Factory Profit & Unrealised Profit

A manufacturing business first prepares a manufacturing account to find the cost of production of the goods it makes. These finished goods are then transferred to the trading (sales) section of the statement of profit or loss, where they are sold.

The transfer can be made:

• at cost of production (no extra profit), or
• at cost of production + a factory (manufacturing) profit — a mark-up added on transfer.

Why add a factory profit? It lets the business compare the factory's performance with the cost of buying the goods in from an outside supplier (the 'market' price). If the factory can make goods more cheaply than buying them, the factory profit measures that saving. The mark-up is notional — it is internal, between two parts of the same business, so it is not a real profit until the goods are sold.

When goods are transferred at cost + factory profit, any finished goods left unsold at the year-end are valued (in the trading section) at the transfer price, which includes the factory profit.

But that factory profit has not been earned — the goods have not been sold to a customer. Carrying inventory at a value that includes profit would overstate both the inventory (an asset) and the profit, breaching the prudence concept (profit should only be recognised when realised).

This embedded profit is called unrealised profit (or provision for unrealised profit, PURP). It must be removed so that closing finished-goods inventory is shown at cost, not at cost-plus-profit. The adjustment is made through a provision for unrealised profit.

The provision for unrealised profit is the profit element inside the closing finished-goods inventory. If goods are transferred at cost + a mark-up of X%, the closing inventory (valued at transfer price) contains that mark-up:

$\text{PURP} = \text{Closing finished-goods inventory (at transfer value)} \times \frac{\text{mark-up \%}}{100 + \text{mark-up \%}}$

Example. Closing finished goods $22,000 at transfer value; factory mark-up 25% on cost → the profit fraction is 25/125 = 1/5 → PURP = 22,000 × 1/5 = $4,400.

Key: the mark-up is on cost, so the profit fraction of the transfer value is mark-up ÷ (100 + mark-up). If instead the question gives the inventory at cost and asks for the profit added, multiply the cost by the mark-up %. Read carefully which value (cost or transfer) the inventory is stated at.

The provision is adjusted each year for the change in unrealised profit:

• Statement of profit or loss:
  • the factory profit is added to the trading/profit section (it boosts the gross profit on goods bought in vs made);
  • an increase in the provision (inventory rose) is a deduction from profit;
  • a decrease in the provision (inventory fell) is an addition to profit.

$\text{Adjustment to profit} = \text{Opening provision} - \text{Closing provision}$

(positive = added to profit; negative = deducted).

• Statement of financial position: finished-goods inventory is shown at transfer value less the provision — i.e. at cost. Only the net figure (cost) appears as the asset.

So the full picture is: add the factory profit in the manufacturing/trading section, then remove the part of it sitting in unsold inventory via the change in the provision — leaving only the realised profit on goods actually sold.