South African Grade 11 and 12 Accounting: Manufacturing Accounts - Production Cost Statement

This post assumes that you are familiar with the ledger accounts of a manufacturing business. This post and this post look at the ledger accounts.

The Production Cost Statement

At the end of the year, we will make a new financial statement that summarises some of the information from the manufacturing accounts in the General Ledger. This is to help people reading the financial statement understand how certain key figures -- such as Cost of Sales -- were arrived at. By putting it into a financial statement, we make the information more accessible to people, as everything is explained quite clearly. Imagine having to dig through the ledgers every time you wanted to work out the net operating expenses, for example, and you'll quickly see the benefit!

In order to show manufacturing information in an accessible way, we draw up a couple of statements and notes to those statements.

Production Cost Statement

The first statement drawn up is a production cost statement. This is essentially the Work-in-Progress Account, but in the form of a statement.

For example, suppose we have a Work-in-Progress Stock account as follows:

An example Work-in-Progress Stock account

The resulting Production Cost Statement would look like this:

An example Production Cost Statement

Note that the coloured "+", "-", and "=" are there to help with understanding, and are not normally part of the statement.

Notes to the Financial Statements for the Production Cost Statement

Also note that the statement refers to notes for Direct Materials Cost, Direct Labour Cost, and Factory Overhead Cost. These are drawn up as notes to the financial statements, and are also essentially ledger accounts in statement form. The Direct Materials Cost note is based on the Raw Materials Stock account, the Direct Labour Cost note is based on the Direct Labour Cost account, and the Factory Overhead Cost note is based on the Factory Overhead Cost account. Continuing the above example, the notes would look like this (the notes are empty for now, but I'll put numbers in when I get a chance):

Example Notes to the Financial Statements for the Production Cost Statement - error in note 1 to be corrected!

Note that any custom duties would be added in Note 1 above.

Again, note that the coloured signs on the left of each note are just there to help, and are not usually included!

Cost of Finished Goods Sold

This note bridges the gap between the Production Cost Statement and the Trading Statement (or Income Statement). It is essentially the Finished Goods Stock ledger account in the form of a statement:

Example of the Cost of Finished Goods Sold note.

The cost of finished goods sold is the same as Cost of Sales.

Once again, the coloured signs on the left are not normally included. Also, note that the "Total Cost of Production of Finished Goods" amount is the total from the Production Cost Statement.

Trading Statement

The trading statement is the last of these additional statements, and is just used to show how the Gross Profit is calculated. It is essentially the same as the first three lines of an income statement.

Example of a Trading Statement

An important reminder

Marks are sometimes deducted in tests and exams if negative amounts are not shown in brackets. For example, in the Trading Statement, the Cost of Finished Goods Sold amount should be enclosed in brackets, because it represents an expense.

South African Grade 11 and 12 Accounting: Manufacturing Accounts - Break-even Point

This post is suitable for Grades 11 and 12. For work that is applicable more to Grade 12s, see the final section on this post, "Advanced Break-even"

The Break-even Point

Before we can actually look at calculating break-even, we need to look at calculating some production costs first.

Total Costs and Costs per Unit

To work out the total fixed costs, we simply add up all the fixed costs. Pretty straight-forward, right?

To work out the total fixed costs per unit, we take the total fixed costs and divide it by the number of units produced. In other words:

Fixed costs per unit = Total Fixed Costs / Number of units

Total variable costs are just equal to all the variable costs added up together. Since, in school accounting, we assume that the variable costs per unit stay the same, we may be asked to calculate the total variable costs -- it's quite straight-forward though, as it is just variable costs per unit times by the number of units produced.

Total variable costs per unit = Total variable costs / Number of units.

Lastly, to work out the total production costs, we just add the total fixed and variable costs together. If we want to work out the total production costs per unit, we just take the total production cost and divide it by the number of units produced.

Changing the Number of Units Produced

It's useful to look at what happens to these costs as the number of units produced is increased or decreased:

• As we increase the number of units produced, the fixed costs stay the same, and thus the fixed costs per unit decrease.

• As we increase the number of units produced, the variable costs per unit stay the same (although obviously the total variable costs increase).

This means that as we produce more, the total costs of production per unit begin to decrease, since the fixed costs per unit are decreasing and the variable costs per unit stay the same. This makes sense, since we all are familiar with the idea that producing things in bulk is usually cheaper.

