Factory Profit & Unrealised Profit (Cambridge (CIE) A Level Accounting): Revision Note

Factory profit

What is factory profit?

• Factory profit is an additional amount added to the cost of production before the finished goods are transferred to the statement of profit or loss

  • Factory profit is also called manufacturing profit

• It is usually expressed as a percentage mark-up on the cost of production

Why might businesses account for factory profit?

• Businesses apply a rate of factory profit so that they can compare the transfer value with the sale prices of the same goods offered by competitors

  • This is known as benchmarking

  • The managers can then decide whether to continue to produce the goods or purchase them from a supplier

• The manufacturing department can be treated as a separate profit centre and its performance can be evaluated

  • Targets can be set for the factory profit

What is the accounting treatment for factory profit?

• The factory profit is calculated

  • Multiply the cost of production by the rate of factory profit

• Add the factory profit to the cost of production to give the transfer value in the manufacturing account

  • This is a debit entry to the manufacturing account

• The transfer value is then used to calculate the cost of sales and then the gross profit

• The factory profit is then added to the gross profit

  • This essentially eliminates the factory profit from the transfer value

  • This ensures that the factory profit does not lower the profit for the year

  • This is a credit entry to the statement of profit or loss

Unrealised profit

What is unrealised profit?

• Unrealised profit is the amount of the factory profit that is included in the valuation of closing inventory of the manufactured goods

• Goods are transferred to the statement of profit or loss using the transfer value which includes the factory profit

  • This profit has not been earned for the goods that remain unsold at the end of the year

What is a provision for unrealised profit?

• A provision for unrealised profit is used to show the true valuation of the inventory held at the end of the year

  • It is very similar to an allowance for irrecoverable debts

• It complies with the prudence concept by ensuring that the assets are not overstated

• The balance on the provision for unrealised profit account is the amount of valuation of the closing finished goods that arises due to the rate of factory profit

How do I calculate the balance of the provision for unrealised profit?

• Use the formula

  • For example, suppose the rate of factory profit is 25% mark-up on cost and finished goods at transfer value is $20 000

  • 

• The fractional part of the formula is the factory profit margin

  • In the example above, the factory profit margin is

• The remaining value of the closing finished goods is the cost to produce them

  • In the example above, the goods cost

• If you know the balance of the provision, then you can find the transfer value of the finished goods by rearranging the formula

  • 

How do I make entries in the provision for unrealised profit account?

• STEP 1
  Calculate the opening balance and enter this on the credit side

  • This uses the value of the opening finished goods

  • This might be given in the question

• STEP 2
  Calculate the closing balance and enter this on the debit side

  • This uses the value of the closing finished goods

• STEP 3
  Calculate the change in the balance of the provision

  • It is entered on the credit side if it is an increase

  • It is entered on the debit side if it is a decrease

  • The other side of the transaction is entered in the statement of profit or loss