Manufacturing Accounting: A Practical Guide for Small Makers

Three inventories, not one

A manufacturer carries raw materials, work in progress and finished goods. Each sits on the balance sheet until the product sells.

Raw materials are inputs you have bought but not started using. Work in progress is anything partly made. Finished goods are ready to ship. Tracking all three shows where cash is sitting.

Cost moves from one bucket to the next as production proceeds. Only when you sell does it leave inventory and become cost of goods sold on the income statement. For the basics of this flow, see our guide to inventory accounting.

What goes into the cost of a product

Product cost has three parts: direct materials, direct labor and manufacturing overhead. Leaving out overhead is the most common mistake.

• Direct materials. Everything that becomes part of the product, including freight in.
• Direct labor. Wages and payroll costs of people who make it.
• Overhead. Rent, utilities, equipment depreciation, maintenance, supervision, and supplies used in production.

Illustrative example: a product uses $18 of materials and $9 of labor. Overhead for the month is $12,000 across 2,000 units produced, or $6 per unit. Full cost is $33 per unit. If you price from materials and labor alone at $27 plus a margin, you may be selling below cost without noticing.

Choosing a costing method

Small manufacturers usually use standard costing or actual costing. Pick one, apply it consistently, and compare actual results to your expectations.

Actual costing records what you really spent. It is accurate but slow to tell you anything before the month closes. Standard costing sets expected costs per unit and tracks differences, called variances, between expected and actual.

Variances are the useful part. A materials price variance says suppliers raised prices. A labor efficiency variance says jobs are taking longer than planned. Either one is an early warning. Inventory valuation methods like FIFO and weighted average also matter for taxes, so discuss them with your accountant. See cash vs. accrual accounting, since most manufacturers with inventory need accrual-style tracking for inventory.

Reports a manufacturer should read monthly

At minimum: income statement, balance sheet, cash flow statement, inventory report and a gross margin by product.

Add a few manufacturing-specific views:

1. Gross margin by product line to see which items earn their keep.
2. Inventory aging to spot slow movers and obsolete stock.
3. Production cost variances.
4. Capacity use of key machines.
5. Open orders and receivables aging.

Our guide to necessary reports for small business accounting covers the core set.

Where manufacturers get squeezed on cash

Cash goes out for materials and labor weeks before customers pay. The longer your production and payment cycle, the more working capital you need.

The cash conversion cycle is the time from paying suppliers to collecting from customers. Add days in raw materials, days in production, days in finished goods and days waiting for payment, then subtract the days you take to pay suppliers.

Illustrative example: 20 days in materials, 15 days in production, 10 days in finished goods and 45 days to collect is 90 days. If suppliers give you 30 days, you fund 60 days of costs yourself. At $50,000 of monthly production cost, that is about $100,000 tied up. Seeing it clearly makes it manageable. Our piece on cash flow management shows ways to shorten the cycle.

Funding materials, machines and growth

Match the tool to the need: working capital or a line of credit for materials and payroll timing, equipment financing for machines.

A large purchase order can strain cash before it pays you. A revolving line covers materials. A new CNC machine or packaging line is better financed over its life through equipment financing. See also our page for manufacturing businesses.

ROI Funder funds $5,000 to $5,000,000 for owners with 500+ FICO, 6+ months in business and $20,000+ monthly revenue. We show true cost and payback first, so you know whether the order is worth financing. Ask your accountant to confirm cost and tax treatment for your situation.