Manufacturing Accounting: A Complete Guide

Manufacturing accounting is the process of forecasting, analysing, and reporting on the financial status of a manufacturing organisation. It includes the management of labour, equipment, and overhead costs. Manufacturing accounting also involves tracking raw material costs, making inventory valuations, and strategically pricing finished goods.

What is a manufacturing account?

A manufacturing account is a written record of all the financial information in a manufacturing business. By the end of a financial year, you’ll likely have more than one type of manufacturing account to help you determine the costs and losses associated with different parts of your production pipeline.

Types of manufacturing accounts include:

• Direct material costs
• Direct labour costs
• Overheads (indirect costs)
• Work-in-progress (WIP) costs

Other manufacturing account types may include administrative costs, marketing costs, and cost of goods sold (COGS).

Once a product has been manufactured, its costs will typically be transferred from the manufacturing account to the income statement along with the price markup.

Manufacturing cost accounting refers to accounting for the various inventory and production costs within a manufacturing business. It focuses on identifying all the costs associated with producing a finished good. The sum of these costs is known as manufacturing cost, which can be calculated by combining the cost of materials with labour costs and overhead expenses.

In production management, manufacturing cost accounting seeks to determine the cost of goods sold to better understand revenue and profitability at both the business level and the individual product level. This knowledge enables you to plan better budgets and spot production inefficiencies.

Direct costs vs. indirect costs

When tracking manufacturing expenditure, it’s important to understand both direct and indirect costs.

The costs that contribute to your total manufacturing cost are known as direct costs. These are the costs that directly impact production.

Materials and production labour make up the bulk of a manufacturer’s direct costs. Manufacturing supplies, wages for non-production staff, and overheads like fuel or electricity can also all be considered direct costs.

Indirect costs are difficult to trace back to the manufacturing of a specific product. However, they must still be paid to keep the business operating. 

These include things like rent, asset depreciation, marketing, and office expenses – all of which may be necessary to operate a manufacturing business.

Variable vs. fixed costs

Manufacturing costs can also be categorised as either variable costs or fixed costs.

Variable costs are any production costs that change as you produce more or fewer items. For example, raw materials are typically variable because more materials are required to produce more items.

Labour is sometimes a fixed cost and sometimes a variable cost. This depends on whether the labour requirements of a particular job change as you add more volume.

Your building lease is most likely a fixed cost because, regardless of what you do inside the building, the lease usually stays the same.

A manufacturing accountant’s job is to understand the cost of purchasing raw materials, how much money it takes to turn those materials into finished goods, and the optimal price to set for products so the business turns a profit.

Manufacturing accountants also keep an eye on other important areas of expenditure to ensure the budget is followed throughout the financial year.

Some of the figures tracked by a manufacturing accountant include:

• Inventory holding costs
• Inventory valuations
• Labour and overheads
• Equipment maintenance
• Transportation costs

It’s wise for a manufacturing accountant to follow shifting customer trends as a change in demand could drastically alter the cost landscape for the business.

Manufacturing costs are split into three primary categories: direct materials cost, direct labour cost, and manufacturing overhead costs. These account for all the resources consumed to produce a product. 

In addition, there are also indirect costs that must be managed within a manufacturing business, such as insurance premiums and daily office expenses.

1. Material costs

Material costs cover all the inventory stock items that go into a finished product. This includes raw materials, parts, and components – and also consumables like screws and adhesives.

Material costs can be direct or indirect, for example:

• Direct materials – These can include metals, wood, plastics, and (in the case of food manufacturing) flour or water. These are tangible materials consumed during the production process that can be directly accounted for on a per-unit basis.
• Indirect materials – These can include daily consumables such as cleaning solutions, safety equipment, glues, and oils. These are important supplies that may not go into the final product.

From a manufacturing accounting perspective, indirect materials are often considered overheads rather than materials. This can vary depending on the manufacturing costing method being used.

2. Labour costs

Labour costs cover everything you spend on production staff. This includes wages, retirement, sick leave, company vehicles, and bonuses. It can also account for any health insurance or retirement benefits that are part of their employee contracts.

