A guide to basic accounting for manufacturing businesses

Lean manufacturing is all about minimising waste while maximising productivity.

It is a practice first initiated by Toyota but has influenced manufacturing for decades, particularly the automobile industry.

Since then, many other industries have come to regard removing waste from their processes as beneficial to the bottom line.

As you streamline manufacturing processes to eliminate waste and shorten the time between receiving and orders, you can also streamline your accounting processes and use them to gather relevant operating information.

This provides valuable feedback on your manufacturing and inventory processes.

Without adapting accounting for manufacturing processes, especially as they increase in complexity as your business grows, it may be difficult to understand how changes in your operations are making a difference to your manufacturing bottom line.

To reduce the costs of doing business, you must understand first where your production costs lie.

It helps if you break down product costs from all the contributing factors that play a part in the cost of the manufacturing product – not only for each item but for all the activities that add cost to the end product.

If you want to refine your production process and automate aspects of your business, accurate costing information helps you identify wasteful costs passed on to the customer or absorbed within the company.

This is all in aid of increasing your revenue and your profit margins.

Ready? Let’s get started. Here’s what we cover in this article:

Manufacturing cost terms to understand

Manufacturing overheads

Production costing methods

Inventory valuation

What you should look for in your manufacturing accounting software

Manufacturing cost terms to understand

You need to think beyond profit and loss to manufacturing costs such as the costs of materials, plus the cost to convert these materials into products.

This is necessary, for example, to understand how you should be pricing your product and how to achieve or exceed your set profit margins.

In a manufacturing business, there are some important terms you need to understand when it comes to calculating the costs of manufacturing your product, as well as the amount of inventory you hold.

Direct materials

Direct material (or raw material) inventory is a calculation of all the materials your manufacturing business is using to make your product – all the materials consumed or identified with your product.

Very often, this is listed in a bill of materials, which itemises quantities and costs the materials used in your product.

In process manufacturing, such as food and beverage or chemicals, the bill of materials is known as a production recipe.

Direct labour costs

Direct labour is the value given to the labour that produces your goods, such as machine or assembly line operators.

Generally, this includes the cost of the regular hours, overtime, and relevant payroll taxes.

Manufacturing overheads

Along with direct materials and direct labour, you must include the cost of manufacturing overhead to ensure you get the right valuation when it comes to inventory and selling price.

Manufacturing overheads might include the costs for powering a factory’s equipment and personnel not directly involved in producing the product.

Work-in-process goods

As part of the manufacturing process, your business is likely to have items in production that have not yet been completed.

This will be an accumulation of the money you have spent on direct materials, direct labour costs, and manufacturing overheads on each work-in-process item in your inventory.

Finished goods

This is the cost associated with the goods you have completely ready to sell to your customers. You would also add the cost of storing these finished goods and other associated expenses.

On your typical manufacturing balance sheet, you should have raw materials, work in process, and finished goods as part of your inventory calculation.

You will also want a periodic or perpetual inventory system to track how many products you have in your production line at any one time.

Production costing methods

When it comes to accounting, you need the right costing method to help you achieve higher profitability. Accounting software for manufacturers may offer different costing methods.

Here are the ones that you should be aware of:

Standard costing

Standard costing is an accounting system where you establish standard rates for materials or labour used in production or inventory costing.

By doing this, you can work out the labour and material costs to produce a single unit of your product.

Having these standards allows you to detect variances that can be analysed, allowing trends to be spotted, and enabling you to make the right adjustments to pricing.

If you are spending more on manufacturing the product than necessary, you will not meet your income targets.

Look at where the inefficiencies are in the production process and where the waste is coming from, adjusting the pricing if required.

Standard costing is useful if you are making similar products or large quantities of a specific product.

Job costing

Job costing, also known as variable costing, is better if you manufacture to order or focus on a small amount of units.

For example, this could include a custom-built machine or a small batch of products.

This accounting system allows you to work out the individual cost of manufacturing for a product and apply the right mark-up to get the project margin you desire.

You might look at each project in detail – down to costs, materials, and overhead. It is particularly popular in construction.

Activity-based costing

This is a costing method that differs from job costing in that it incorporates more indirect costs, such as resource consumption.

It can help you hone which products are profitable and spot opportunities to drive better results for your existing products.

This might be good if you have a complex product mix.

Inventory valuation

Inventory management is crucial for a manufacturer.

At the end of an accounting period, at the end of the financial year, you will want to have a value associated with the number of goods in your inventory.

Valuing your inventory will help establish the costs of goods sold and how much profit you are making. Having a shortage or excess inventory directly affects the production and profitability of your manufacturing business.

Inventory is continually being sold and restocked, so you may need to make a cost flow assumption. There are four accepted ways to value inventory.

First in, first-out (FIFO)

Many manufacturers use the ‘first-in, first-out (FIFO)’ method, where products are sold in the order they are added to inventory.

A popular way of costing inventory; this could work for businesses that have products with a shelf life.

Last in, last out (LIFO)

This inventory valuation method operates under the assumption that the final product added to a company’s inventory is the first one sold.

Fewer manufacturers use this method.

Average cost

This is a common accounting method that uses a weighted average of all products to determine and track inventory.

Average costing is useful in situations where it is difficult to assign costs to specific or individual products.

Specific identification

This accounting method tracks individual items of inventory, which is useful if you can identify each item with, for example, a serial number or radio-frequency identity (RFID) tag.

This can produce a higher degree of accuracy, but many manufacturers are unlikely to have items that have a unique identification.

This is better for high-value items that need differentiation, rather than interchangeable items.

What you should look for in your manufacturing accounting software

Without accurate, timely and quality information, it won’t be easy to understand what is happening in your business.

As a manufacturer, you must always be on top of materials and other associated costs to correctly price your finished items. At the same time, you need to consider external market factors affecting your business and industry.

It would help if you had a manufacturing software solution that allows you to deal with the extra complexity of calculating inventory and the cost of your manufacturing goods.

This software can be used to extract data and analyse trends, improve efficiency, and make the best business decisions.

Your manufacturing accounting software should also help you keep compliant with regulations and the tax laws of the countries you have a business in.

Often, manufacturers invest in an all-in-one solution, which handles other tasks away from finances, such as planning and production. This is known as enterprise resource planning (ERP).

Ideally, data should move freely between production lines and the back office, meaning you have accurate real-time data.

Final thoughts

Features found in accounting software such as inventory management can help you optimise the way you use inventory, such as providing alerts when your stock needs replenishing.

It is crucial when understanding raw materials, work-in-process, and finished goods.

It will avoid a situation where you have too much inventory (which costs money) or, even worse, not enough inventory, where you can’t fulfil the requirements of your customers.