Factory Profit & Unrealised Profit (Cambridge International A-Level Accounting)

Factory profit

Spec point — how to account for manufacturing profit the reasons why a business may account for manufacturing profit

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

Worked Example P Limited is a manufacturing business. It applies a rate of factory profit of 20%.

At 1 January 2025, the finished goods inventory at transfer value was $28 800.

The cost of production for the goods produced during the year ended 31 December 2025 was $314 000.

At 31 December 2025, the finished goods at transfer value was $21 600.

Find the transfer value of the goods produced for the year ended 31 December 2025.

Answer:

Multiply the cost of production by the rate of factory profit to find the factory profit

20% × $314 000 = $62 800

Add this to the cost to find the transfer value

$314 000 + $62 800 = $376 800

Unrealised profit

Spec point — how to account for manufacturing profit and the elimination of unrealised profit from unsold inventory

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 (Factory profit %)/(100 % + Factory profit %) x Transfer value of the closing finished goods

  • For example, suppose the rate of factory profit is 25% mark-up on cost and finished goods at transfer value is $20 000
  • \frac{25}{125} \times \ 20 000 = $ 4 000$

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

  • In the example above, the factory profit margin is $\frac{25}{125} \times 100 \% = 20 \%$

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

  • In the example above, the goods cost \ 20 000 - $ 4 000 = $ 16 000$

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

  • $\text{Transfer} \text{value} = \text{Provision} \text{for} \text{unrealised} \text{profit} \times \frac{100 \% + \text{Factory} \text{profit} \%}{Factory \text{profit} \%}$

Exam Hint Remember, you use a mark-up percentage to find the transfer value. But if you have the transfer value, you use the margin percentage to find the provision for unrealised profit.

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

Layout of the provision for unrealised profit account

Worked Example P Limited is a manufacturing business. It applies a rate of factory profit of 20%.

At 1 January 2025, the finished goods inventory at transfer value was $28 800.

The cost of production for the goods produced during the year ended 31 December 2025 was $314 000.

At 31 December 2025, the finished goods at transfer value was $21 600.

Prepare the provision for unrealised profit account for the year ended 31 December 2025.

Answer:

Calculate the opening balance of the provision for unrealised profit

\frac{20}{120} \times \ 28 800 = $ 4 800$

Calculate the closing balance of the provision for unrealised profit

\frac{20}{120} \times \ 21 600 = $ 3 600$

Calculate the decrease

\ 4 800 - $ 3 600 = $ 1 200$

Provision for unrealised profit account

	$		$
Statement of profit or loss	1 200	Balance b/d	4 800
Balance c/d	3 600
	4 800		4 800
		Balance b/d	3 600