distinguish between direct and indirect costs

Manufacturing Accounts – Topic 5.5

Objective

To distinguish between direct and indirect costs, use that distinction to prepare a complete manufacturing account, calculate the factory cost of production and the cost of goods manufactured (COGM), and show how these figures link to the income statement and the statement of financial position in accordance with the Cambridge IGCSE/A‑Level syllabus.

1. Direct and Indirect Costs

1.1 Definition

• Direct costs: Expenditures that can be traced to a specific product or job without any allocation.
• Indirect costs: Expenditures that benefit the whole manufacturing process and therefore must be allocated to products.

1.2 Typical Examples

2. Prime Cost, Factory Overheads & Factory Cost of Production

• Prime Cost = Direct Materials + Direct Labour + Direct Expenses.
• Factory Overheads (also called factory or production overheads) = All indirect manufacturing costs before adjustments ± the adjustments required by the syllabus (depreciation, accrued wages, prepaid items, etc.).
• Factory Cost of Production = Prime Cost + Adjusted Factory Overheads.
  (Note: this figure does **not** include opening or closing work‑in‑progress.)

3. Work‑in‑Progress (WIP)

• Opening WIP – the cost of partially completed goods carried forward from the previous accounting period. It appears on the balance sheet as a current asset under Inventories – Opening Work‑in‑Progress.
• Closing WIP – the cost of goods still in production at the end of the current period. It is shown on the balance sheet as a current asset under Inventories – Closing Work‑in‑Progress.
• Both opening and closing WIP are presented in the manufacturing account and affect the calculation of COGM.

4. Adjustments to Factory Overheads (Syllabus Requirement 5.1)

Only the adjustments listed in the Cambridge syllabus are required for the exam.

5. Worked Example – Calculation of Factory Cost of Production & COGM

5.1 Data (all figures in £)

5.2 Calculations

1. Prime Cost
   Prime Cost = Direct Materials + Direct Labour + Direct Expenses
   = £25 000 + £15 000 + £2 000 = £42 000
2. Adjusted Factory Overheads
   Overheads before adjustments = £8 000
   + Depreciation = £3 000
   + Accrued wages = £1 200
   – Pre‑paid insurance = £500
   Total Adjusted Overheads = £11 700
3. Factory Cost of Production
   Factory Cost of Production = Prime Cost + Adjusted Overheads
   = £42 000 + £11 700 = £53 700
4. Cost of Goods Manufactured (COGM)
   COGM = Opening WIP + Factory Cost of Production – Closing WIP
   = £10 000 + £53 700 – £12 000 = £51 700

6. Full Manufacturing Account (example figures)

7. Link to the Final Accounts

7.1 Income Statement (Statement of Profit or Loss)

COGM is transferred to the income statement as part of Cost of Goods Sold (COGS).

When opening and closing inventories of finished goods are present, the exam‑style formula is:

COGS = Opening Finished Goods + Cost of Goods Manufactured – Closing Finished Goods

COGS is deducted from sales revenue to obtain gross profit; after deducting operating expenses and tax, profit for the period is arrived at.

7.2 Statement of Financial Position (Balance Sheet)

• Inventories – Closing Work‑in‑Progress appears under Current Assets.
• Inventories – Opening Work‑in‑Progress is the balance carried forward from the previous year’s balance sheet.
• Any accrued overheads not yet paid are shown under Current Liabilities.

7.3 Mock‑up of the Income‑Statement Extract (exam style)

8. Summary Classification of Costs

9. Revision Flow Diagram (optional)

A simple flow diagram to visualise the movement of costs:

Opening WIP → Direct Materials → Direct Labour → Direct Expenses → Factory Overheads (adjusted) → Factory Cost of Production → Closing WIP → Cost of Goods Manufactured (COGM) → Income Statement (COGS) → Gross Profit → Profit for the Period