Essentials of Accounting in an ERP: Manufacturing Accounting 101

Manufacturing accounting presents unique challenges due to the complexities of production, labor, inventory costs, and specific valuation methods used in manufacturing operations. This guide explores distinct cost concepts, best practices, and key considerations for evaluating financial and manufacturing accounting software, highlighting how Rootstock Cloud ERP enhances manufacturing accounting processes.

What is Manufacturing Accounting?

Manufacturing accounting involves the specialized process of capturing, analyzing, and reporting the financial details specific to the production of goods. While manufacturers share common business activities with other industries—such as selling products, employing staff, utilizing equipment, paying vendors, and receiving payments from customers—manufacturing accounting uniquely focuses on manufacturing costing.

Capturing the cost of manufactured goods requires unique considerations and methods. Manufacturing cost accounting systems must accurately capture these costs while being flexible enough to accommodate various manufacturing methods, processes, and techniques.

For instance, consider the cost of producing something as simple as a toothpick. Wood, the raw material, must be received, processed, and stored properly. Machinery is required to convert large pieces of wood into toothpicks and apply a coating. Workers handle the movement and storage of work-in-process goods. Packaging must be either manufactured in-house or procured from a vendor, and the toothpicks need to be boxed and prepared for shipment. Workers then load these boxes onto trucks. Throughout this process, the manufacturer must account for the costs of wood, machinery, labor, electricity, and other overhead, all before receiving payment from customers.

Clearly, cost accounting for manufacturers is complex and challenging. So, let’s delve deeper into the intricacies of manufacturing accounting!

Common Challenges with Accounting for Manufacturing

Manufacturing cost accounting presents unique challenges, whether in discrete manufacturing, distribution, or supply chain operations. Key issues include:

Inventory Valuation Methods: Determining the appropriate method for inventory valuation (e.g., FIFO, LIFO, or weighted average) can be complex and impact financial reporting.
Tracking Costs: Complex manufacturing processes make it difficult to accurately track and pinpoint costs. Identifying direct and indirect costs associated with production requires meticulous management.
Allocating Indirect Costs: Allocating indirect costs such as overhead, utilities, and maintenance can often involve estimations, leading to potential inaccuracies.
Real-Time Reporting: Providing real-time, accurate, and actionable data is crucial for production management, customers, suppliers, and overall business intelligence. Ensuring that reports meet these needs is a significant challenge.

The Accounting Department is tasked with addressing these challenges, ensuring accurate cost tracking, and producing reliable financial reports that support effective decision-making in the manufacturing process.

Accounting for Manufacturing Costs

Manufacturing accounting begins with understanding the various costs involved in production. Here’s an overview of the key components and terms:

Total Manufacturing Cost

Accurately determining total manufacturing cost depends on the manufacturing processes used. Understanding common terms and concepts in manufacturing accounting can guide better decision-making and lead to more precise cost calculations.

Indirect Costs vs. Direct Costs

Manufacturing costs are divided into direct and indirect costs:

Direct Costs: These are traceable to a specific product, such as the raw materials (e.g., wood for toothpicks) and direct labor involved in production.
Indirect Costs: These are necessary for running the manufacturing business but cannot be directly traced to a product, like safety glasses, facility security, depreciation, and utilities.

A useful rule of thumb is that direct costs increase with production, while indirect costs are incurred regardless of production levels.

Direct Materials Costs

Direct material costs increase with production. These are the costs of raw materials used to manufacture goods. They must be itemized and tracked in a bill of materials and stored before production begins.

Direct Labor Costs

Direct labor costs include wages, benefits, and insurance for workers directly involved in production. Distinguishing between direct labor and overhead labor (e.g., managers, and maintenance workers) is crucial, as some roles might blur the lines during specific tasks.

Manufacturing Overhead Costs

Manufacturing overhead, or indirect costs, are not directly linked to product creation. This category includes utilities, administrative staff, security, cleaning supplies, rentals, and insurance. Accurately distinguishing direct costs from overhead is essential for determining inventory values and gross profits.

Product Costs

Product costs encompass the total cost of producing an item, including both direct and indirect costs. For example, the cost of a toothpick includes the wood, labor, equipment, security, and utilities.

Production Cost

Production cost refers to the total of direct materials, direct labor, and manufacturing overhead costs associated with producing a specific product or batch. Manufacturers often track these costs by product, product line, project, or customer order to assess profitability.

Inventory

Inventory includes raw materials, work-in-progress, and finished goods not yet sold. Manufacturing accounting must capture these costs, including the challenges of partially assembled products and rework processes. Consistency in units of measure is critical to avoid inaccuracies in reporting.

Depreciation

Depreciation accounts for the decrease in the value of assets over time. Common methods include:

Straight-line depreciation: Evenly spreads the cost over the asset’s useful life.
Declining balance depreciation: Accelerates depreciation initially, then slows it as the asset ages.
The sum of the years’ digits depreciation: Uses a unique factor for each year to calculate depreciation.
Operating Costs

Operating costs cover material and production costs (cost of goods sold or COGS) plus the costs to run the business (SG&A costs). These include travel, office supplies, maintenance, salaries, utilities, and facility taxes. Operating costs can be either variable or fixed.

Variable Costs

Variable costs change with production volume. In manufacturing, these costs rise with increased production and fall with decreased production, such as the cost of wood, production labor, and packaging for toothpick production.

Fixed Costs

Fixed costs remain constant regardless of production levels. These include expenses like security, real estate, factory facilities, insurance, and other necessary business operations.

By understanding and accurately accounting for these costs, manufacturers can optimize their financial management and improve overall business performance.