Labour costs can be direct or indirect:

• Direct labour: The costs associated with anyone directly involved in the production of a product, such as assembly line workers, warehouse managers, and quality controllers.
• Indirect labour: The costs of non-production staff, such as administrators or security teams. Indirect labour costs are usually accounted for as an overhead in manufacturing.

Labour costs can also be fixed or variable. 

Fixed labour costs could include contractors, technicians, and maintenance staff with set jobs to do with set fees. Variable costs, on the other hand, can include assembly line workers whose roles change as you produce higher volumes.

3. Overhead costs

Manufacturing overhead costs are indirect costs that are incurred during a particular accounting period but cannot easily be accounted for on a per-unit basis. 

If it isn’t a direct material or labour cost, it’s probably an overhead.

Accounting for manufacturing overhead costs requires more effort, and can be more challenging compared to other costing efforts because of the difficulty in assigning them to specific products or outcomes.

You can define overhead costs in two ways. 

The indirect costs associated with inventory and the factory floor can be classified as manufacturing overheads. Business overheads – or just ‘overheads’ – could include manufacturing overheads as well as those costs required to operate the entire company, such as legal fees and marketing budget.

4. What is Manufacturing Overhead in Accounting?

Manufacturing overhead, also referred to as factory overhead or production overhead, is the indirect costs related to production, such as utilities, maintenance, and factory rent. Manufacturing overheads are the essential costs when running a manufacturing facility. However, these expenses are not directly used to manufacture the products, unlike direct costs such as ingredients or packaging materials.   Expenses that are used to manufacture the product are known as direct costs. Examples of manufacturing overhead costs include: 

• Factory rent & utilities – Expenses including rent, gas, electricity, water, and Wi-Fi are considered as manufacturing overheads as they aren’t directly involved in the manufacturing process.  
• Indirect labour – Indirect labour costs relate to maintenance staff or supervisors, not people who are directly involved in manufacturing the product.  
• Insurance – Insurance is required to ensure that a business is protected if something were to go wrong, including heavy damage to the factory. These include property insurance, equipment insurance, as well as worker’s compensation insurance.  
• Communication systems – Communication systems, such as computers and intercoms, are also considered indirect costs 

Manufacturing overheads are factored into total manufacturing costs by identifying all manufacturing overhead expenses, calculating the total and adding these to the direct materials and direct labour costs.

For information about how TMC is calculated, check out the formula here. 

Production costing methods are manufacturing accounting methods used to calculate and analyse your costs to produce finished goods.

Each production costing method generates these figures differently. This can result in drastically different figures for your business financials, which is why it’s important to use the right approach based on your specific business requirements.

Here’s a short list of the most common production costing methods:

1. Job costing: The tracking of costs as they relate to specific manufacturing orders. Job costing considers direct as well as indirect costs, drilling down into those costs by batch or lot.
2. Process costing: The tracking of costs as they relate to the entire production process. Process costing is used when it can be safely assumed that costs will be identical each run (such as with mass-produced goods). It tracks the entire process over time rather than by batch or lot.
3. Activity-based costing: The tracking of overheads as they relate to specific products. Activity-based costing investigates individual activities and cost drivers, identifying which production jobs generate the highest overheads, so products can be priced accordingly.
4. Direct costing (or variable costing): The tracking of the variable costs in a particular production. Direct costing doesn’t factor in overheads. This method is often used for quick decision-making.
5. Target costing: The tracking of costs based solely on inventory and demand forecasts. Target costing tries to predict what it might cost the business to manufacture a new product and how much customers will likely pay for it. Target costing aims to determine whether a future innovation will be profitable and viable to produce.

Commonly used manufacturing accounting metrics include Total Manufacturing Cost (TMC), Cost of Goods Manufacturing (COGM) and Costs of Goods Sold (COGS). These manufacturing accounting metrics are vital for analysing production efficiency, understanding pricing strategies, and improving operational decisions.  This is because these metrics can give businesses the chance to look at quantitative data, showing profitability and where resources could be allocated.

