Preparation of Final Accounts of Sole Proprietors

Introduction to Financial Statements and Trading Account

Objectives After going through this lesson, you shall be able to understand the following concepts.

• Meaning and Need of Manufacturing Account • Elements of Manufacturing Cost • Types of Manufacturing Cost • Format of Manufacturing Account

Introduction Till now, we have learnt about the financial statements prepared by a sole proprietor. It mainly comprises of Trading and Profit & Loss Account (to ascertain the financial performance) and Balance Sheet (to assess the financial position). In this lesson, we will discuss the financial statements prepared by manufacturing entities and the cost incurred by them at various stages of production. Before proceeding further, let us go through the basic difference between sole proprietorship and manufacturing entities.

Basis of Difference

Sole Proprietorship

Manufacturing Entities

Role Performed

Seller of goods

Producer of goods

Accounts Prepared

Trading and Profit & Loss Account

Manufacturing Account

Purpose

To ascertain the gross profit and the net profit

To ascertain the cost of goods manufactured

Transfer of Balance

Transfer of balance of Trading Account to Profit & Loss Account

Transfer of balance of Manufacturing Account to Trading Account

Meaning and Need of Manufacturing Account A manufacturing entity prepares an additional financial statement, that is, Manufacturing Account, which accounts for all the expenses and helps in ascertaining the total cost incurred on the production of goods. The following diagram will help you understand the meaning and need of Manufacturing Account. Elements of Manufacturing Cost The cost incurred by manufacturing entities can be classified into three basic elements: materials, labour and expenses.

1. Materials: Materials represent the cost incurred in acquiring the inputs that are later transformed into final goods. For example, to produce a chair, a manufacturer requires wood, glue, tools, nails, cloth, etc. These items involved in the production of a chair are regarded as materials. Let us discuss the various types of materials with the help of following diagrammatic presentation.

2. Labour: This element of cost deals with the expenditure incurred in acquiring or hiring labour (basically workers) who will be involved in the production process directly or indirectly. Considering the above example, we can say that the remuneration paid to the workers for making the chair will be included under this element of cost.

3. Expenses: All entities incur certain expenses to ensure the smooth running of their day-to-day business activities. This element of cost basically includes the running and maintenance expenses of a business, for example lighting expenses and rent. The above three elements of cost can further be classified on the basis of their nature, as shown in the diagram below.

Example 1: Use the following information to answer the next question.

An apple juice manufacturing company purchased 100 tetra packs for Rs 500.

Identify the type of material purchased in the transaction given above. (a) Raw Material (b) Packing Material (c) Consumable Material (d) Maintenance Material Solution Expenditure incurred on the purchase of tetra packs will be categorised under the head ‘Packing Material'. Moreover, it is regarded as the primary packaging material that is treated as a part of direct material. Hence, the correct answer is option (b). Example 2: Which of the following items do not form a part of maintenance material? (a) Repair Tools (b) Lubricants (c) Cartons (d) Screwdriver Solution Materials that are used in maintaining the plant and machinery in proper order are called maintenance materials. Repair tools, lubricants and screwdrivers are the materials generally used in keeping the machinery and other equipment running. On the contrary, cartons are used to pack products and are regarded as the secondary packing material. Hence, the correct answer is option (c). Types of Manufacturing Cost A manufacturing account is prepared to ascertain the total cost incurred on the production of goods. The costs included in this account are further divided into two categories: prime costs and manufacturing overheads.  

1. Prime Costs - These include all the expenses that are regarded as prime, as they are directly incurred for carrying out the production process. In other words, the expenses that are incurred directly on the inputs to transform them into the final output are regarded as prime costs. Prime costs can further be segmented into the following categories on the basis of the elements on which these costs are incurred.

a. Raw Material Consumed - The name itself suggests that this cost is incurred to bring the state of materials from raw to final output. It basically refers to all the tangible inputs that are used and acted on by the fixed assets and transformed into the final output. For instance, cotton, button, threads, needles, etc. are a few raw materials that are required in the production process of shirts. Thus, the expenses incurred on these inputs are regarded as raw material consumed. Algebraically, it is ascertained in the following manner. Raw material consumed = Opening Stock of raw material + Net Purchases of raw material – Closing stock of raw material + Carriage and freight inwards* Here, Net Purchases = Purchases – Returns *Only those carriage and freight expenses will be considered here that are directly incurred for transporting and collecting the raw materials.

b. Direct Manufacturing Wages - These are basically the labour costs; that is, the costs incurred to hire labourers and workers on daily or monthly basis. These workers work in factories and manufacturing units. They provide their labour services and in exchange are remunerated in the form of daily wages.

c. Direct Manufacturing Expenses - These are the direct expenses that are not covered in the above two sub-parts of prime costs. These expenses are very important, as they facilitate the use of raw materials and labour inputs. The consultancy fees paid to a placement agency for providing labour is one example of direct manufacturing expenses. This is because this expense enables the manufacturing unit indirectly in accumulating the production factors that help in carrying out the production process. Similarly, expenses such as royalties and rent paid for using any tool are a few examples of direct manufacturing expenses. Let us now go through the following diagram that summarises the various elements of prime costs.

2. Manufacturing Overheads (or Production Overheads or Works Overheads) - These expenses are known as indirect manufacturing expenses, as they are indirectly incurred on the factor inputs, for example electricity and lighting charges. Although electricity and lighting are very much required to carry out the production process, expenditure on them cannot be classified u