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Accounting for cogs in manufacturing without using manufacturing module

Hi everyone,

We are in a small manufacturing startup, and I don’t want to activate manufacturing module yet until all our other accounting modules are in a good state.

For now though, what would be the best way to handle cogs? For simplicity, lets say we manufacture 1 product only. Would the best approach be to capitalize direct labor costs into finished goods inventory? And if I do that, wouldn’t that alter my direct labor expense account (and hence render me unable to track our salaries accurately?)

And on a differente note, how would I treat manufacturing overheads vs non-manufacturing overheads?

Hi trynix,

You really don’t need to activate the manufacturing module to be able to do a bunch of manufacturing related stuff.

So, let’s break up COGS into three components:

Direct Material
Direct Labor
Direct Manufacturing Overheads (such as power, water, consumables, factory rent etc. etc. directly related to the machines that are used in manufacture - that could also include energy costs to light up the factory - or maybe not :slight_smile: - check with your accountant and I am not one BTW)

Direct Material: This is perhaps the least complicated of the lot. Just have a BOM for the manufactured item and ensure that the quantities consumed and the valuation rates of the input materials are appropriate and the Manufactured Item will assume the value of the Input Materials. You don’t even need a BOM. You can do a Stock Entry Purpose: Manufacture and you will accomplish the same outcome. Only trouble is that the quantities of input materials will need to be calculated manually and keyed in by your users, which can be a bit of a drag. But if you have variability in your manufacturing process and you want to track actual consumption as against consumption according to BOM, you are way better off not connecting up the manufacturing stock entries to the BOM.

Direct Labor: You can setup a BOM to attribute a labor cost to each manufactured item. Like you can say $1 direct labor to make ItemA. So, the Stock Entry will look like this:

Consumption:

Raw Materials of Value $2

Transformed Item

Item A
Cost of Input Items: $2
Direct Labor Markup: $1
Total Valuation of ItemA: $3

Incoming value (Manufactured Item): $3, Outgoing Value (direct materials) $2, so the principles of double entry book keeping that we are all completely familiar with says that this $1 needs to be attributed to an expense account.

Here’s where the complications begin. Use a “Labor Charge to be attributed” account to charge the Labor Mark Up in the Manufacturing Entry. Now as you pay (or pass accounting entries) to book direct labor costs don’t expense it out, but book it to the same “Labor Charge to be attributed”.

So this “Labor Charge to be attributed” account is like piggy bank. As you book your direct labor costs on your accounting system, you are dropping $s into the piggy bank. And as you pass manufacturing entries, you are drawing out of the piggy bank.

Because tracking labor is complicated, you will never get the piggy bank (“Labor Charge to be attributed”) to reconcile perfectly. But just tracking this account will get you a sense as to whether you are over estimating labor in your BOM or underestimating labor. And you can revise the BOM for the next period.

Things are really complicated as the actual time sheets and the actual consumption of those labor hours may not match. Plus you have labor rate variability across skills, across people, across shifts and top of all of that you will need to somehow factor overtime charges into this mix.

I have implemented ERPNext in many manufacturing setups in India. The Indian labor force is not used to the concept of time sheets, consequently, all my implementations do not appropriate the direct labor cost to the valuation of the manufactured item. My clients charge Labor separately on the P&L and as they incur those labor expenses.

There is another way to hack this: Setup as many items as necessary as a Stock Item. Like DL-LatheOperator, DL-CNC_Operator, etc. etc. Do a Stock Entry at the beginning of each shift and inward that many number of hours of these skills based on the number of workers that have reported to work that day. Use the average labor cost per hour as the valuation rate of this item. If you want to get real analytical about this you can even setup separate items like DL-LatheOperator-JohnSmith, DL-LatheOperator-RachelWyman and so on and ensure that the valuation rates are the actual cost of what you pay them per hour. Now your users just pull the appropriate labor item and plug in the quantity in the Manufacturing Entry and boom, you have a much better way of tracking things. At the end of the Shift, you run a stock balance report of the Direct Labor Items and any balances could be because of under utilization of your labor force. Or errors in posting entries. Plus you have to flush out balances at the end of the shift so that you can get the system ready for the next shift.

Of course, doing this is a drag and has a huge overhead in terms of time, energy and bandwidth to do this every shift, but if you have a budget or if there is interest in doing this by other organizations, you all can collaborate, find a service provider that can build this for you. Like as soon as John Smith checks in, 8 hours are inwarded for John Smith’s related labor item.

Direct Overheads: Concept is the same and complexities are similar too.