Total Manufacturing Cost (TMC)

The Total Manufacturing Cost (TMC) is the calculation of all expenses associated with product manufacturing. This includes direct materials, direct labour, and Manufacturing Overheads. The formula for calculating the total manufacturing cost is: 

Total Manufacturing Cost = Direct Materials + Direct Labor + Manufacturing Overhead 

For example, if your direct materials cost is £50,000, your direct labour cost is £20,000 and your overheads cost is £45,000, your Total Manufacturing Costs is £115,000.

The total manufacturing costs should be calculated at the end of a specific period throughout the year, such as the end of a quarter or at the end of the year. This is used to understand how a manufacturing business has performed financially by providing data into the profitability, the efficiency and strategies behind the pricing, allowing businesses to find areas in which they need to improve.

Cost of Goods Manufactured (COGM) 

The Cost of Goods Manufactured (COGM) is the costs that a business accumulates when producing goods, specifically costs relating to production and not administrative or selling expenses. COGM is measured at the end of an accounting period. This can be monthly, end of a quarter or yearly. These costs include direct materials, direct labour, manufacturing overhead costs, Beginning Work in Process (WIP) inventory and Ending Work in Process (WIP) inventory.  

Work in Process inventory refers to products that are partially completed and still undergoing production. It represents the costs of materials, labour, and overhead incurred during the manufacturing process, but which have not yet been transferred to the finished goods inventory. 

The formula for calculating the costs of goods manufactured is: 

Cost of Goods Manufactured = Direct Materials Used + Direct Labour Used + Manufacturing Overhead + Beginning WIP Inventory – Ending WIP Inventory  

Or 

Cost of Goods Manufactured = Total Goods Manufactured + Beginning WIP Inventory – Ending WIP Inventory 

There are two ways to calculate COGM. The first formula breaks down each component. The second formula is the shorthand version when TMC has already been calculated.

 For example, if direct materials cost is £50,000, your direct labour cost is £20,000, your overheads cost is £45,000, your beginning WIP inventory is £10,000 and your ending WIP inventory is £30,000, your Cost of Goods Manufactured is £95,000.  

Cost of Goods Manufactured allows a business to determine the cost of manufacturing products during an accounting period. Just like Total Manufacturing Goods, calculating COGM allows businesses to understand the costs of manufacturing the product, making data-backed decisions for pricing and analysing financial performance.  

Cost of Goods Sold (COGS) 

Cost of Goods Sold (COGS) is the direct expenses a business accumulates when manufacturing and selling products, measured during an accounting period.  

 These costs include beginning inventory costs (raw materials, labour, etc), purchase inventory (transportation costs, taxes, etc) and ending inventory costs (unsold products).  

The formula for calculating the cost of goods sold is: 

Cost of Goods Sold = Beginning Inventory + Cost of Goods Manufactured – Ending Inventory 

For example, if your beginning inventory cost is £50,000, your COGM is £25,000 and your ending inventory is £20,000, your cost of goods sold is £55,000. 

COGS is calculated in an accounting period, usually at the end of the quarter or end of a year. Just like COGM, this is calculated to get a better understanding on the profitability of a business, helps to manage inventory and made decisions backed by data.  

How These Metrics Work Together and Why They Matter

Think of these metrics as a production pipeline: TMC captures all costs going into production, COGM shows the cost of completed goods, and COGS reveals the cost of what you actually sold. This is because the total manufacturing costs represent expenses during the production process, the cost of goods manufactured represents the expenses of finished goods and the cost of goods sold is the profit made from selling products. 

These metrics are used together to aid in the calculation of each other. For example, COGM is required to calculate COGS. TMC is used to calculate COGM, and COGM is used to calculate COGS, creating a logical flow from production costs to sales costs. 

These three metrics are used together to allow a business to see their profitability, get a better understanding of production costs, and manage inventory better through data. They are also able to see where improvements need to be made, such as pricing for slower-moving products.  

Manufacturing accounting software helps you track your financials in real time using cloud-based technology and multi-platform integrations.

The best manufacturing accounting software uses automation to ensure accurately recorded costs throughout the year, reduce admin time, and minimise the risk of human error.

Let’s look at some of the key systems and features that facilitate efficient manufacturing accounting.

Key manufacturing accounting software features

When investing in manufacturing accounting software, it’s important to find a system that contains all the features you need – and not too many that you’ll never use. If the software is too complex or too time-consuming to implement, you can end up without seeing any return on the investment.

