Raw material cost (Raw Material Warehouse)
OK now that you’ve had a chance to look at the numbers, let’s get right into them. Let’s assume that we are all accountants for Morgana manufacturing company and that we manufacture high-quality furniture like tables etc.
As in any manufacturing process to manufacture any product you need raw materials. So let’s assume that we have a couple of buildings as part of our manufacturing facility. The first building is building number one and I call this our raw material warehouse. Now what goes into raw materials? As an example hypothetically in this case let’s assume our raw materials are made up of wood, nails and glue to make our table. Wood would be an example of a direct material and nails and glue would be examples of indirect materials.
However all of these three materials would be stored in our raw materials warehouse. Now from accounting standpoint I’m going to show you first how to calculate the direct materials used in the production process during this period of time. So we start off with our beginning direct materials inventory. And if you recall the ending inventory of one month becomes the beginning inventory of the next month.
So this is our beginning direct materials inventory of $1,000. Now to this we are going to add any new purchases that we would have made this month of our wood direct material. So we’ve negotiated we’ve checked our different suppliers, negotiated with different suppliers, and ultimately have chosen one supplier to buy our wood from, and so in this month we have purchased $2,000 of wood. Now in addition to the base purchase cost it also cost us transportation fees to bring the wood over to our factory that those transportation costs we classify them as freight in and are an integral cost of purchasing this direct material and in this case it’s $500.
So this gives us a total of $3,500 of direct materials of available for usage in the production process this month. Now during the month raw materials including this direct materials of wood is being used constantly in the production process. How do we know how much of direct material we have used.
One way to do that is at the end of the month, we calculate how much of direct material do we have left, in this example we $1,900 of direct material left at the end of the month. So earlier we have $3,500 of direct material available, now we only have 1,900, so obviously the difference between the two which is 1,600. 1,600 would be the amount of direct material used in the production process this period of time, assuming of course that there was no theft, no spoilage etc.
So that’s the way we would calculate the direct materials used in this case $1,600. Now where does this information go? To understand where the $1,600 fits in, we next look at the work in proccess account. Well before we look at the work in process account, let’s go down here where I have building number 2 the plant.
Cost Of Goods Manufactured (Plant)
So earlier we had the building number 1 the raw material warehouse, now we have building number 2. So visualize this folks the materials are moving from the building number 1 raw materials warehouse into building number 2 the plant.
For accounting purposes we generally don’t have an account called plant, but we have account called work in process. So work in process very broadly represents all of the activitiy that takes place physically in the plant.
One way to understand work in process is it is the value of those partially finished goods. Now if you recall manufacturing is a continuous process, so at the end of any given month you may have a number of partially finished furniture that becomes your work in process.
So in this example our beginning work in process inventory is $5,000. To that we add the direct we do that we add the product cost of this month. The product cost if you recall from an earlier discussion is made up of three components direct materials, direct labor and manufacturing overhead. In this example we have $1,600 of direct materials used, recall we do the calculations a minute back on this number.
Then we have direct labor of $3,000. Where we get this? Well there are multiple sources in the real world as to where you can pick up this information from. One possible source would be the time sheets of the factory workers that are directly involved in the production process. That’s $3,000 in this example.
Next we look at the manufacturing overhead. Now you may recall from an earlier discussion, manufacturing overhead all those factory related costs, that are not classified as direct materials and not classified as direct labor.
So again any factory cost that is not direct materials and not direct labor would be then by default a manufacturing factory ovehead cost. Some example, can you think of some examples or factory overhead? How about factory utilities or factory insurance or factory property taxes, factory janitorial services, factory equipment depreciation and on and on and on, factory supervisor salary that would be an indirect labor which is also part of your factory overhead.
So in this example we have $4,400 of manufacturing overhead. So when we add up our beginning working process to the direct materials used to the direct labor and then the manufacturing overhead we end up with total manufacturing costs to be accounted for $14,000.
Then first-forward to the end of the month. End of the month we take a inventory again of our partially finished products that’s our ending work in process inventory. In this example our ending work in process inventory is valued at $2,500. So when you take the difference then between the total manufacturing costs to be accounted for less your ending work in process inventory $20,000 you end up with your cost of goods manufactued of $11,500.
Cost of goods manufactured let’s try to understand what do we mean by this not by this term. Cost of goods that this is your cost of the goods that I’ve been fully finished. Now what happens when your goods are fully finished? remember this building number 2 is your plant, well onece your goods your furniture is fully finished it moves to the next building, building number3. And building number 3 we call that your finished goods warehouse.
Cost Of Goods Sold (Finished Goods Warehouse)
So this is where the maerchandise is stored waiting to be sold to a customer. So cost of goods manufactured goes right into the next set of calculations. So here we have beginning finished goods inventory of $1,800. And then during this month we get a new batch of goods that were fully manufactured in the amount of 11,500 that we just finished calculating earlier.
So this gives us cost of goods available for $13,300 that’s your beginning finished goods inventory plus your cost of goods manufactured. Now during the month you’re selling some of this merchandise to your customers. Well what is your cost of this merchandise that you have sold.
To get to that with first forward to the end of the month and we take another inventory of our finished goods. In this example our ending finished goods inventory is $3,000. Now recall we had $13,300 of finished goods available for sale to our customers. We only have $3,000 left at the end of the month of these finished goods.
So the difference between the two that’s $10,300. This represents our cost of the goods that we sold, we call this cost of goods sold. So this would be the calculations for both the cost of goods manufactured and then the cost of goods sold.
But please don’t confuse the cost of goods sold with the sales. So for instance hypothetically if I said Morgana manufacturing company’s policy is to sell everything at double its cost. Then in this period of time what would be our sales. Remember cost is $10,300 a cost of what we sold.
So our sales would be double that number which is $20,600. So remember the relationship between sales and then cost of goods sold. So again we are three buildings, building one the raw material warehouse whether materials flow into building number two which is our plant and then from the plant once the goods are fully finished they flow into building number three which is our finished goods warehouse.
So this gives you an overview of the discussion of these different terms and how we do the calculations and rather than putting all of this in one schedule, I broke it out into small bite-sized pieces to help you.