Calculating Cost of Goods Manufactured (COGM) and Cost of Goods Sold (COGS)

Manufacturing accounting involves nuanced calculations, particularly for the cost of goods sold (COGS) and the cost of goods manufactured (COGM). Understanding the distinction between these two metrics is essential for accurate financial reporting.

Cost of Goods Manufactured (COGM)

COGM represents the total cost of manufacturing goods that are completed during a specific period and added to inventory, either as finished goods or work in progress. The formula for COGM is:

Cost of Goods Sold (COGS)

COGS includes the costs of goods sold during a specific period, encompassing both manufacturing costs and sales and administrative expenses. The formula for COGS is:

Key Considerations

Understanding how inventory valuations and methods impact COGS and COGM is crucial for accurate manufacturing accounting. As financials are reported periodically, changes in inventory levels directly affect these metrics. For instance, if a manufacturer produces 1,000 widgets in February but sells only 1925, the finished goods inventory will increase by 75 units. This change in inventory must be accounted for when calculating both COGM and COGS.

By accurately tracking and calculating COGM and COGS, manufacturers can better understand their production costs, optimize pricing strategies, and improve financial decision-making.

Inventory Valuation

Inventory valuation represents the cost of goods that have been manufactured but not yet sold. These items, including work-in-process (WIP) units, can constitute a significant portion of deferred costs in manufacturing, as they await packaging and shipment to customers. Accurate costing of these units is essential for financial reporting and decision-making.

Costing Methods for Inventory

Several methods can be used to calculate manufacturing costs and inventory valuation. These methods can impact inventory costs and the cost of goods sold (COGS), particularly when raw material prices or market conditions fluctuate.

First In, First Out (FIFO)
- FIFO assumes that the first units added to inventory are the first to be sold. This method is akin to a storage system where new items are added to the back, and sales are made from the front. The cost of goods sold is based on the oldest inventory costs.
Last In, First Out (LIFO)
- LIFO assumes that the most recently added units are sold first. In this system, new items are added to the front, and sales are made from the front. The cost of goods sold reflects the most recent inventory costs.
Weighted Average Cost (WAC)
- WAC calculates the average cost of all inventory items and updates it with each new purchase. This method simplifies manufacturing cost accounting and helps smooth out cost fluctuations over time.

Production Costing Methods

Manufacturing accounting must accurately track all business costs, with production costs being unique to the industry. Different production costing methods are used based on the nature of the manufacturing process.

Job Order Costing
- Ideal for manufacturers producing customized or variable products. Costs are calculated for each job order, reflecting the specific raw materials and options used.
Process Costing
- Used by manufacturers producing standardized goods through similar processes. Costs are spread across all units produced, reflecting uniform production steps.
Activity-Based Costing (ABC)
- ABC assigns costs based on activities involved in production. It accounts for overhead and indirect costs by determining the cost of each activity. For example, if a toothpick shaper earns $50 per hour and shapes 1,000 toothpicks per hour, the activity-based cost is $0.05 per toothpick. Summing the ABC of all operations yields the total cost for a finished good.

By understanding and applying these inventory valuation and production costing methods, manufacturers can ensure accurate financial reporting and effective cost management.

Best Practices for Improving Manufacturing Accounting

Manufacturing accounting is complex and critical for the success of manufacturing businesses. To streamline this process, consider these five best practices:

1. Allocate Indirect Costs Accurately

Ensure that indirect costs are allocated properly. Different costing methods can significantly impact business operations and financial interpretations. Choose the most accurate costing methods to facilitate growth and consider unique situations like employee purchases with company credit cards. Utilizing manufacturing accounting software can help allocate these costs accurately.

2. Streamline the Production Process

Reducing inefficiencies in production processes simplifies cost accounting calculations. Eliminating waste and unnecessary steps lowers costs. Regularly review production methods and associated costs to identify high-cost areas and improve efficiency.

3. Implement Real-Time Inventory Tracking

Real-time inventory tracking minimizes manual accounting tasks and enhances planning, pricing, shipping, and customer experience. Modern manufacturing planning engines ensure sufficient inventory levels without excess, reducing strain on the business.

4. Implement Real-Time Costing of Components and Finished Goods

Adopting real-time costing for components and finished goods provides accurate insights, improving overall manufacturing accounting. This approach integrates data, highlights costs, and continuously evaluates business health.

5. Adopt Advanced Manufacturing Accounting Software

Advanced manufacturing accounting software is essential for modern manufacturers. It provides powerful, intuitive financial reporting with customizable dashboards for real-time monitoring of costs, profitability, cash flow, and financial health. The software should handle complexities like subsidiaries, foreign currencies, and credit card transactions, and generate actionable reports.

By following these best practices, manufacturers can improve their accounting processes, leading to better financial management and decision-making.

Versa Cloud ERP is an All-in-One for Manufacturing Accounting

Versa Cloud ERP is an all-in-one solution for manufacturing accounting, offering a robust and adaptable platform that integrates procurement, inventory management, production planning, quality control, and finance. This comprehensive system ensures real-time visibility and tracking of inventory and warehouse operations, enhances production agility with advanced scheduling and maintenance features, and supports seamless data flows. By leveraging dynamic reorder management and powerful analytics for strategic sourcing, Versa Cloud ERP helps manufacturers optimize costs, improve efficiency, and achieve faster time-to-benefit with a lower total cost of ownership (TCO) compared to legacy systems. With intuitive interfaces that ensure high user adoption, Versa Cloud ERP drives enterprise-wide optimization and prepares manufacturers for the future of smart manufacturing.

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