Accounting for a manufacturing business
Manufacturing businesses have their own special accounting requirements – here's what you need to know.
Your business is unique
Manufacturing isn't like other types of business. Retailers sell stock and service companies sell their time, but only manufacturers create new products from scratch.
This can lead to accounting problems. Manufacturing businesses have to account for their raw materials and processing costs, but they also have to work out the value of the finished items they create.
There are different methods of doing this. You'll need to choose the right one for your business and use it properly. In this guide we'll look at the methods available to you, and some potential problems and useful benefits once you’re up and running.
With this knowledge you'll be able to choose the right accounting system to help your manufacturing business grow.
Get the right accounting deal for your company
No manufacturing company is too small for you to properly track its accounts. Of course, you'll need the right accounting software. There are plenty of packages available, so don't just buy the first one you see. Manufacturing accounting software will probably stay with you for the life of your business, so choose it wisely:
- Research the available products: Read forums, ask friends and colleagues, find out what other businesses like yours are using
- Make sure it works for you: Choose accounting software that was created with input from manufacturers, so you know it'll handle your business needs
- Ensure it's scalable: You're starting small but you may not stay that way so be sure to go for accounting software that will grow with you
- Aim for the cloud: Cloud-based accounting software will let you access your accounts from anywhere and should cost you less up-front, as well as reducing your IT support costs
Choose the right accounting methods
Once you've chosen the right software, you'll need to decide how you're going to use it. That means working out which accounting methods best fit your business. The examples here will give you an overview, but you should discuss this further with your accountant or financial advisor:
- Job order costing: Generally used for batch manufacturing (as opposed to product tracking). It's calculated by recording labor hours and raw materials units required for each batch.
- Process costing: Handy if you run a production line, continuously manufacturing the same products or parts. Costs are accounted for by department instead of by job.
- Activity-based costing: For use when fine-tuning and improving a manufacturing process. This can also be tied to activities such as customer service. Time-driven activity-based costing is a variation of this, which accounts for costs over a given period.
- Variable costing: Would be used in a similar way to overhead costs, but this varies with production output – the more product you make, the higher the costs.
- Absorption costing: Used when the product cost includes all variables and fixed manufacturing costs – raw materials, labor costs and factory overhead (FOH).
- Other costing methods: Depending on where in the world you do business, other terminology might include standard costing, actual costing, weighted average costing and resource consumption accounting. These include elements of the methods listed above, but sometimes in a different structure.
If all this sounds confusing, don't worry. It'll make more sense when you start applying the methods to your own business. There's no one-size-fits-all, and you may find yourself using different methods for different parts of your organization.
Keep track of your business data
Once your accounting system is set up with the right methods, you're ready to start tracking valuable business information. Some of the items to track include:
- Transactions: Expenses and revenues within a given period. Includes purchases, sales, repayments, loans, etc. Categorize them in the right ledger, whether that's expenses, Accounts Payable, Accounts Receivable or elsewhere.
- Assets and liabilities: Necessary for the end of a given accounting period and useful at other times.
- Cash at hand: You need to keep a close eye on how much cash is in the bank at any time.
- Inventory: Inventory tracking is a detailed process that's beyond the scope of this guide, so discuss it with your accountant or financial advisor. To learn more first, read up on "cash method" and "accrual method" for taxes, FIFO (first in and first out), LIFO (last in and first out) and inventory flow tracking.
Ideally you'll want to be able to do all this tracking online. That'll make it easy to keep tabs on your business wherever you are. Cloud-based software will let you do this and will also produce a paper trail if required.
Analyze your manufacturing process – and improve it
With these accounting processes in place, you can use them for more than just tracking your financials for the tax office. You can also use them to find out how efficiently your business is running – and make changes so it runs even better. Some of the common types of analysis include:
- Cost analysis: A basic overview. Analyze costs over whatever period you define. Great for seeing what you're spending and how input price changes affect product costs and profits.
- Constraint analysis: See where your business is being held back by identifying bottlenecks – the slowest parts of the manufacturing process. Widen the bottlenecks and production speed should increase.
- Margin analysis or profitability analysis: Find out how much profit you're making on each product (or each distribution channel, each customer, each product line, etc.). Useful, but being replaced by constraint analysis which is considered to be more accurate.
- Variance analysis: How much did you budget? And how much did you actually spend? Variance analysis will find the difference and help you work out why it exists.
- Budget refinement: The methods of analysis above will help you refine your budgets for the next accounting period, though you'll need to take into account more detailed production schedule information too.
Accounting can be a benefit, not a chore
As you can see, accountancy for manufacturing is about much more than just recording numbers. With the right manufacturing accounting software you'll get a fresh, valuable perspective on the way your business is running. Look at it as a tool for analyzing and refining the way you do business.
Remember, your expertise is probably in manufacturing, not accountancy. So don't be afraid to ask for help. Find an experienced accountant or other financial professional. Interview them before hiring them. Make sure they understand manufacturing in general and your business in particular.
With the right accounting systems in place for your manufacturing business, you'll be able to optimize your processes. This will help you identify your most profitable product lines and customers and improve your budgeting – which will help your business to grow.
Xero does not provide accounting, tax, business or legal advice. This guide has been provided for information purposes only. You should consult your own professional advisors for advice directly relating to your business or before taking action in relation to any of the content provided.
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