost to you, and you should get deductions for them… but it is not as easy as entering the amount you paid for the materials and calling that your deduction.
Let me explain…
You may have heard of ‘cost of goods sold’ which is the value (cost) of the goods (products) that have been sold to customers that period. Oftentimes the ‘cost’ is pretty simple to calculate when you have just purchased a finished product from another supplier, that you then brand and sell to your customers. Cost might be equal to what you paid for it. There are a lot more complex ways to calculate ‘cost’ and value of stock on hand too. There will be more on COGS later in this blog.
The ‘cost of goods manufactured’ is as it sounds… the cost of the goods (products) that you have manufactured. These costs include the total of all direct and indirect costs incurred in manufacturing your product, from raw materials into finished goods, including: direct labor, direct materials, and overhead costs.
Direct costs are expenses that are spent in the product manufacturing process. This primarily includes direct materials and direct labor costs. They are directly related to the product itself.
a. Direct Materials
Direct materials are raw materials used in creating your finished products. Each material is identifiable and is easily accounted for. For example, leather and zipper for bags, or beads and glitter for jewellery.
For example: $1 zip (which then gets added to other costs)
b. Direct Labor
Direct labor includes the wages of employees/labourers that are directly involved in creating your products, labor that is associated in the production. Examples include cutting and preparation of leather, part assembly and stitching. To do this calculation you need to be tracking time, wages costs, and time taken to produce the specific goods.
If you are a sole trader, I am terribly sorry but you are not an employee (of yourself) and as such you don’t have a wage and your time is not factored into cost. That said it might be good to track for your own information anyway.
Manufacturing overhead cost is the sum of all indirect costs in product manufacturing. It is included in product pricing based on cost per unit of the activity. Make sense? Let me explain…
Think about the costs that are involved in manufacturing but that are not directly in the product itself.
Example of Manufacturing Overhead (Indirect Costs):
To calculate the cost (for your product), do this:
Total Manufacturing overhead - rent | $ 20,000
Divided by no of units manufactured | $ 2,000
Manufacturing cost per unit | $ 10
This then can be added to the other costs.
WIP = work in progress (nothing to do with whip it, whip it good).
Work-in-progress inventory are products still in the ongoing phase of manufacturing. There is still value in these…the things sitting on the factory floor, so to speak. These are unfinished products that are considered as assets and should be reported to your balance sheet at the end of the financial year. So, we need to calculate the cost/value.
To calculate the ending WIP inventory, we must identify the following:
*based on stocktake and calculations done 30 June last year.
Then you can use this calculation:
Beginning WIP Inventory | $10,000
Add: Manufacturing Costs | $ 5,000
Less: COGM | $11,000
Ending WIP Inventory | $ 4,000
Now…remember we mentioned COGS before?
The Cost of Goods Sold is the total cost of manufacturing of finished goods that were sold for the financial year. Which items were sold? And what did it cost you to buy or produce them? COGS costs include only direct costs, such as labor and materials, but not indirect expenses, like rent or utilities.
We use this formula:
Finished goods inventory is the value of manufactured products available in stock. This is the ‘ending inventory’ balance. The value or cost of the goods (products) that you have on hand as at 30 June.
At the end of the financial year, you should do a stocktake where you go around and count up everything and update your inventory lists. Besides each product, for accounting, we need the cost (not sales price), so we can then add them all up. Again, this is easier when you buy the products from someone else because there is a clear cost. For manufactured goods we have to calculate the cost.
To get the ending balance of Finished Goods Inventory you can use this calculation:
Beginning Finished Goods Inventory |$ 5,000
Add: Cost of Goods Manufactured
Which we calculated previously as:
Beginning WIP inventory + Total manufacturing cost (-) Ending WIP inventory |$10,000
Less: Cost of Goods Sold
Which we calculated previously as:
Beginning inventory + Purchases during the period(-) Ending inventory |$ 7,000
Ending Finished Goods Inventory |$ 8,000
Let’s say at the end of last year, your pillow company had 1,000 finished pillows in stock. Each pillow cost $4 to produce, so the previous finished goods inventory value would look like: 1,000 x $4 = $4,000 finished goods ending (which then becomes your ‘beginning’)
During this current fiscal year, your brand manufactured 1,200 pillows and sold 800 of those.