In Conclusion

Though I have not been exposed to a country where tracking and appropriating direct labor is very important from a regulatory perspective and/or being successful perspective, I just think it is way better for most organizations to monitor direct labor and direct overheads and then move it using correction entries.

Maybe there are others that have managed to rein in this part very well for their organizations. I would love to hear their perspectives.

Not sure if this helps. But hey, you guys have to deal with it. If you read it, that is. :slight_smile:

Thanks

Jay

1 Like

Hello Jay,

Thank you very much for your thoughtful response!! I had spent sometime reading about all this and your response came in a timely manner to confirm my thoughts, so thank you again!

There are just a couple of areas that confuse me. What type of account (from ERPNext perspective) is “Labor charge to be attributed” - is it an expense account, or expense included in valuation, or something else? I ask because regardless of cogs, I still want to fully track my direct salary expenses, and having it charged into a piggy bank account which is then reduced as we manufacture items may hide the numbers, or am I misunderstanding how it applies?

Regarding direct manufacturing overheads, I read multiple resources that actually suggest using similar method to what you suggested, and using a “manufacturing overheads” account as piggy bank, so perhaps that can be applied to!

The other bit that confuses me, is how to handle periods during which no production is taking place for any reason, at this point there is no inventory to attribute the COGS to, so it either bulks up and get applied to whatever production takes place next (therefore leading to low or maybe even negative gross profit!) or it is taken out of COGS and applied as non-manufacturing overheads of some sorts!

Thanks for your advice!

I am not 100% Sure, but it will be either an Expense Account or Expense Included in Valuation account. Most likely the latter. Your accountant could move balances in that account to other more appropriate accounts during your periodic closing of accounts.

Now that I have answered your question a few observations. Apologies if I sound too full of myself and preachy. :slight_smile:

  1. Appropriating direct labor cost to the valuation of an item may be mandatory from a regulatory perspective in a few countries. Or there may be tax or other advantages to doing that, but it’s nice to remember one thing. It’s just accounting. At the base level, organizations are selling stuff and achieving revenue and then incurring expenses in making or buying the stuff that they sell. So whether the direct labor cost hits your direct labor account and stays there. Or whether it stays there till it gets appropriated to the items that you make, does not alter the fundamental underlying reality of organizations.
  2. The whole idea of structuring this is to give you an easy report for people to look at and understand what they are doing well and what’s going wrong within organizations. So, let’s say you are looking at the “Labor charge to be attributed” account and you are consistently seeing costs balances in this account that indicate that labor cost is not being appropriated completely. This most likely means that you are under utilizing your workers. Now you could choose to:
    2.1 Align your labor requirement to the items you need to make. You may not have the ability to do this, in the sense that, say you have to pay for 40 hours a week anyways. Now if you have work for a worker only for 25 hours a week, you have to figure out how you are going to manage this situation. You could cross skill this worker so that s/he can work on other things for the 15 hours that you have to pay her/him anyways. But as you do that you have to figure out if it is just busy work. Or are you really able to reduce the total number of direct labor hours that your workers are billing you every day/week/month.
    2.2 Or you could choose to make items so that the workers 40 hours is used up. That may seem like you are being more efficient, but if there is no demand for the items that are made the direct material + direct labor is sitting as unsaleable finished goods stock in your Stock Assets section and after a few months/quarters or years will have to be written off. So what you thought was being efficient is actually way more wasteful in the medium-long term.
  3. So the idea of structuring this initiative is to give you the ability to get actionable information about your business that will make the business more profitable and robust. However you have to be a little careful about unintended consequences. Like if you obsess over unappropriated labor cost with your manufacturing team and are not careful, you, as an organization, could end up missing the woods for the trees and get to a configuration where the labor charges are getting efficiently appropriated, but you are making items/products for which there is no demand (capacity driven manufacturing as against demand driven manufacturing) and that has even more serious implications for your organization.

Life is complicated and as we all know running even a small business is fraught with a myriad of risks and it’s sometimes easy to get lost.

Hope this helps.

Thanks

Jay

1 Like

Hello Jay!