 

The Break-even Point

The Break-even Quantity

For a business that manufactures the goods that it produces, it is very important that it know just how many units of stock it must produce and sell to make a profit. Note that when I talk about "profit" here, I'm referring to Gross Profit (so Sales less Cost of Sales).

As we saw in the previous section, as we produce more, the total costs of production per unit begin to decrease. As a result, if we choose a selling price that's not too ridiculous, we might find that if we only produce and sell a few units, we might make a loss. If we produce a few more, because the fixed costs per unit will decrease, we will find that we'll make less of a loss. As we carry on producing and selling even more, eventually we'll reach a point where we stop making a loss, and instead start to make a profit. This point is called the break-even point.

More formally, the break-even quantity is the quantity of units that a business needs to produce and sell in order to make a (gross) profit of zero.

Any quantity greater than the break-even quantity that is sold will result in a profit; any quantity that is produced and sold that is less will result in a loss.

Calculating the break-even quantity

To calculate the break-even quantity, there is a fairly simple formula to use. In Grade 11 and Grade 12, you won't be given the formula in tests, and you will be expected to remember it. The formula is:

Break even quantity = (Total Fixed Costs) / (Selling price per unit - Variable cost per unit)

For example, if we have total fixed costs of R50 000, a selling price per unit of R12, and a variable cost per unit of R7.50:

Break-even quantity = (50 000) / (12 - 7.50) = 50 000 / 4.50 = 11 111.11

This means that we would have to produce (and sell) 11 112 units to start making a profit, because it's more than the break-even quantity. If we produced only 11 111, we would make a loss (although it would be a very small loss) because it's less than the break-even quantity.

Calculating the break-even price (or value)

Sometimes a business will know what their production capacity is -- i.e. the number of units that they can produce -- and instead will want to know what selling price they should use if they want to break even. When this is the case, people tend to talk about the break-even "price" or sometimes the "value". Note that this is not always asked consistently, and some tests and exams I've seen will talk about "value" and mean quantity instead. Hopefully as you do more exercises, you will get a good feel for what they are really asking.

We've already seen the formula to calculate the break-even quantity. If we want to work out the break-even selling price, we just have to rearrange the equation (since we'll have been given the quantity):

Break-even quantity = Total Fixed Costs / (Selling price per unit - Variable cost per unit)

=> Selling price per unit - variable cost per unit = Total Fixed Costs / Break-even quantity

=> Selling price per unit = (Total Fixed Costs/Break-even quantity) + Variable Cost per unit

This selling price is the price at which a given production quantity will be sold for the business to not make a loss. If they sell it for a lower price, the business will make a loss; if they sell it for a higher price, the business will make a profit.

A bit more on the Break-even formula

Instead of having "Selling price per unit - variable cost per unit" in the denominator, people have defined a term called contribution. Instead of trying to worry about what "contribution" means, instead we just need to know that:

Contribution = Selling Price per Unit - Variable Cost per Unit

Sometimes contribution will also be referred to as marginal income. For Grade 11 and 12, the only real advantage to the idea of "contribution" is that it makes the formula look a little simpler:

Break-even quantity = Total Fixed Cost / Contribution

While understanding the idea of a contribution is not important, in tests and exams the contribution is often given, instead of giving the selling price and variable costs. It is expected that you will know how to use it in the break-even formula.

Advanced Break-even

This section is applicable to Grade 12s.

So far we have only examined the break-even point from a production perspective. Of course, a real business also has non-production costs, and it must take these into account when it does break-even analysis. The non-production costs of a business are divided up into Administration Costs and Selling & Distribution Costs.

When we calculate the break even quantity, we are only really interested in the selling price per unit, the total fixed cost, and the variable cost per unit.

Administration Costs and Selling & Distribution Costs can also be divided up into variable and fixed costs. Unless we are told otherwise, we assume at school that:

• Administration Costs are fixed costs, and
• Selling & Distribution Costs are variable costs.

This means that to calculate total fixed costs:

Fixed Cost = Factory Overhead Cost + Administration Cost,

and to calculate total variable costs:

Variable Cost = Direct Material Cost + Direct Labour Cost + Selling & Distribution Cost.

The Break-even formula remains the same.

The big advantage of this method is that it takes net profit into account, rather than just the gross profit. This gives the business a much better idea of where it will actually break-even, and thus whether it will actually make a profit or a less.

South African Grade 11 and 12 Accounting: Manufacturing Accounts - Different types of costs

Different types of costs

When we look at the costs of a manufacturing business, we have a number of different ways of breaking them up. The first way breaks up all the expenses of the business, while the other two ways look at production costs in particular.

