Analysis Made for the Internal Accounting Configuration

By Dr. Emanuel F. Schwarz

(September 13, 1999) - In my previous article covering the Internal Accounting structure - I wrote about the importance of replacing the accounts called "Work in Process" with a more logical denomination, such as "Production Cost Accounts" in order to establish these accounts under the global denomination of "Functional Activity Accounts. "I also wrote that Functional Activity Accounts would be controlled under the Class of Accounts with the numbers 5 and 6.

Understand that these two classes of accounts are the most important, and are give substantial information to the management of the company. With this new structural development of the Internal Accounting of our company separate from the External [Financial] Accounting - you were able to observe the essential question of having clearly separated the departments of a company from the distinct Functional Activities.

This is important because several books used in universities and colleges mix up the department's accounts with production cost accounts. The separation of these two arrangements is highly important. Separate accounts should be created so that we have a clear control of the departmental operating cost and we should not mix them with the production cost of our company.

With such a structure of Chart of Accounts for the Internal Accounting, we receive a clear picture of all our individual Production Costs and how to transfer these values to the Inventory of Finished or Semi-Finished goods.

I would like to call your attention to the fact that Class 5 is not only referring to the production costs of our company, but also to the cost of such Functional Activities as Maintenance, Repair and internal production. But I will identify these details later in this article.

I covered the idea that the first groups of accounts in Class 5 refer to the different Production Cost of the products of our company. We debit these accounts with the Raw Material value, the Direct Labor value and the Departmental Operating Costs - all referring to a specific product and its Job Order. I also recommended that you should use Standard Cost for raw material, direct labor and pre-established absorption rates.

Remember that within the Departmental Operating Costs of a specific Finished Production's Transfers direct production department working with this Job Order are also included departmental operating costs of some Indirect Production Departments and some Service Departments. In past article I discussed the question of the re-allocation of these departmental operating costs, which are not direct related with the production activity.

This procedure is referring to the insinuations given in the ABC philosophy (Activity Based Costing), which indicates, that the production should also be charged with the operating costs of departments that are not directly related with this production, but are indirectly supporting the Direct Production Departments with their different activities. These services may be realized by the Janitorial department, by the Security and Fitness departments and several others.

If our company is working with Standard Production costs we will be able to identify clearly the value of the production transferred to the Inventory. Just knowing the quantity of the units transferred, we will receive the amount of the production given to the Finished Goods Inventory.

These values will be credited to the corresponding accounts in Class 6 and debited to the Finished Goods Inventory accounts in Class 7. Some of these amounts may also go to the Semi-Finished Goods Inventory - if our company has some production that we do not sell but keep it for the assembling of our final product.

Next, I will analyze how we transfer the cost of finished production to our inventory accounts in the Assets. If our production is controlled by Job-Orders, then every day we will transmit an information to the Internal Accounting Processing department that so many units of this Job-Order were transferred to the Finished Goods Inventory.

After days or weeks this Job-Order will be totally finished, and our Class 5 information will tell us in a summary (that refers to this Job-Order) the total value of the Raw Material, total value of the Direct Labor and the total calculated value of this Direct Production Departments Operating Cost that was applied to this Job-Order (or, we could say absorbed by this Job-Order).

This important detailed information will be compared with the Budgeted Cost of this Job-Order. The total standard value charged to the Class 5 account is the same amount that was credited to Class 6 and transferred to Class 7-4-01-001 account.

As this Job-Order is finished we will now take the total amount of this Job-Order recorded in Class 7 and transfer it to Class 0, Group 3 of the Assets of our Company. This transfer of the total Job-Order value may be realized the day the order was finished or postponed and realized during the month-end closing.

This described the procedure that should also be used with Job-Orders of the Semi-Finished Products. The next important point of discussion is the cost of the Functional Activity identified as Maintenance and Repair.

Control of the preventive maintenance is very important - specially in industries with highly sophisticated machines. To be able to realize such control, several accounts referring to maintenance were opened in Class 5. Besides this information, management is also interested in knowing the maintenance cost of the buildings belonging to the company, such as cost to maintain trucks, cars or other equipment.

Regarding such maintenance, account in Class 5 will be transferred as all costs of a specific direct material used in such maintenance work. These values will be credited Class 2 Inventory of Material - and debited to Class 5.

For routine and daily maintenance we will not need to open Job-Order. The personnel working with these maintenance will have to prepare daily some information about their time spent on such work. This time measurement will be used to apply some amount of the Maintenance department operating cost to the corresponding Class 5 account.

The total amount accumulated during a month on these maintenance accounts in Class 5 should be distributed to the different departments where such maintenance work was realized by crediting the corresponding account in Class 6.

If specific machine maintenance was realized, this amount should be transferred from Class 6 to the Production Cost account in Class 5 where this machine was used. Routine maintenance could also be re-allocated from Class 6 to the corresponding department in Class 3, and be included in the absorption rate of this department.

As these maintenance accounts may be classified as Temporary, no amount should be transferred to the next accounting period. The repair accounts will be handled basically in the same way as the maintenance accounts.

The direct spare parts and other direct material for such repair should be charge directly to this account in Class 5. Some absorption rate will have to be prepared and used to transfer the departmental operating cost from Class 4 to the repair accounts in Class 5.

Some of these repairs will take several weeks to finish, and consequently we have to carry the month-end balance from Class 5 to some Other Asset account in Class 0. In the Class 0 account, we will accumulate this larger repair amount to the moment that this repair is finished. From Class 6 the total repair will be transferred to Class 7 and at month-end carried over to Class 0 Machine account.

Constructions and Projects accounts are created primarily to control the investment that our company is doing in construction works within the company. Here we will also control the production cost of tools or other units that our company produces within some specific department.

Charge the direct material used to these accounts and some absorption rate to establish the amount of the departmental operating cost that would correspond to this production activity. When the project is finished, we will credit Class 6 account and transfer to Class 7. From month to month we should use the same procedure as used with the repair accounts.