Thank you once again for all your feedback in my post! I was just reading your profile and it’s very very impressive - no wonder you’re full of great thoughts and advice :slight_smile:

I followed your line of thought, and I have just two areas of confusion that I’ll share in two examples to separate them.
Example 1: Say that I operated for one month that was full of manufacturing, so all hours are appropriated. Now, lets say I had an “accrued wages” account as liability collecting all direct labor wages. End of month, I normally would journal it against “wages expense” account as I pay the employees. In your example, I would instead journal it against “labor charge to be attributed”, and from there journal it against the finished goods inventory, rendering the labor charge account to zero. The confusing bit for me is that in the end I still have to track and pay their salaries, but if I don’t collect all salaries in some kind of “wages expenses” account I’d lose track of the salary pay for the period (i.e. if I want a report on all salary expenses for the month or year)! Am I missing something? I know this is more of a bookkeeping question, but I’m also an engineer (albeit chemical) and trying to figure out some of this accounting language :slight_smile:

Example 2: Say that in the last 3 months I only manufactured for 1 month but I still had direct labor for the whole duration (2 months were just machine maintenance for example, because of big machinery issues). In this case would you lodge all 3 months of direct labor against the inventory of the 1 month of production, or would you somehow separate them?

I look forward to hearing from you.

EDIT: On an additional note, how would you treat manufacturing overheads vs non-manufacturing overheads?

So, let’s say you have just one worker. John Smith and he’s billing you for 40 hours a week and you are paying him $25/hr.

So On Friday, you book John’s wages $1,000.00 and let’s say you book it against “Labor Cost to be Appropriated Account”. On the other side you use say Wages Payable Account.

When you pay John Smith you charge Wages Payable and the money goes out of your Bank/Cash account.

I hope this part answers #1 to some level.

Now as John starts manufacturing items the Labor cost starts hitting the “Labor Cost to be Appropriated Account” and let’s say it’s a perfect world and all 40 hours are perfectly accounted at $25 per hour, so the $1,000.00 gets neutralized.

The $1000.00 has gotten onto the valuation of Items so it is sitting in your Stock Assets account. As you sell the Items that John made, you make either a Delivery Note or a Sales Invoice with Update Stock checked and at that time the John’s Labor component for that Item hits your COGS. And when you sell all the items that John made in that 40 hours costing you $1K, John’s labor expense for that week has essentially been expensed out completely.

So, how will you know how many hours John billed you for that week? Hopefully you have timesheets to help you keep track of this.

How much of John’s time did you manage to use? Look at the “Labor Cost to be Appropriated Account” and you will know. But only because John Smith is the only employee being tracked. But a typical shop floor has many workers working on many items that get used in many products/projects. So, getting a sense as to the utilization of your workers and the costs being appropriate correctly to the projects is a lot more complicated than simply appropriating a notional cost of direct labour and direct overheads to the valuation of manufactured items. Is my use of my workers optimal? This is a crucial metric for organizations, so the projects or tasks that workers worked on is best captured in the Time Sheet and analyzed in detail at the individual/team/supervisor and other appropriate levels. You could using appropriate reports get a sense of how the valuation of your items are getting impacted by direct labor and direct overheads, even if you are not loading up the valuation rate of your manufactured items for direct labor or direct overheads. You will have to build the mechanism to capture required demand for labor for a period, available labor during the period and utilization of workers.

Again: My observations are all bookish. I would love to hear from somebody in the community that has been able to address this difficult issue adequately and using ERPNext. How did you do that?

You would separate them. The last one year has been very unusual. Organizations have got payroll support from local/state/federal governments and maybe have some obligations when they use such support. If your question is related to this, your best bet is to talk to your CA/CPA that can guide you how to manage this exceptional year.

But I will go ahead and answer your question for a “normal” (and I do hope we will have them again) year: You would book Direct Labor only for the Month. The others you would book against maintenance expenses. Depending upon the nature of the maintenance involved, you may even be able to (from a tax/profitability perspective) charge this “extraordinary” expense against the Gross/Net Block of the asset. Again talk to your CA/CPA for optimum outcomes.

That’s too broad a question. Even manufacturing overheads may need to classified as direct manufacturing overheads (such as a line supervisor’s wages) against indirect manufacturing overheads (such as factory rent, or plan manager’s wages, etc.).

Overheads have to be covered by the product/s and service/s that you rig together and sell. So either you have to sell enough to cover your overheads or you have reduce your overheads to cover your income so that you can turn in a profit and have some positive cash flows.

So proceed with caution about charging overheads to the valuations of items. Most times its not possible to get the valuation to any level of accuracy. I think it is better to crunch number periodically (weekly, monthly or quarterly) and have targets that’s published in the organization: Sales Targets, Production Targets, Managing Overheads within limits. Doing that will help you achieve the same underlying objectives: Turning in a Profit. Achieving positive cash flows. But in a less contentious, confrontational and disruptive manner.

Hope this helps.

Thanks

Jay