raw materials inventory

Manufacturing companies are companies that make a product. Because these companies have inventory in various stages of production, there are three inventory accounts that we must deal with in order to calculate cost of goods sold. The three inventory accounts are:

  1. Raw materials inventory
  2. Work-in-progress inventory
  3. Finished goods inventory

Each of these accounts must be calculated to see how much inventory from that account moves to the next account and eventually to cost of goods sold. The basic calculation for each of the accounts is the same.

Beginning Inventory
Plus: Something added to the account
Less: Ending Inventory
Equals: materials or goods transferred out of the account

The important thing here is knowing what gets added to the account and knowing the proper label for the amount that is transferred out of the account. This is where terminology is key to your understanding and performing the calculations correctly. When I’m thinking about inventory accounts, I like to imagine three rooms within the product facility, one for each of the types of inventory. Try to think about what is in each room, the costs that are added to the goods in that room and what happens to items that leave the room.

three rooms for inventory

Raw Materials Inventory

Raw materials inventory is the inventory of materials waiting to go into production. These are components of our product that have been purchased to make our product. In this case, we start with beginning inventory for the raw materials inventory account. What do you think we add to this account? We would add purchases of raw materials. Next, we subtract the ending inventory in the raw materials inventory account which is obtained by counting what is still on hand at the end of the period.

What happened to the stuff that is no longer there? Those materials were requisitioned by employees to use in the production process. They are being used to make our product. We call the materials that were taken from the room materials used in production.

Those materials were transferred into work-in-progress inventory.

RM room

Raw materials inventory is pretty straight forward.

RM formula

Work-In-Progress Inventory

Now that we have put materials into production, what else goes into the cost of our product? The three product costs are direct materials (which we have already placed in the room), direct labor, and manufacturing overhead. These three accounts are also called manufacturing costs. Add the cost of materials used in production to direct labor and manufacturing overhead costs. These costs are our “something added to the account.”

WIP Room before inventory

We have not yet figured in beginning and ending inventory for the work-in-process account. Just like the previous room, take beginning inventory and add your total manufacturing costs (our “something”) then subtract ending inventory. If goods transfer out of this room, it is because they are finished. Those goods are called cost of goods manufactured because they have finished the manufacturing process. They are now complete and have been moved to the finished goods room.

FGI Room before inventory

When calculating work-in-progress, add your materials used in production, direct labor cost, and manufacturing overhead cost to get total manufacturing costs. Then the formula is similar to our raw materials calculation.

WIP formula

Finished Goods Inventory and Cost of Goods Sold (FINALLY!!)

We have finally made it to the last room. We have transferred cost of goods manufactured into finished goods inventory. For this room, this is our “something”. Add beginning inventory and subtract ending inventory balances for finished goods inventory and we are done.

FGI room

The items that leave the finished goods inventory room leave because they have been sold and therefore, are called cost of goods sold. The formula for this calculation is very similar to both of our previous calculations.

FGI Formula

Once you have completed these calculations, the income statement for a manufacturing company is exactly the same at the income statement for a merchandising company. Both statements use cost of goods sold to calculate gross profit, then subtract selling and administrative expenses (or operating expenses) to arrive at operating income.

Manuf IS

Final Thoughts

While the calculations for cost of goods sold for a manufacturing company may seem overwhelming, remember that the calculations for each inventory account are very similar:

Beginning Inventory
Plus: Something added to the account
Less: Ending Inventory
Equals: materials or goods transferred out of the account

When you try to create a story to explain the process, you will not need to remember the formulas. Think about how the materials are moving through the company and into production, where labor and overhead are added. When goods are finished, they transfer to the finished goods inventory account. Once they are sold, they are transferred out of the finished goods account to the income statement as cost of goods sold.

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It is important to identify the type of company you are working with in managerial accounting. Depending on the type of company, you will identify different costs and set up reports differently. There are three major types of companies we will deal with in this course:

  1. Service companies
  2. Merchandising companies
  3. Manufacturing companies

Service companies

Service firms make up the largest business sector in the United States. Service companies are those that do not sell a physical product but instead provide services to their customers. Service firms include accounting firms, law firms, marketing firms, IT services firms, banks, dry cleaners, health care organizations, educational institutions and many other businesses we interact with on a daily basis.

One major difference between service companies and the other two types is that service companies do not have cost of goods sold because there is no product being sold. Service firms also do not have inventory, also because no physical product is being sold. There many be direct costs associated with providing the service, but no physical product.

Merchandising companies

Merchandising companies are those which sell products but do not make products. Merchandising companies are broken up into two different types: retailers and wholesalers.

Retailers sell products directly to the end user. Staples, Wal-Mart, Target, American Eagle, GAP, and Home Depot are all retailers. They sell products that consumers and businesses use, rather than resell.

Wholesalers buy products from manufacturers and sell them to other merchandising companies, usually retailers. For example, most small breweries will use a distributor to help get their beers into stores and restaurants. These distributors have established relationships with local stores and restaurants, making easier for small breweries to get their beers to the public. A distributor is a wholesaler. Wholesalers are sometimes referred to as “middlemen” because they act as an intermediary between a manufacturer and a retailer.

Merchandising companies purchase inventory (an asset) and sell that inventory. When inventory is sold, the asset is considered used up and the cost of that inventory is transferred from the balance sheet to the income statement as an expense. This expense is called cost of goods sold. For merchandising companies, the inventory account can also be referred to as merchandise inventory.

Manufacturing companies

Manufacturing companies are companies that make make a product. Monster Beverages, Dell Computers, Boeing, and General Motors are all companies that produce a product. These companies use labor and machinery to turn materials into a product. Some manufacturing companies sell their products directly to the end user, like Boeing. Some companies like Dell, sell their product directly to consumers and to retailers. Monster Beverages and General Motors sell their products to retailers who sell the product to the end user.

All manufacturing companies have three different inventory accounts to account for the steps in the production process.

  1. Raw materials inventory – Raw materials are the components that companies use to produce their products. Don’t let the word “raw” lead you to think that this account is full of wood, plastic, metal or bolts of fabric. Many companies purchase components already manufactured and use them in their finished products. For example, Dell purchases processors from Intel to put in their computers. These processors are considered raw materials until those processors actually go into a computer. Raw materials are any materials that have not yet been used in the production process.
  2. Work-in-progress – Companies are continuously making products, which means that at the end of each day or week or month there are products that are not finished. These products have entered the manufacturing process but are not completed. Work-in-progress is inventory that has gone into the production process but has not yet been finished. Think of an aircraft at Boeing that does not have the seats or engines installed, but the rest of the plane is built. We cannot call this raw materials, but we also cannot say that it is finished. This plane would be considered part of work-in-process.
  3. Finished goods inventory – When a product is finished it is transferred to finished goods inventory. Typically when we think of inventory we think of finished goods inventory, the stuff that is ready to be sold to our customers. Once a product is classified as finished goods inventory, no additional costs can be added to the product. This is a very important concept when we start talking about types of costs.

Hybrid companies

Many companies do not fit neatly into one of these categories. For example, restaurants make a product (meals), sell products it does not make (wine and beer), and provides a service (serving the meal). These companies are considered hybrid companies. When classifying companies, make sure to consider that a company could fit into more than one of the categories above.

Final Thoughts

Considering the type of company you are working with can help you better identify the types of costs the company will incur, how those costs should be allocated and the types of reports that would be useful in the planning, decision making and controlling aspects of managerial accounting.

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