Raw materials are used in manufacturing finished goods.  The conversion of raw materials into a final product is not usually immediate and at a point in time, some raw materials inventory is being used at different stages of production.

Started but not finished production is called work-in-process inventory.

Work-in-process normally includes not only raw material costs, but also other related costs, such as costs of production employee wages, electricity, water and others that can be attributed to the production process. Therefore, work-in-process inventory includes the following costs:

• Direct materials
• Direct labor
• Factory overhead

For example, Friends Corporation will have work-in-process because the valve manufacturing process takes some time (raw materials are not converted into finished goods immediately).  If there are three production stages (e.g. drilling holes, attaching plastic seals, and applying paint), then at a point in time, there will be some raw materials that have gone through drilling station, but not assembly or painting station, or some raw materials that have gone through drilling station and assembly, but not painting station.  Because all of the mentioned raw materials are in production already, but have not gone through all manufacturing processes, they represent work-in-process inventory.

Direct materials and direct labor are recorded in the Work-in-Process Inventory account directly, while factory overhead is initially recorded in the Factory Overhead account and then transferred to the Work-in-Process Inventory account at the end of the period.  Let us review the Factory Overhead account and then we will return to the Work-in-Process Inventory account.

The Factory Overhead account includes the following information (also refer to the below illustration with the T-account):

• Zero beginning balance.
• Overhead costs debited (incurred) to the account during the accounting period (debit side).
• Overhead costs transferred (applied, credited) to the Work-in-Process Inventory account (credit side) during the accounting period.
• Zero ending balance (*).

(*) Note: The Factory Overhead account may have a balance different from zero after overhead costs are applied to the Work-in-Process Inventory account during the period.  This may happen when actual overhead costs incurred are different from the overhead costs applied to the Work-in-Process Inventory account. However, the calculation of overhead application rate and determining how to treat the balance in the account after period end is beyond the scope of this lecture.  For this illustration, we assumed that the entire balance in the Factory Overhead account is transferred to the Work-in-Process account and the ending account balance is zero.

Illustration 10: Factory overhead T-account

From the above illustration we can see that the incurred overhead costs are recorded on the debit side with credits to various other accounts, such as:

• Raw Materials Inventory (for indirect materials)
• Accounts Payable (for various overhead costs incurred on account)
• Cash (for various overhead costs paid with cash)
• Accumulated Depreciation (for depreciation expense related to production fixed assets).

Let’s see how the Factory Overhead account looks like for Friends Corporation.  The company used $100 of light bulbs during March 20X9.  The bulbs represent indirect materials (factory overhead) and their use is recorded as follows (entry from the Raw Materials topic repeated here for convenience):

To continue with the example, in March Friends Corporation recognized $400 of depreciation expense on factory equipment (overhead), and paid $600 in cash for factory utilities (overhead).

To record these costs, Friends Corporation makes the following entries:

As we noted earlier, the balance in the Factory Overhead account is transferred to the Work-in-Process Inventory account at period end.  Thus, at the end of March, Friends Corporation transfers the balance from the Factory Overhead account to the Work-in-Process Inventory account.  The accumulated overhead and journal entry are presented below (also refer to the illustration of the T-account):

Illustration 11: Friends Corporation factory overhead T-account