Production, Selling and Distribution, and Administration Costs

The first way that we will break up costs lets us break up all the expenses in the business into three different types of costs.

Production costs are any costs that have to do with production. They can be costs that are directly related to production, like the cost of raw materials, or they could be costs that are only indirectly related, like the rent for the factory where the goods are made. In tests and exams, these costs will often have "Factory" in the name, such as "Factory wages" or "Rent: Factory".

Selling and Distribution costs are any costs that have to do with either selling goods or with distributing the goods. This includes expenses such as advertising, wages of salesmen, or the rent of the shop. It also includes Bad Debts. In tests and exams, these costs will often have "Shop" in the name, such as "Insurance: Shop".

Administration costs are any costs to do with the administration of the business. For example, the salary of the business's accountant would be an administration cost. In tests and exams, administration costs will usually have "Office" in the name, such as "Salaries: Office Staff" or "Depreciation: Office Equipment".

In the manufacturing section, we are most interested in production costs, and for the remainder of this post we will ignore the others.

Direct and Indirect Costs

Note that these categories of costs only apply to Production Costs.

Direct Costs are costs that are directly applicable to the goods being produced. For example, the cost of the labourers who actually assemble each unit (Direct Labour Cost), or the cost of the materials used to make up each unit (Direct Materials Cost). We consider Direct Labour and Direct Materials Cost to be the only two direct costs. We call their sum "Prime Cost", i.e. Prime cost = direct labour cost + direct materials cost.

Indirect Costs, or Overheads, are all those costs that still form part of production costs, but are not directly applicable to the goods being produced. For example, the insurance of the factory or the wages of the cleaners in the factory.

Fixed, Variable, and Semi-variable Costs

Note that these categories of costs are only applied to Production Costs.

Fixed Costs are costs that are independent of the number of units produced. This means that fixed costs would be the same regardless of whether we produced zero, 100, or 1000 units. Note that this does not mean that fixed costs have to stay the same every month -- it just means that fixed costs have nothing to do with the number of units produced. For example, depreciation is a fixed cost -- it does not depend on the number of units produced, even though it may be different from one period to the next if we calculate it using the diminishing balance method.

Variable Costs are costs that vary according to the number of units produced. This means that variable costs will be zero if no goods are produced, and would be bigger if 100 units were produced, and even bigger if 1000 units were produced. If you do economics, you may be used to quite complicated look curves for variable costs, but in school accounting we assume that variable costs are linear -- in other words, they are directly proportional to the number of goods we produce. This means that if the variable cost to produce 1 unit of stock is R5, the total variable cost to produce 100 units is R500, and the total variable cost to produce 1000 units is R5000.

Semi-variable Costs are costs that have a fixed component and a variable component. For example, in many businesses, electricity would be a variable cost. If we produced no goods at all, the cost wouldn't be zero, because we'd still have to pay for lighting, electric fences, security cameras and so on. However, when we started producing, our machines would use more electricity and so we would have costs that rose as we produced more. In Grade 11 and 12, we usually assume that costs that might be semi-variable in the real world are actually fixed costs -- so electricity would be a fixed cost.

A post on this topic showing the fixed and variable costs on graphs will be put up as well, as well as a post on the maths behind them -- and how we derive the break-even point.

South African Grade 11 and 12 Accounting: Manufacturing Accounts - Ledgers at the Year-End

This post looks at the year-end transactions of a manufacturing business. It follows on from other posts on different types of costs, as well as the recording of buying direct and indirect raw materials in the general ledger.

Year-End Transaction in the General Ledger

In Grade 10 we saw how businesses closed off accounts at the end of the financial year: Sales and Cost of Sales were closed off to the Trading Account, which was in turn closed off to the Profit and Loss account. All other income and expenses were closed off to the Profit and Loss account, which was then closed off to the Capital account.

In a manufacturing business, we still follow a process related to the one we learnt in Grade 10, but there are some new accounts that we have to deal with when closing off.

The following diagram shows us how all the accounts will be closed off, or the "flow" of the accounts:

To help with understanding and remembering all this, I've used different shapes and colours to represent the different types of accounts.

The most important new accounts that we have to know about are the Cost Accounts. There are five that we use: Direct Materials Cost, Direct Labour Cost, Factory Overhead Cost, Administration Cost, and Selling and Distribution cost. The first three deal with production costs (and are all closed off to Work-in-Progress stock), while the last two deal with non-production costs (and are closed off to Profit and Loss).

