Manufacturing Handbook
University of Michigan OM
Professor R. Eugene Goodson

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SUBJECT: Accounting (Plant-Wide Systems)

DESCRIPTION: The purpose of this entry is to give a brief introduction to the type of accounting systems used in the manufacturing industry and to provide a foundation from which to interpret financial data provided by manufacturing facilities. This will provide support when performing cost analysis during a plant assessment.

KEYWORDS: Accounts, Cost, Profit, Financial, Managerial

OVERVIEW:

This entry will first introduce the two main types of accounting: financial and managerial, as well as the primary financial statements used. The focus of this entry will be on which accounts are the are the ones of primary concern when dealing with a manufacturing facility.

Types of Accounting

Financial Accounting: The preparation and interpretation of accounting information describing the financial position and operating results of a business entity. Financial accounting serves as the basis for the preparation of both financial statements and tax returns. The information included in such financial statement must conform to generally accepted accounting principles (GAAP).

Managerial Accounting: The preparation and interpretation of accounting information designed to assist managers in planning and controlling the operations of the business. Thus, managerial accounting information is used by insiders to the business rather than outsiders. Since managerial accounting reports are used exclusively by management, the content of these reports is not governed by GAAP.

The differences between these two types of accounting are important to distinguish, as you may be exposed to either kind during an analysis of a manufacturing operation.

Accounts of Importance

There are three primary financial statements: Income Statement (Statement of Operations), Balance Sheet, and Statement of Cash Flows. They are all dependent on one another through a system of double-entry accounting (equal and opposing entries of debits and credits). For the purposes of analyzing manufacturing facilities we will focus only on portions of the balance sheet and income statement. It is important to note that another statement, the Statement of Cost of Goods Manufactured is used by many manufacturing companies and is a subset of the income statement. This statement arrives at the total cost of goods manufactured during the year by analyzing raw materials, direct labor, manufacturing overhead, and WIP inventory.

Income Statement: The primary focus in the financial statements of a manufacturing facility is on the "top half" of the income statement. This contains the Gross Profit of the operation. The gross profit is the Sales less the Cost of Sales, or cost of goods sold (COGS). Below is the basic order of the income statement:

         Sales
-       Cost of Sales
        Gross Profit
-       SG&A
+/-    Interest Income/Expense
+/-    Other Income/Expense
         Net Profit

Important notes:

  • Depreciation is recorded in Cost of Sales if it is directly related to the creation of the product. If not, it is included below gross profit, in SG&A.
  • R&D costs are generally expensed when incurred and recorded in Other Expense (sometimes they are recorded under a separate account called R&D Expense).
  • The term Gross Margin refers to the % of gross profit to sales: ((Sales – COGS)/Sales)

Costing Methods: There are two concepts that exist relative to the costs that attach to he product as it flows through the manufacturing process: Variable Costing (direct costing) and Absorption Costing (full costing).

In a variable cost system all costs must be classified as variable or fixed. Variable costs are those that fluctuate in direct proportion to changes in output and are charged to work in process and finished goods inventories, subsequently becoming part of COGS. Fixed costs are those that remain constant in spite of changes in output and are expensed to the current period.

AUnder absorption costing, all manufacturing costs, variable and fixed, direct and indirect, incurred in the factory or production process attach to the product and are included in the cost of inventory. Direct material, direct labor, and all manufacturing overhead are charged to output and allocated to COGS and inventories.

Balance Sheet: The primary accounts of interest in the balance sheet are Property, Plant, & Equipment (PP&E) and Inventory. It is important to have a good understanding of these items when evaluating a manufacturing facility as they have a direct relationship to the costs associated with the operations.

  • Property, Plant, & Equipment - The balance of PP&E is important, as this is the primary determinant of what the facilities depreciation charge will be. Depreciation represents the portion of the assets cost that has been used in the current accounting period. The most common methods of depreciating PP&E are straight-line, sum of the year’s digits, and double-declining balance. To determine an asset’s book value, accumulated depreciation must be deducted from the asset’s original, or historical, cost.
  • Inventory - Inventory is the direct result of manufacturing costs, and is the primary focus of any manufacturing facility. The three inventory accounts utilized by a business that manufactures goods are Raw Materials, Work in Process, and Finished Goods. Work in process and finished goods include raw materials, direct labor, and manufacturing overhead costs. Manufacturing overhead costs include all manufacturing costs except direct materials and direct labor. To illustrate how these different costs affect the inventory accounts, the cost of goods manufactured statement (mentioned earlier) should be reviewed.

REFERENCES:

  • Accounting: The Basis for Business Decisions, Seventh Edition; Meigs, Walter B. and Robert F.
  • Intermediate Accounting, Sixth Edition; Kieso, Donald E. and Weygandt, Jerry J.

ACKNOWLEDGEMENT: This is a March 29, 1999 revision by Gene Goodson of an assignment for OM742 contributed by Greg Holden.


 

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Copyright 1999
R. E. Goodson
University of Michigan Business School