The accounting for a manufacturing business deals with inventory valuation and the cost of goods sold. These concepts are uncommon in other types of entities, or are handled at a more simplified level. The concepts are expanded upon as follows:
- Inventory valuation. A manufacturing business must use a certain amount of raw materials, work-in-process, and finished goods as part of its production processes, and any ending balances must be properly valued for recognition on the company balance sheet. This valuation requires the following activities:
- Direct cost assignment. Costs are assigned to inventory using either a standard costing, weighted-average cost, or cost layering methodology. See the standard costing, weighted-average method, FIFO, and LIFO topics for more information.
- Overhead cost assignment. Factory overhead costs must be aggregated into cost pools and then allocated to the number of units produced during a reporting period, which increases the recorded cost of inventory. The number of cost pools should be minimized to reduce the amount of allocation work by the accountant.
- Impairment testing. Also known as the lower of cost or market rule, this activity involves ascertaining whether the amount at which inventory items are recorded is higher than their current market values. If so, the inventory must be written down to the market values. This task may be completed at relatively long intervals, such as at the end of each annual reporting period.
- Cost of goods sold recognition. At its most basic level, the cost of goods sold is simply beginning inventory, plus purchases, minus ending inventory. Thus, the derivation of the cost of goods sold is really driven by the accuracy of the inventory valuation procedures that were just described. In addition, any abnormal costs incurred, such as excessive scrap, are not recorded in inventory, but instead are charged directly to the cost of goods sold. This calls for a detailed scrap tracking procedure. Also, costs may be assigned to specific jobs (known as job costing) and then charged to the cost of goods sold when the inventory items in those jobs are sold to customers.
In addition, a manufacturing business must use either a perpetual inventory or periodic inventory system to track the number of units of inventory that it has on hand; this information is crucial for determining the valuation of inventory. Though the periodic inventory system is easier to maintain, it only yields an accurate value when a physical inventory count is made, and so is not recommended. The perpetual system should yield accurate inventory unit quantities at all times, though rigorous record keeping and cycle counting are required to ensure that a high level of accuracy is maintained.
In summary, the accounting for manufacturing businesses is much more detailed than is required for a business that maintains no inventory. A company can reduce this workload by shrinking the amount of inventory on hand, encouraging suppliers to own some on-site inventory, employing supplier drop shipping, and other techniques that reduce the overall level of investment in inventory.