One question that I am sometimes asked is why the expenses related to production don't appear in the Profit and Loss Account. Remember that the Trading Account has Sales and Cost of Sales in it -- and Cost of Sales is all the combined costs of production of the goods that we have sold. The cost of production of goods that we haven't sold is still contained in the Finished Goods Stock account.

Notice how the final transaction of all is to close the Profit and Loss account off to Capital -- just like we did in Grade 10. This represents the Net Profit that has been made over the past year. Because the owner owns the business, the Net Profit belongs to him or her, and thus gets added to Capital.

The best way to understand this process is to practise it. Don't think that you'll have remembered everything just by reading this!

The flow of accounts shown above is only an image; for higher quality pdfs, click here for colour and here for black and white.

South African Grade 11 and 12 Accounting: Manufacturing Accounts - Buying Raw Materials

Note that this post is aimed at South African high school Accounting, and assumes that students are at a Grade 11 level. It also assumes that learners understand the basic concepts behind manufacturing, such as direct and indirect costs, fixed costs, variable costs, etc.

Buying Materials

Direct raw materials

This section assumes that you know that the "Raw Materials Stock" account represents direct materials.

Buying raw materials is perhaps the simplest transaction to deal with. By now you should be happy with buying an asset: If the business pays cash, we credit Bank (to decrease it) and we debit the asset; if we buy it on credit, we credit Creditors' Control (to show that we owe them more) and we debit the asset.

Over the year, the business will probably buy raw materials fairly frequently, but we only post through journal totals at the end of the period. This means that if, over the course of the year, we purchased R50 000 worth of raw materials with cash and we also bought R75 000 worth of raw materials on credit, our ledger will look like this:

The beginnings of the Raw Materials Stock account

Note that we had a starting balance of R14 000. This means that at the beginning of the year, the business had raw materials to the value of R14 000.

For the year-end transactions for Raw Materials Stock -- as well as other accounts -- see the post on the end-of-year procedures.

Carriage on Purchases

Now is a good time to mention Carriage on Purchases. This is a fancy name that just means the cost of transporting an asset from the seller to our business, but we must be careful in how we handle it.

As you should remember, we always record assets at the lower of historic cost and net realisable value. This means that we usually record assets at their historic cost price -- the price that we originally paid for the asset. The important thing to remember is that the cost price of an asset is the total of all the costs that get the asset to our business in a useful condition. If we buy an asset but it sits in our supplier's warehouse, it's useless to us. If it isn't doing anything for our business, it's not really an asset.

Because all these costs make up the historic cost, we add costs like carriage on purchases directly to the asset account. This means we treat carriage on purchases as though we were just buying more stock at that price.

As an example, let's say that we also paid R1 200 for carriage on purchases out of petty cash. Our ledger would now look like this:

Raw Materials Stock -- now with carriage on purchases paid from Petty Cash.

Normally in the exercises that we will do, carriage on purchases will just be added to the bank or the creditors' control amounts, depending on whether we pay with or use credit.

Note that carriage on purchases is probably going to appear in every test and exam that covers this section!

Indirect Raw Materials (Consumable Stores)

Some tests and exams will tell you that indirect raw materials have been purchased. Do not confuse these with the direct raw materials dealt with above.

Buying Consumable Stores

When we buy indirect raw materials, we usually put them into the expense account Consumable Stores, which we treat like Stationery or any of the other consumable stores accounts that we have dealt with. We will credit bank and debit Consumable Stores. After purchasing consumable stores on cash and credit, the ledger account will look something like this:

Buying Consumable Stores

This makes it seem as if Consumable Stores behaves like Raw Materials Stock or another asset, but remember that Consumable Stores is an expense!

Consumable Stores at the end of the year

At the end of the year, if any consumable stores are left over, we put them into the asset account Consumable Stores on Hand, and close off the rest to Factory Overhead Cost (See the post on closing-off ledger accounts at the end of the year for more on that).

For example, if we have only R500 of consumable stores left over at the end of the year, we will put the R500 into the Consumable Stores on Hand account (an asset), and the rest will be closed off to the Factory Overhead Cost account:

Consumable Stores at the end of the year

Consumable Stores on Hand will be balanced at the end of the year.

Consumable Stores at the beginning of the year

At the start of the next financial period, this balance will be transferred back to Consumable Stores, like this:

Consumable Stores on hand and Consumable Stores at the beginning of the year.

For more end-of-year transactions, look at the other post on the year-end process.