Eliminate unrealised factory profit from closing inventory
Calculate the internal factory profit included in unsold stock, remove unrealised profit and explain why factory profit may be used.
Section 3.1 · Preparation of financial statements
Exam scope and assessment notes
Cambridge International AS & A Level Accounting 9706, 2026–2028 syllabus, Version 2. These original lessons map all five Topic 3.1 objectives: financial-statement purpose; partnership changes; clubs and societies; manufacturing accounts; and limited-company financial statements and notes. Practice is self-checked, not an official Cambridge grade. Full timed Papers 1–4 and human subject-teacher review remain outstanding.
Before you begin
- Use the Topic 1.5 adjustment and statement skills: apply accruals, distinguish capital from revenue, reconcile balances, and keep each entity's owners' funds separate from income and cash.
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
Goods transfer at cost plus 20%. What fraction of the transfer price is profit?
What you will learn
- Calculate factory profit on transferred goods
- Remove unrealised profit from inventory still held within the business
- Explain reasons and limitations for accounting for factory profit
Internal profit is not earned from an external customer
A factory may transfer goods to a selling department at cost plus a stated factory profit. This can support internal performance measurement or compare factory output with its transfer value. The transfer is internal to the same reporting entity, so it does not by itself create profit earned from an outside customer.
If closing inventory is stated at transfer price, it includes a profit element on goods not yet sold externally. Eliminate that unrealised profit from closing inventory and profit, using the markup basis given. If markup is on cost, profit as a fraction of transfer price is markup ÷ (100% + markup); if the margin is on transfer price, use the stated margin directly.
Show the adjustment and its reason
For goods transferred at cost plus 25% markup, transfer price is 125% of cost and the profit element is 25/125 = 20% of transfer price. A $24,000 unsold inventory at transfer price therefore contains $4,800 unrealised profit; reduce inventory and profit by that amount.
Factory profit may provide an internal measure or encourage cost control between departments, but it can overstate external profit if unsold goods remain at a transfer value. Follow the syllabus and question's required account format, then reconcile the adjusted inventory to its required external measurement.
Pause and explain
If internal markup is 25% on cost and unsold transfer-price inventory is $30,000, what is the profit element?
Worked example
Goods are transferred at cost plus 25%. Closing inventory is valued at $24,000 transfer price. Calculate unrealised factory profit and adjusted inventory at cost.
Show the worked solution
- Markup is 25% of cost, so transfer price equals 125% of cost.
- Profit fraction of transfer price = 25/125 = 1/5; unrealised profit = $24,000 × 1/5 = $4,800.
- Inventory at cost = $24,000 − $4,800 = $19,200.
Answer Unrealised factory profit is $4,800 and adjusted closing inventory at cost is $19,200.
Try a topic test
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Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
Factory goods are transferred at 30% markup on cost. Closing inventory at transfer price is $39,000. Calculate the unrealised profit and inventory at cost.
Give me a hint
Convert the cost markup to a fraction of transfer price: 30/(100+30).
Compare my reasoning
- Profit fraction of transfer price = 30/130.
- Unrealised profit = $39,000 × 30/130 = $9,000.
- Inventory at cost = $39,000 − $9,000 = $30,000.
Unrealised profit is $9,000 and inventory at cost is $30,000.
Look for these in your work
- Markup converted to transfer-price fraction
- Profit calculated
- Adjusted inventory calculated
Goods transfer at cost plus 15%. Unsold stock is shown at transfer price of $46,000. Calculate unrealised profit and adjusted inventory.
Give me a hint
Use 15/115 because the 15% is a markup on cost.
Compare my reasoning
- Profit fraction of transfer price = 15/115.
- Unrealised profit = $46,000 × 15/115 = $6,000.
- Adjusted inventory at cost = $46,000 − $6,000 = $40,000.
Unrealised profit is $6,000; inventory at cost is $40,000.
Look for these in your work
- Correct fraction used
- Profit removed
- Inventory at cost found
A manufacturer argues that factory profit should stay in closing inventory because the factory has completed its work and met its target. Explain one potential internal benefit of factory profit and why the external financial statements still need an adjustment.
Give me a hint
Separate internal department performance from profit earned by the reporting entity as a whole.
Compare my reasoning
- A transfer profit can help compare factory output or monitor a factory's cost and efficiency against an internal target.
- The factory and selling department are part of the same reporting entity, so the transfer is not a sale to an external customer.
- Profit in goods still held internally is unrealised; remove it from inventory and profit under the required treatment.
Factory profit can support internal performance measures, but unsold internal transfers have not created external profit. Eliminate the unrealised element from closing inventory and reported profit as required.
Look for these in your work
- Internal purpose stated
- Entity boundary considered
- Adjustment explained
Common mistakes
- Applying a cost markup percentage directly to the transfer price
- Leaving internal profit in closing inventory as if earned externally
What can you explain now?
Why is factory profit in unsold goods unrealised for the reporting entity?
Compare with the explanation
The goods have not yet been sold to an external customer
The transfer between internal departments does not itself create external profit.
After trying it yourself, choose your next review. This is your self-assessment.
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Make it stick
For a markup on cost, how do you convert the markup rate to the profit fraction of transfer-price inventory?
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.