ADVANCED MANAGEMENT ACCOUNTING

Advanced Management Accounting



Advanced Management Accounting

Requirement 1

So far, we have considered the final accounts of sole traders who do not make the goods that they sell. In all prior examples, the firms generate profits by purchasing stock and then selling this stock for a price higher than the cost meaning a profit has been earned - i.e. the difference between sales and the cost of those goods that were sold. In reality, most firms do not act in this way. Even if a firm does not make its own products, it is likely to add something to the products themselves (Herrold, 2000).

If a firm actually produces the goods that they sell then there will be no obvious 'purchases' figure to include in the trading account. The costs incurred in the production of goods will appear instead and these will be calculated in a manufacturing account. A manufacturing account shows the cost of producing the goods that are sold during an accounting period. It is split into the following sections:

Prime cost - Direct costs of physically making the products (e.g. raw materials)

Overhead cost - Other indirect costs associated with production but not in a direct manner

The cost of manufacturing the products will be the total of the prime cost and the overhead cost added together. This total factory cost (or production cost) will then be transferred to the trading account where it will appear instead of the 'normal' purchases figure.

Prime cost

The prime cost covers all the costs involved in physically making the products and other costs that are directly related to the level of output. These are usually known as direct costs and common examples would include:

Direct materials

Direct labour/wages

Other direct costs (e.g. packaging, royalties)

Cost of raw materials consumed

Within the prime cost adjustments will have to be made for opening and closing stocks of raw materials. There may also be carriage inwards charged on the raw materials and returns outwards of materials sent back to their original supplier. A true direct cost will vary directly with the level of output. If the output level doubles, then we would expect a direct cost to also double. If the cost does not behave in this manner then it may be an indirect cost and not a direct cost (Campos, 1998).

Overhead cost

This section includes all other expenses concerned with the production of output but not in a direct manner. This means that if the level of production increased, then these expenses may also increase but not by the same proportion. These are sometimes known as indirect costs, factory overheadsor indirect manufacturing costs. Common examples of overhead costs would include:

Factory rent

Indirect labour

Depreciation of factory plant and equipment

Depreciation of fixed assets should be included in this section only if it is depreciation on assets included for production. For example, depreciation of machinery would appear as an overhead cost but depreciation of office equipment would appear in the profit and loss account as an expense as would be expected in a non-manufacturing ...