Running a manufacturing company while managing its books is a challenging prospect. Manufacturing involves a significant amount of cost accounting, which is a notoriously complex subject. Here’s what you need to know to navigate manufacturing accounting successfully, including the best practices for the industry, the most complicated processes involved, and some fundamental terms. Manufacturing Accounting Tips Manufacturing accounting follows the same fundamental principles as accounting in other industries, but there are many more moving parts than usual. Let’s look at some general best practices you should follow to optimize your accounting system. Leverage Manufacturing Software Bookkeeping is one of the most time-consuming aspects of manufacturing accounting. Maintaining accurate and organized records of all the transactions and costs involved in production can be incredibly laborious if you do it manually. However, manufacturing accounting software can automate a significant portion of this responsibility. You or an accountant should still perform reconciliations to confirm the accuracy of your financial records, but it’s much easier than doing everything by hand. Fortunately, Lendio offers free accounting software for small businesses. It can keep track of your financial transactions and generate your income statement automatically. Give it a try today! Invest In Your Financial Education While you probably won’t handle all your business’s accounting personally, you still need to understand it. A lot of manufacturing accounting revolves around creating records that managers can use to inform business decisions. As a result, it’s worth investing in developing a deeper understanding of the related accounting and tax rules. If nothing else, it’ll help you analyze your financial statements and reports to improve the efficiency of your business. Choose Your Accounting Basis Carefully Because manufacturing businesses carry an inventory, the Internal Revenue Service (IRS) requires them to use the accrual basis of accounting. However, there’s an exception for small businesses with less than $26 million in average annual revenues. As a result, your manufacturing company may get to choose between using cash or accrual accounting. While the cash method is often easier to implement, it’s not always the best way to organize your financial records. Because you must get special permission from the IRS to change your accounting basis later, it’s best to get it right the first time. Consider consulting an expert before choosing one or the other. Get Expert Assistance Getting expert tax and accounting advice is worthwhile for virtually every business. A Certified Public Accountant (CPA) with experience in your industry can provide valuable financial insight and ensure you meet your tax obligations. Fortunately, you don’t necessarily have to hire an accountant full-time for your manufacturing business at first. Outsourced accounting from a CPA firm is less expensive and may be enough to meet your needs. What Type Of Accounting Is Used In Manufacturing? The primary type of accounting used in manufacturing is known as cost accounting. It’s a form of accounting that tracks production costs in a way that managers can use to inform business decisions. As a result, cost accounting is less about creating financial statements for third parties and more about facilitating various forms of internal analysis. For example, manufacturing businesses use cost accounting to complete processes like the following: Budgeting: Manufacturers must create budgets for each stage of the production process to ensure they stay on track and set appropriate sales prices. Cost accounting tracks historical production costs, which helps create more accurate estimates for future activities. Constraint analysis: This involves isolating potential bottlenecks in your manufacturing and improving them to increase overall efficiency. Organizing your production costs helps managers determine which resources limit their output most and plan accordingly. Margin analysis: This involves calculating all the costs associated with an aspect of production, then subtracting them from the revenue it generates. That gives you each aspect’s marginal profitability, which managers can use to find the most lucrative products, customers, or channels and inform business decisions. In addition, manufacturing involves inventory management accounting. Because manufacturers carry significant inventories, they need to know how to track their costs to create accurate financial statements and comply with accounting standards. Cost-Flow Assumption Methods Your cost of goods sold and ending inventory values play a significant role in your manufacturing business’s profitability. Because that directly affects your tax liability, the IRS requires that you use specific methods to calculate both numbers. These are the inventory tracking methods they accept for manufacturing businesses. Specific Identification The specific identification method is the most straightforward option. It involves keeping track of each item in your inventory. If that’s feasible for your business, the Internal Revenue Service (IRS) requires you to use this method. However, specific identification is usually only possible for manufacturing businesses that produce a low volume of differentiated products. For example, car manufacturers may use this approach, but a stapler manufacturer probably wouldn’t. FIFO If you can’t keep track of every item in your inventory because the units are interchangeable, you must assume which ones you sell first. While you can’t know for sure which you sell first, this keeps your books organized. The first-in-first-out (FIFO) inventory valuation method assumes that the first unit you manufacture is the first one you sell. FIFO is generally the most popular approach, especially for manufacturers of products with limited shelf lives. LIFO The last-in-first-out (LIFO) inventory valuation method is the opposite of the FIFO approach. It assumes that the last unit you produce is the first one you sell. Because prices tend to rise over time, the LIFO method generally maximizes your cost of goods sold and minimizes your closing inventory values. As a result, it also leads to the lowest possible net income, which is beneficial for tax purposes. However, LIFO is controversial among regulators. The International