Understanding the flow of costs through a manufacturer’s inventory accounts is essential for accurate product costing, financial reporting, and decision-making. The manufacturing cost flow includes direct materials, direct labor, and overhead, which pass through the Materials Inventory, Work in Process (WIP) Inventory, and Finished Goods Inventory before finally being expended as Cost of Goods Sold (COGS) when the products are sold.
I extend my sincere gratitude and acknowledgment to Dr. Farman Afzal, from the Institute of Business & Management (IB&M), UET Lahore, for his invaluable assistance and insights in shaping this knowledge. His expertise in Financial and Managerial Accounting has greatly enriched the content, making it more relevant to contemporary financial practices. This acknowledgment also highlights his continuous contributions to promoting awareness and fostering meaningful discourse on Corporate Social Responsibility (CSR), benefiting both the student and professional community.
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1. Overview of the Manufacturing Cost Flow
The movement of manufacturing costs follows four key stages:
- Purchase of Materials → Materials Inventory
- Production of Goods → Work in Process (WIP) Inventory
- Product Completion → Finished Goods Inventory
- Product Sale → Cost of Goods Sold (COGS)
Each stage involves Inputs (I), Tools & Techniques (T&T), and Outputs (O) to ensure accuracy and control.
2. Flow of Costs Through Inventory Accounts in Manufacturing
A. Purchase of Materials (Materials Inventory)
Flow Explanation:
- Raw materials are acquired through a purchase request initiated by the production department.
- The purchasing department generates a purchase order, which is sent to a supplier.
- When materials arrive, they are received, inspected, and recorded in Materials Inventory.
- The cost of purchased materials is recorded as an increase in the Materials Inventory account and an increase in accounts payable (or cash if paid immediately).
Documents Involved:
| Document | Type | Purpose | Key Information |
|---|---|---|---|
| Purchase Request | Internal | Initiates the request for purchasing raw materials | - Item description - Quantity - Estimated cost - Department requesting materials |
| Purchase Order | External | Formal order sent to a supplier to procure materials | - Supplier details - Materials description - Price - Delivery terms - Payment terms |
| Receiving Report | Internal | Verifies received materials against the purchase order | - Date of receipt - Quantity received - Inspection results - Discrepancies |
| Vendors Invoice | External | Bill issued by the supplier requesting payment | - Invoice number - Supplier details - Materials supplied - Cost breakdown - Payment terms |
Example:
A factory purchases 200,000 of raw materials. This is recorded in the Materials Inventory.
Key Formula: Direct Materials Used = Beginning Materials Inventory + Materials Purchased - Ending Materials Inventory
Accounting Entry:
- Dr. Materials Inventory 200,000
- Cr. Accounts Payable 200,000
B. Production of Goods (Work in Process Inventory)
Flow Explanation:
- Materials that are issued for production,they are transferred from Materials Inventory to Work in Process (WIP) Inventory.
- Direct materials costs are added to WIP Inventory.
- Indirect materials are recorded as part of Overhead Costs.
Documents Involved:
| Document | Type | Purpose | Key Information |
|---|---|---|---|
| Materials Request Form | Internal | Authorizes the transfer of raw materials from inventory to production | - Material type - Quantity requested - Job order number - Approval signature |
| Job Order Cost Card | Internal | Tracks all costs incurred in the production process | - Job number - Materials used - Direct labor hours - Applied overhead - Total cost |
| Timecard | Internal | Records direct labor hours spent on a specific production job | - Employee details - Work hours - Job number - Total labor cost |
Example:
150,000 of raw materials, 100,000oflabor,and
80,000 of overhead are applied to production.
Key Formula: Total Manufacturing Costs = Direct Materials Used + Direct Labor + Overhead
Accounting Entry:
- Dr. Work in Process Inventory 150,000
- Cr. Materials Inventory 150,000
- Dr. Work in Process Inventory 100,000
- Cr. Wages Payable 100,000
- Dr. Work in Process Inventory 80,000
- Cr. Overhead Applied 80,000
C. Product Completion (Finished Goods Inventory)
Flow Explanation:
- Once production is complete, costs are transferred from Work in Process Inventory to Finished Goods Inventory.
- The total cost of completed products is known as Cost of Goods Manufactured (COGM).
Documents Involved:
| Document | Type | Purpose | Key Information |
|---|---|---|---|
| Job Order Cost Card | Internal | Continues tracking costs as production is completed and transferred to finished goods | - Final total cost of production - Materials - Labor - Overhead allocation |
Example: 300,000 worth of completed goods are transferred to Finished Goods Inventory.
Key Formula:
Cost of Goods Manufactured (COGM) = Total Manufacturing Costs + Beginning WIP Inventory - Ending WIP Inventory
Accounting Entry:
- Dr. Finished Goods Inventory 300,000
- Cr. Work in Process Inventory 300,000
D. Product Sale (Cost of Goods Sold)
Flow Explanation:
- When goods are sold, their cost is removed from Finished Goods Inventory and recorded as Cost of Goods Sold (COGS).
- At the same time, revenue is recorded.
Documents Involved:
| Document | Type | Purpose | Key Information |
|---|---|---|---|
| Job Order Cost Card | Internal | Ensures accurate recording of cost before the sale of the product | - Cost summary - Product details - Assigned sales price |
| Sales Invoice | External | Official bill issued to the customer for purchased goods | - Invoice number - Customer details - Product description - Unit price - Total amount - Payment terms |
| Shipping Document | External | Confirms the dispatch of goods to the customer | - Shipment date - Carrier details - Tracking number - Recipient details |
Example: 250,000 worth of products are sold, reducing inventory and recognizing revenue.
Key Formula: Cost of Goods Sold (COGS) = COGM + Beginning Finished Goods Inventory - Ending Finished Goods Inventory
Accounting Entry:
- Dr. Cost of Goods Sold 250,000
- Cr. Finished Goods Inventory 250,000
- Dr. Accounts Receivable 450,000
- Cr. Sales Revenue 450,000
3. Summary of the Cost Flow with ITTO
Inventory Account Transitions
- Materials Inventory ➝ Used in production ➝ Work in Process Inventory
- Work in Process Inventory ➝ Completed goods ➝ Finished Goods Inventory
- Finished Goods Inventory ➝ Sold goods ➝ Cost of Goods Sold
Key Formulae
- Direct Materials Used = Beginning Inventory + Purchases - Ending Inventory
- Total Manufacturing Costs = Direct Materials Used + Direct Labor + Overhead
- Cost of Goods Manufactured (COGM) = Total Manufacturing Costs + Beginning WIP - Ending WIP
- Cost of Goods Sold (COGS) = COGM + Beginning Finished Goods Inventory - Ending Finished Goods Inventory
Author:
Mohsin Yaseen
On behalf of the SolBizTech Team
https://www.linkedin.com/in/rmyasin