Manufacturing Cost Accounting: Definition, Guide and Best Practices

Manufacturing cost accounting is an essential aspect of the process of managing manufacturing businesses. It includes tracking and analyzing the costs incurred during the production of goods. Here is a guide from Viindoo Enterprise Management Software to manufacturing cost accounting, including the best practices that can be followed to ensure accurate and effective cost accounting.

What is Manufacturing Cost Accounting?

Manufacturing cost accounting includes all the costs associated with the production of goods, such as materials, labor, and overhead. It involves tracking the costs incurred at each stage of the production process, from purchasing raw materials to assembling and packaging finished products.

Manufacturing cost accounting

The goal of manufacturing cost accounting is to determine the cost of producing each unit of a product and to analyze the profitability of the manufacturing process. By understanding the costs involved in production, manufacturers can make informed decisions about pricing, production volumes, and cost reductions.

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Elements of Manufacturing Cost Accounting

Manufacturing accounting refers to a set of procedures for managing inventory and production in order to monitor and regulate the expenses associated with manufacturing goods. To do manufacturing cost accounting, you need to equipped yourself with full understanding of the elements involved in this process.

Direct Materials

This includes the cost of raw materials used in the production process. It includes the purchase price of materials, freight and handling costs, and any other costs incurred in acquiring and transporting the materials to the manufacturing facility.

Direct Labor

This includes the cost of wages, salaries, and benefits for employees directly involved in the production process. It also includes any additional labor costs such as overtime, bonuses, or commissions.

Direct Labor in manufacturing cost accounting

Manufacturing Overhead

This includes all indirect costs associated with the production process that cannot be directly attributed to a particular product or service. Examples of overhead costs include rent, utilities, equipment depreciation, and maintenance expenses.

Work in Progress (WIP)

This includes the cost of partially completed products that are still in the production process. WIP inventory includes the cost of direct materials, direct labor, and manufacturing overhead.

Finished Goods

This includes the cost of completed products that are ready for sale or distribution. Finished goods inventory includes the cost of direct materials, direct labor, and manufacturing overhead.

Finished goods in manufacturing cost accounting

Cost of Goods Sold (COGS)

This includes the total cost of products sold during a specific period, including the cost of direct materials, direct labor, and manufacturing overhead. COGS is an essential measure of profitability for manufacturing businesses.

Standard Costing

This involves setting standard costs for materials, labor, and overhead and using these costs to calculate the cost of goods sold. Standard costing helps to identify variances between actual and expected costs and can help to improve cost efficiency.

Activity-Based Costing (ABC)

This involves allocating overhead costs based on the activities involved in the production process. ABC can help to identify the true cost of producing a product or service and can help to identify areas where costs can be reduced.

By tracking and analyzing these elements of manufacturing cost accounting, businesses can gain a better understanding of the costs involved in producing their products and can make informed decisions about pricing, production volumes, and cost reductions.

How to calculate Manufacturing Cost?

The primary objective of manufacturing accounting is to monitor and manage the different cost-related measurements involved in production. Beginning with the most basic, let's examine these metrics in more depth.

Total Manufacturing Cost

To determine their financial status, manufacturing companies must address a fundamental query: what are the overall expenses involved in producing goods? This inquiry is answered by a measurement known as the Total Manufacturing Cost (TMC) or Total Cost of Production. The TMC comprises two types of costs: direct and indirect, and it's calculated by summing up all the expenses linked with the manufacturing process.

Total Manufacturing Cost

Total manufacturing Cost formula:

TMC = (Direct materials + Direct labor + Direct misc.) + Manufacturing overhead

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COGM and COGS

Determining a company's Gross Profit and Gross Margin involves two essential KPIs that are influenced by the Total Manufacturing Cost. These KPIs are the Cost of Goods Manufactured (COGM) and the Cost of Goods Sold (COGS).

Cost of Goods Manufactured formula:

COGM = Beginning Work-in-Process Inventory (WIP) + Total Cost of Production – Ending WIP

Cost of Goods Sold formula:

COGS = Beginning Finished Goods Inventory + COGM – Ending Finished Goods Inventory

Overhead Cost

Overhead costs are indirect expenses that are not related to business activities that make the company money—payment of overhead costs is required, no matter what, even when business is slow. Companies will have overhead costs to keep the business operating during these periods.

