Companies that manufacture goods must follow generally accepted accounting principles like every other company. These rules are set by the Financial Accounting Standards Board and the International Accounting Standards Board. Manufacturers face unique challenges in accounting for parts, supplies, inventory and sales that other companies do not have to contend with. Some accounting rules apply only to manufacturers to address these unique accounting and reporting needs.
Accounting in a Manufacturing Environment
A manufacturing company must account for all of the components of the products it makes and sells. These include raw materials, any supplies used in the process, partially-manufactured components and finished goods inventory. In every step of the manufacturing process, labor is added, which adds value to the goods. Labor costs must be separated between direct manufacturing labor and administrative labor. The first is built into the inventory and the second is a period expense.
Accounting for Work-in-Progress
Manufactured goods may be in progress for an extended period of time. There may be products that are in different stages of production at the end of the period, and all of the costs of each item to that point in time must be included. Production costs in a manufacturing company are often standardized to make tracking easier. For example, a company may look back at its cost history and estimate that its product is valued at $18 when it is 25 percent complete, $43 when it is 50 percent complete and $52 when it is 100 percent complete. The company will apply these standards costs to each manufactured unit that is in each of these stages of completion.
Another reporting issue a manufacturer faces is when to recognize a sale. There are several stages at which a sale can be recorded, such as when an ordered unit is completed, when it is shipped, when it is received by the customer or when the cash is received by the company. Generally accepted accounting principles require that a sale is recognized when the risks and rewards of ownership have passed to the customer. This means the point in time when the customer can use the product to his own advantage, and when he would have to repair or replace it if it broke or was lost. Depending on the sales contract, this often occurs when the product is shipped from the manufacturer or when it is received by the customer.
A manufacturer often holds finished inventory in its warehouses waiting to sell it. During this period of time, many things can happen that make the inventory worth less to a customer or even valueless. Storing the inventory may cause damage through environmental means, such as heat, cold, water or smoke. Inventory may also become worthless through obsolescence. Inventory can become obsolete because new products have been introduced in the market that customers prefer or new technologies have allowed manufacturing prices and sale prices to drop on the items. A manufacturer must review its inventory regularly to ensure that it can be sold for at least the value it is recorded at on the balance sheet. If not, the inventory must be written down to its current market value to reflect its obsolescence. This may mean writing it off completely if the company does not believe that it can be sold at all.
Angie Mohr is a syndicated finance columnist who has been writing professionally since 1987. She is the author of the bestselling "Numbers 101 for Small Business" books and "Piggy Banks to Paychecks: Helping Kids Understand the Value of a Dollar." She is a chartered accountant, certified management accountant and certified public accountant with a Bachelor of Arts in economics from Wilfrid Laurier University.