An automobile manufacturer, for example, buys steel, rubber, aluminum, plastic, etc., which is used to make motor vehicles that are sold to dealers (the trading company). These dealerships, in turn, sell vehicles to the customer.

From an accounting point of view, the activities of manufacturing and trading companies are very similar, especially their administration, sales and financing activities. Therefore, accounting principles and most procedures can be applied to both manufacturing and trading companies. The main difference between the two is their costing and accrual method for (1) valuing inventory and (2) calculating cost of goods sold. The difference arises from the fact that trading companies buy finished goods, while manufacturers make the goods sold by merchants.

Therefore, the ‘accounting cost of goods manufactured’ item in the manufacturing company corresponds to the ‘accounting cost of goods purchased’ item in the trading company. In both cases these amounts represent the cost of finished products available for sale. The trading company, having purchased its goods in a ‘finished’ form, experiences little difficulty in determining its cost. The manufacturing company, on the other hand, has to account for the cost of turning raw materials into finished goods (also known as manufacturing costs).

By turning raw materials into finished products, the manufacturer uses manpower, machinery, and equipment and also incurs other manufacturing costs such as energy consumption, machinery maintenance, etc. All of these costs must be added to the cost of raw materials to determine the cost of goods manufactured for any period.

Therefore, the accounting records of a manufacturing company must be expanded to provide for the recording of the various additional costs inherent to manufacturers.

The three most important elements of manufacturing costs are materials, labor, and manufacturing overhead. In accounting cost terminology, the costs of materials and labor together are known as primary costs, while the accounting term conversion costs represents the combination of labor and manufacturing overhead costs.

By virtue of the nature of a manufacturing company’s activities, it will require more ledger accounts than a trading company. The general ledger should cover aspects such as machinery and equipment, inventory, raw materials, work in process, finished products, etc. Special attention needs to be paid to the various inventory accounts.

At any given time, a manufacturer will have different types of inventory on hand: inventory of materials ready for use in the manufacturing process; partially finished products still in manufacturing process; and finished products that must be sent to distributors. Inventory accounting records and different inventory accounting accounts must be kept to determine the costs of each type of inventory at the end of a fiscal year. All three inventory accounts are asset accounts and are generally maintained according to a perpetual ledger inventory system. In turn, they are control accounts supported by the corresponding subsidiary records.