Financial Reporting Standards (IFRS) prohibits it, and businesses in the United States may not be able to use it forever. Weighted Average The weighted average cost flow assumption is between FIFO and LIFO. It involves calculating the weighted average cost of all units available for sale during a given period. You then assign that cost to your goods sold and ending inventory. The weighted average is generally the least common cost flow assumption for manufacturers. In fact, the IRS previously dismissed this method as inaccurate, only allowing businesses to use it for tax purposes in 2008. Production Costing Methods Production costing methods organize your cost accounting records to help management make decisions. Depending on your business model, you may prefer to structure your accounting around individual units, product lines, or processes. Here are the most popular production costing methods for manufacturers. Keep in mind that the terminology for these approaches can vary between sources. Standard Costing Standard costing is one of the most common production costing methods among manufacturers. It involves calculating a standard rate for groups of costs that go into each unit, including direct materials, direct labor, and manufacturing overhead. This approach to production costing helps with creating and refining budgets. When you can estimate how much it’ll cost to produce each unit, you can gauge your progress during each accounting period. Variance analysis, which involves comparing your standard costs to your actual expenses, is a great way to reveal areas of overspending, improve production efficiency, and increase cash flow. Job Costing Job costing organizes your accounting around each unit. It involves tracking the costs for every item you produce, including direct materials, direct labor, and manufacturing overhead. It’s also popular in construction accounting. This approach is primarily beneficial for manufacturers who produce a relatively low number of unique products. For example, a manufacturer of made-to-order furniture would likely employ job costing. Manufacturers of highly differentiated products need to track costs for each unit so they can set prices appropriately and monitor the profitability of their products. Process Costing If job costing is ideal for manufacturing businesses that produce lower numbers of unique products, process costing is for those that create a high volume of homogenous units. For example, a cement manufacturer might use this method. Process costing involves tracking the cost of each stage of production. It helps facilitate analysis and efficiency refinement for businesses that revolve less around each unit and more around repetitive procedures. Activity-Based Costing Activity-based costing (ABC) is a way to assign indirect manufacturing costs like overhead to products or processes. Though it takes more work than applying a standard overhead rate, it generates more accurate cost estimates. ABC systems involve sorting your business’s indirect costs into groups, calculating a per-unit rate based on their primary cost drivers, then using that rate to allocate costs to products or activities. It helps businesses factor indirect costs into pricing. Basic Manufacturing Cost Terms Deciphering jargon can be a frustrating challenge when you’re learning to navigate the complexities of manufacturing accounting. Here are brief explanations of some fundamental terms you’ll need to know to succeed. Direct Materials Direct materials refer to the raw materials that manufacturers transform into finished products. That includes everything you can readily identify as going into a unit. For example, wood and screws are direct materials for table manufacturers. Direct Labor Direct labor includes the cost of workers who transform raw materials into finished goods. For example, say you’re a table manufacturer. The wages of the worker who assembles the tables are direct labor, but not the salary of the janitor who keeps your factory clean. Direct Costs A direct cost is an expense that you can easily trace to product manufacturing processes. Direct expenses primarily include direct labor and direct materials. Manufacturing Overhead Also known as factory overhead, manufacturing overhead refers to the cost of maintaining and operating your production facilities. Overhead costs include expenses like factory rent, utilities, and administrative costs. Indirect Costs Indirect costs are those that you can’t tie directly to the production process. Instead, you must allocate each indirect cost to your products using various methods to determine the value of each unit. It primarily refers to manufacturing overhead. Fixed Costs In manufacturing, fixed costs remain consistent no matter how many units you produce. For example, that might include rent for your factory or interest payments on a business loan. Variable Costs Variable costs change depending on the number of units your manufacturing firm produces. For example, direct materials and direct labor are both variable costs. Cost of Goods Sold The cost of goods sold includes all direct and indirect costs associated with the products you sell during a given period. It typically refers to direct materials, direct labor, and manufacturing overhead. Its value depends on your cost-flow assumption. Cost of Goods Manufactured Your cost of goods manufactured includes all direct and indirect costs that go into the products you finish producing during an accounting period. Like the cost of goods sold, it generally refers to direct materials, direct labor, and manufacturing overhead. WIP Inventory Work-in-process (WIP) or work-in-progress inventory refers to products that have made it through part of the manufacturing process but remain unfinished. Though they’re not ready for sale, these goods are still an asset on your balance sheet. Finished Goods Inventory Finished goods inventory refers to the units that have made it through the production process and are ready for sale. You must use cost-flow assumptions and inventory valuation methods to calculate the balance. *The information provided in this post does not, and is not intended to, constitute business, legal, tax, or accounting advice and is provided for general informational purposes only. Readers should contact their attorney, business advisor, or tax advisor to obtain advice on any particular matter.