The COGM is: 1,200 x $4 = $4,800
and the COGS is: 800 x $4 = $3,200
Now, subtract the COGS from the COGM: $4,800 – $3,200 = $1,600
From there, you can calculate the new finished goods inventory by adding the previous finished goods inventory value to the answer from COGM minus COGS. This looks like: $4,000 + $1,600= $5,600… meaning your finished goods inventory is worth $5,600.
To show a better picture on how the manufacturing cost is computed for accounting purposes, here’s a sample case study taken from our resources (links below):
XYZ Co., a company that manufactures bags, had $10,000 remaining unsold bags and $50,000 WIP at the end of FY 2022. Throughout FY 2023, the factory spent $30,000 on direct labor, $20,000 on manufacturing overhead, and direct materials as follows:
Beginning Raw Materials | $ 10,000
Purchases of Raw Materials | $100,000
Ending Raw Materials | $ 5,000
At the end of FY 2023, XYZ Co. prepare its Statement of Cost of Goods Manufactured as shown:
Schedule of Cost of Goods Manufactured
For the Year Ending June 30, 2023
Raw Materials, beg. balance | $ 10,000 |
Add: Purchases of Raw Materials. | $100,000 |
Total Raw Materials available for use | $110,000 |
Less: Raw Materials, end. balance | $ 5,000 |
Raw Materials Used | | $105,000
Direct Labour | | $ 30,000
Manufacturing Overhead Cost:
Indirect materials. | $ 8,000
Indirect Labour Factory Utilities | $ 6,000
Factory Utilities | $ 3,000
Factory Depreciation | $ 1,000
Total Manufacturing Overhead Cost | | $ 20,000
Total Manufacturing Cost | | $155,000
Add: WIP, Beg. Balance | | $ 50,000
Less: WIP, End. Balance | | $ 10,000
Cost of Goods Manufacturing | | $195,000
Add: Finished Goods, Beg. Balance | | $ 10,000
Less: Finished Goods, End. Balance | | $ 5,000
Cost of Goods Manufacturing | | $ 200,000
You may have asked yourself: How many products should I manufacture?
To help you answer that question here are the 3 types of manufacturing that you may consider:
In Make-To-Stock strategy, products are produced in advance and are kept in stock until customers purchase it. This is very common for small businesses.
In MTS, production scheduling needs an accurate forecast of market demand. Accurate forecasting helps the business decide on the number of products that it needs to produce to match the increase or decrease in demand instead of keeping a steady level of production throughout the year. If there is an expected increase in demand, say during the holiday season, manufacturers tend to produce more goods to be held in inventory to meet the consumers’ needs.
This helps the business reduce cost through bulk production, but may also result in an excessive number of inventory in stock if demand changes.
Examples of industries that are using the Make-To-Stock approach:
As the name suggests, production only begins once there is an order. This strategy allows more product customisation and results in increased customer satisfaction. One advantage of the make-to-order method is that there’s little to no waste in production as the business only responds to what the customers actually require. However, this method requires a longer waiting period for customers as products are not readily available. For a business to keep its profitability, despite the make-to-order strategy, they have to keep a steady stream of orders.
Example of products that are made to order:
Make-to-assemble method is like the combination of make-to-stock and make-to-order where component parts or sub-parts of the product are readily available, but still needs to be assembled once the orders come in before manufacturing the final product.
In this method, waiting time of clients is shorter as parts are already in stock. Orders are made based on the actual orders which lessen the risk of product surplus or shortage, unlike in the make-to-stock method.
To avoid stock of unwanted parts if there is no demand for a product, the make-to-assemble method could also use forecasting to maintain the proper number of needed parts and the factory workflow.
Common example of products that uses make-to-assemble method:
Inventory management can be complicated and as your business grows, becoming more efficient and precise with all of these processes will become increasingly important. We are here to help you every step of the way.