Reporting Income for a Manufacturing Business
A manufacturing business purchases raw materials to make products. Each product is referred to as a unit of production. Cost accounting is the discipline used to keep track of all manufacturing costs associated with each unit of production.
Manufacturing costs assigned to each unit of production consist of three elements:
- Direct materials
- Direct labor
- Factory overhead
At the end of each accounting period, some units of production may have been fully completed while others only partially completed. Consequently, at the end of each accounting period, a manufacturer's inventory will generally consist of three elements:
- Finished goods - these are fully completed units of production
- Work in process - these are partially completed units of production
- Direct materials - these are materials not consumed that remain available for use directly in the manufacturing process.
Figuring Net Profit
To figure net profit for a manufacturing business, the following calculation is performed:
- Sales, minus
- Cost of goods sold (see calculation below), equals
- Gross profit, minus
- Administrative and marketing expenses, equals
- Net income from operations, plus
- Other income, if any, (e.g., royalties, dividends) minus
- Other expenses, if any, (e.g., interest on indebtedness) equals
- Net income BEFORE income taxes, minus
- Estimated income taxes, equals
- Net income AFTER estimated income taxes
Cost of Goods Sold for a Manufacturing Business
There are two steps for determining the cost of goods sold for a manufacturing business:
- First, determine the cost of goods MANUFACTURED.
- Then, determine the cost of goods SOLD:
STEP 1: Cost of Goods Manufactured:
The following elements are included in the cost of goods manufactured:
- Direct Materials Consumed equals:
- Direct materials on hand, January 1, 200X, plus
- Direct materials purchased during the year, minus
- Purchase returns and allowances, minus
- Materials inventory, December 31, 200X, plus
- Direct labor, plus
- Factory overhead, equals
- Total manufacturing costs, plus
- Beginning work in process, minus
- Ending work in process, equals
- COST of GOODS MANUFACTURED
Elements included in cost of goods manufactured explained:
a) Direct materials consumed.
Direct materials consumed are materials that become part of the finished unit of production.
b) Direct labor.
This is the cost of those employees whose work can be identified directly with the product manufactured.
c) Factory overhead.
Factory overhead is added to the cost of each unit of production.
Factory overhead includes items such as indirect labor, payroll taxes, utilities, depreciation for equipment, depreciation for the factory building (if the building is owned and not rented), factory supplies, insurance, repairs and maintenance, etc.
d) Beginning work in process.
These are units of production started in the previous year but remained unfinished as of the beginning of the current year.
e) Ending work in process:
These are units of production partially finished as of the end of the current year.
Step 2: Cost of Goods Sold:
Once the cost of goods manufactured is determined, the next step is to determine the Cost of goods sold.
The cost of goods sold is determined by adding the cost of goods manufactured to the difference between:
- The cost of the beginning and ending inventory for FINISHED GOODS.
- Cost of goods manufactured: $100,000, plus
- Inventory of finished goods, January 1, 200X: $10,000, minus
- Inventory of finished goods, December 31, 200X: $2,000, equals
- Cost of goods sold: $108,000
- Return to the Tax Basics for Startups Table of Contents to find related links.