Overhead Cost formula:

Overhead cost = Allocation measure/ Indirect costs

Overhead Cost

Example of manufacturing cost accounting

Let's say a company manufactures and sells a widget. Here is an example of the Total Manufacturing Cost (TMC) for a batch of 1000 widgets:

• Direct Materials: The company uses raw materials such as metal, plastic, and electronic components to manufacture the widgets. For this batch of 1000 widgets, the total cost of the raw materials used is $5,000.
• Direct Labor: The company employs 10 workers to assemble the widgets. Each worker is paid an hourly wage of $20, and it takes 4 hours to complete the assembly of one widget. Therefore, the total direct labor cost for this batch of 1000 widgets is $8,000.
• Manufacturing Overhead: The company incurs indirect costs such as rent, utilities, and maintenance in the manufacturing process. For this batch of 1000 widgets, the total cost of manufacturing overhead is $2,000.
• Depreciation: The company uses specialized equipment in the manufacturing process. For this batch of 1000 widgets, the total depreciation expense on the equipment is $1,500.
• Quality Control Costs: The company conducts quality control checks to ensure that the widgets meet the required quality standards. For this batch of 1000 widgets, the total cost of quality control is $500.
• Shipping and Handling Costs: The company incurs costs to transport the widgets from the factory to the customers. For this batch of 1000 widgets, the total shipping and handling cost is $1,000.
• Rework Costs: During manufacturing, some widgets may require rework or repair due to defects or other issues. For this batch of 1000 widgets, the total cost of rework is $500.

An example for manufacturing cost accounting

For this batch of 1000 widgets, we have:

Total manufacturing cost

• TMC = Direct Materials + Direct Labor + Manufacturing Overhead + Depreciation + Quality Control Costs + Shipping and Handling Costs + Rework Costs
• TMC = $5,000 + $8,000 + $2,000 + $1,500 + $500 + $1,000 + $500
• TMC = $18,500

Cost of Goods Manufactured (COGM)

• COGM = Direct Materials + Direct Labor + Manufacturing Overhead + Depreciation
• COGM = $5,000 + $8,000 + $2,000 + $1,500
• COGM = $16,500

Cost of Goods Sold

• COGS = Beginning Finished Goods Inventory + COGM – Ending Finished Goods Inventory
• COGS = $1,500 + $16,500 - $2,250
• COGS = $16,750

Overhead Cost

• Rent and utilities for the manufacturing facility: $500
• Indirect labor (e.g. supervisors, maintenance workers, etc.): $700
• Depreciation on manufacturing equipment: $300
• Other miscellaneous overhead expenses: $500
• Overhead Cost = $500 + $700 + $300 + $500 = $2000

Production Costing Methods

Production costing methods are used by manufacturing businesses to determine the cost of producing their goods. Here are some of the most common production costing methods:

• Job Order Costing: This method is used when manufacturing businesses produce custom or unique products. The cost of each job is determined by tracking the costs of direct materials, direct labor, and manufacturing overhead.
• Process Costing: This method is used when manufacturing businesses produce similar products in large quantities. The total cost of production is spread evenly over the units produced, with each unit receiving the same cost per unit.
• Activity-Based Costing (ABC): This method is used to determine the cost of each product based on the activities involved in producing it. It is more accurate than traditional methods because it considers all the indirect costs of producing a product.
• Standard Costing: This method is used to determine the cost of production based on a predetermined standard cost for each item produced. It is useful for analyzing variances between actual and standard costs.
• Backflush Costing: This method is used when manufacturing businesses have a high volume of low-cost products. The cost of production is not tracked until the end of the production cycle, at which point the total cost is calculated and allocated to the units produced.
• Hybrid Costing: This method combines two or more costing methods. For example, a manufacturing business might use job order costing for custom products and process costing for standard products.

Choosing the appropriate production costing method depends on the nature of the manufacturing business and the types of products being produced.

Manufacturing cost accounting best practices

Manufacturing accounting provides crucial information about processes vital for maintaining a manufacturing business's financial well-being. By thoroughly examining manufacturing accounting, managers can gain knowledge of all the company's operating costs and make informed decisions to increase profits and generate revenue. To conclude this article, let's review some of the top manufacturing accounting best practices that should be prioritized.

Manufacturing accounting best practices

Keep Accurate Records: Maintain a record of all transactions, including receipts, invoices, and purchase orders. Use accounting software specifically designed for manufacturing businesses to help you manage these records.

• Use Standard Costing: Standard costing is a cost accounting method that helps manufacturers accurately track and evaluate their production costs. It is essential to use standard costing for effective financial analysis and decision-making.
• Implement Activity-Based Costing (ABC): Activity-Based Costing (ABC) is a method of accounting that helps identify the actual cost of producing each product. Implementing ABC will help you make informed decisions about pricing and production strategies.
• Monitor Inventory Levels: Keep track of inventory levels to prevent overstocking or stockouts. Overstocking can tie up your capital, while stockouts can lead to lost sales and customers.
• Forecast Accurately: Develop a forecasting process that considers past sales trends, market trends, and economic indicators. Accurate forecasting will help you plan your production schedule, manage your inventory levels, and avoid stockouts.
• Analyze Financial Statements: Regularly review your financial statements, such as your income statement, balance sheet, and cash flow statement. Analyze these statements to identify trends and make informed decisions.
• Conduct Regular Audits: Conduct regular audits to ensure that your financial records are accurate and up-to-date. Audits will also help you identify areas where you can improve your accounting practices.

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