Inventory Accounting in Manufacturing Companies¶
1. Inventory Components in Trading vs Manufacturing Industry¶
- Trading Firms: Only finished goods (bought and sold).
- Manufacturing Firms:
- Raw Materials: Materials used in production.
- Work-in-Progress (WIP): Partially completed goods.
- Finished Goods: Completed goods ready for sale.
2. Raw Material Inventory Accounting Process¶
2.1 Choose Inventory Accounting Methods¶
- Periodic Inventory Accounting: Inventory is counted and valued at specific intervals (e.g., monthly, annually). Suitable when:
- Few raw materials.
- Small closing inventory.
- Low price variance.
- Perpetual Inventory Accounting: Inventory is tracked continuously, with each purchase and issue recorded. Preferred in most other cases.
2.2 Decide Inventory Valuation Methods¶
- FIFO (First-In, First-Out):
- LIFO (Last-In, First-Out):
- Weighted Average:
- Specific Identification: Tracks the cost of each individual item. Suitable when:
- Few closing inventory items.
- Ability to track individual item costs.
2.3 Calculate Cost of Raw Materials¶
The cost of raw materials includes:
- Invoice value.
- Transportation and other acquisition costs (e.g., freight, handling).
If transportation costs cannot be directly traced to individual items, they are pooled and allocated based on quantity or value.
2.4 Issuing Raw Materials¶
NOW, Raw materials are issued to the production department, where they become part of WIP.
3. Work-in-Progress (WIP) Accounting¶
WIP includes:
- Raw materials used in production.
- Direct labor costs.
- Other direct manufacturing expenses (e.g., direct utilities, machine operation).
Indirect manufacturing expenses (e.g., factory rent, supervisor salaries, depreciation) are also allocated to WIP and eventually to finished goods. Some companies treat certain indirect costs as period costs and allocate them directly to finished goods.
4. Finished Goods Accounting¶
When production is complete, goods are transferred to the finished goods warehouse. The cost of goods manufactured (COGM) includes all costs incurred to produce those goods (direct materials, direct labor, and manufacturing overhead).
5. Example¶
A garment manufacturer:
- Jan 1: Received materials worth ₹300,000.
- Jan 5: Production used ₹200,000 worth of materials for 1,000 shirts.
- Jan 31: 800 shirts completed and transferred to finished goods. 200 shirts remain in WIP.
- Production expenses: ₹100,000 (direct) + ₹60,000 (period cost).
- 10% of direct expenses are allocated to WIP, and 90% to completed units. Period costs are allocated entirely to completed units.
- 600 units sold for ₹300,000.
Accounts:¶
Raw Material Account¶
| Date | Description | Debit (₹) | Credit (₹) |
|---|---|---|---|
| Jan 1 | Purchase | 300,000 | |
| Jan 5 | Transfer to WIP | 200,000 | |
| Balance | Remaining Material | 100,000 |
Work-in-Progress Account¶
| Date | Description | Debit (₹) | Credit (₹) |
|---|---|---|---|
| Jan 5 | Material from Raw Materials | 200,000 | |
| Jan 31 | Direct Expenses (₹100,000) | 100,000 | |
| Total WIP Cost | 300,000 | ||
| Jan 31 | To Finished Goods (80% Material + 90% Expenses) | 250,000 | |
| WIP Ending Balance (20% Material + 10% Expenses) | 50,000 |
- Cost of Completed Units: (0.80 * ₹200,000) + (0.90 * ₹100,000) = ₹250,000
- Cost of WIP Units: (0.20 * ₹200,000) + (0.10 * ₹100,000) = ₹50,000
Finished Goods Account¶
| Date | Description | Debit (₹) | Credit (₹) |
|---|---|---|---|
| Jan 31 | From WIP (COGM) | 250,000 | |
| Jan 31 | Period Cost (allocated to completed units) | 60,000 | |
| Total Finished Goods Cost | 310,000 | ||
| Cost of Goods Sold (600/800 * 310,000) | 232,500 | ||
| Ending Finished Goods Inventory | 77,500 |
- COGM: ₹250,000
- COGM + Period Cost: ₹310,000 (total cost of 800 units)
- Cost of Goods Sold (COGS): (600/800) * ₹310,000 = ₹232,500
REFER TO THE EXCEL WORKING BELOW:-¶
This example demonstrates the flow of costs through the different inventory accounts in a manufacturing setting.