12 key manufacturing accounting software features to look for:

• Easy-to-use interface
• Payroll management
• Invoicing and purchasing tools
• Interoperability with other business software
• Real-time data analysis
• Integration with inventory management software
• Perpetual stock updates
• Instant reconciliation
• Cloud-based functionality
• Automatic report generation
• SKU tracking
• Supply chain management

You might find all these features – or rather, all the ones you need – in a single system. But in many cases, single-vendor software that offers near-unlimited features can be overwhelming or inefficient.

The solution is to build a custom tech stack out of multiple smaller, cheaper, cloud-based systems that integrate to create a synchronised flow of data between each area of your business.

Manufacturing accounting software systems

There are likely hundreds of software tools available that help with accounting for manufacturing costs. You’ll need to speak with your accountant or financial advisor and consider your current budget before making an informed decision.

Here are our top manufacturing accounting software tools:

• Xero: Xero is a cloud-based accounting platform designed especially for small businesses. It offers a suite of bookkeeping and payroll tools and boasts managed integrations with hundreds of other popular business software systems.
• QuickBooks Online (QBO): QuickBooks Online is another cloud-based tool designed to be smart and simple, automatically tracking your financials in a user-friendly way. QBO is more popular among North American firms, while Xero is based in New Zealand and serves many Australasian and European markets.
• Access Financials: Powered by the parent company of Unleashed, Access Financials offers cloud-based accounting with an expansive suite of scalable tools perfect for advanced manufacturing accounting needs.

Accounting for contract manufacturing

Contract manufacturing is the outsourcing of certain manufacturing jobs to another (third-party) company. For example, a smartphone manufacturer might outsource the audio components to a speaker manufacturing specialist.

Most contract manufacturers price their services in a cost-plus model – that is to say, cost plus profit.

Accounting for contract manufacturing involves investigating which direct material and labour costs are involved in the manufacturing process and identifying the indirect costs – such as the cost of communications with the contractor.

Accuracy and efficiency are the primary goals of manufacturing accounting.

You need accurate financials to correctly forecast cash flow and ensure you’re paying the right amount of taxes. And the efficiency with which you perform accounting for manufacturing directly impacts your bottom line.

Here are some best-practice tips for conducting successful manufacturing accounting.

1. Maintain good data hygiene

Data hygiene is essential for modern business. It’s the practice of keeping your company data clean and accurate by ensuring its integrity through careful monitoring and best-practice manufacturing accounting.

Integrating or upgrading your accounting software, though important, runs the risk of increasing errors in your recorded business data.

Keep an eye out for errors such as:

• Missing data or fields
• Invalid data
• Inconsistent mapping
• Duplicate or conflicting entries
• Conflicting or messy naming conventions
• Sloppy syntax

To get off on the right foot with data hygiene, invest in good systems and follow the correct steps to implement them. Automation and efficient implementation will reduce the number of human errors and the likelihood of other issues arising in the future.

Learn more: 5 Major Consequences of Poor-Quality Data and How to Avoid it

2. Employ a cycle of continuous improvement

Technology and global trends are always changing – and so must a manufacturing business if it wishes to stay agile. By the time you finish upgrading your systems, the world may have evolved to make them obsolete.

The solution to this dilemma is to look at the process of upgrading your manufacturing accounting processes as a cycle of continuous improvement. Rather than a one-and-done approach, monitor and regularly review the effectiveness of your current processes.

Analysis leads to action, which leads to feedback and creates an opportunity for more analysis. The cycle is never-ending, earning it the name ‘continuous improvement’,

Write the process of continuous improvement into your company policies and employee handbooks. New employees should be introduced to continuous during onboarding to establish this process as part of the fabric of your business operations

3. Implement automated inventory management

Manufacturing accounting relies on accurate inventory and sales data. An automated inventory management system facilitates accurate inventory accounting and can greatly reduce the time and cost required to manage physical stock.

You can automate your inventory management by implementing inventory management software, barcode scanners, and warehouse robotics. These tools serve to boost the efficiency with which your inventory is managed and the accuracy of your stock-on-hand records.

Learn more: 21 Vital Inventory Management Software Features