CHAPTER 4
PROCESS COSTING SYSTEM
Companies that produce identical or similar units of a product or service (for example, an oil-refining company) often use process costing. A key part of process costing is valuing inventory, which entails determining how many units of the product the firm has on hand at the end of an accounting reporting period, evaluating the units’ stages of completion, and assigning costs to the units. There are different methods for doing this, each of which can result in different profits.
Illustrating Process Costing
Before we examine process costing in more detail, let’s briefly compare job costing and process costing. Job-costing and process-costing systems are best viewed as ends of a continuum:
In a process-costing system, the unit cost of a product or service is obtained by assigning total costs to many identical or similar units of output. In other words, unit costs are calculated by dividing total costs incurred by the number of units of output from the production process. In a manufacturing process-costing setting, each unit receives the same or similar amounts of direct material costs, direct manufacturing labor costs, and indirect manufacturing costs (manufacturing overhead).
The main difference between process costing and job costing is the extent of averaging used to compute unit costs of products or services. In a job-costing system, individual jobs use different quantities of production resources, so it would be incorrect to cost each job at the same average production cost. In contrast, when identical or similar units of products or services are mass-produced, not processed as individual jobs, process costing is used to calculate an average production cost for all units produced. Some processes such as clothes manufacturing have aspects of both process costing (cost per unit of each operation, such as cutting or sewing, is identical) and job costing (different materials are used in different batches of clothing, say, wool versus cotton). The final section in this chapter describes “hybrid” costing systems that combine elements of both job and process costing.
Consider the following illustration of process costing: Suppose that Pacific Electronics manufactures a variety of cell phone models. These models are assembled in the assembly department. Upon completion, units are transferred to the testing department. We focus on the assembly department process for one model, SG-40. All units of SG-40 are identical and must meet a set of demanding performance specifications. The process-costing system for SG-40 in the assembly department has a single direct-cost category – direct materials – and a single indirect-cost category – conversion costs. Conversion costs are all manufacturing costs other than direct material costs, including manufacturing labor, energy, plant depreciation, and so on. Direct materials are added at the beginning of the assembly process. Conversion costs are added evenly during assembly.
The following graphic represents these facts:
Process-costing systems separate costs into cost categories according to when costs are introduced into the process. Often, as in our Pacific Electronics example, only two cost classifications – direct materials and conversion costs – are necessary to assign costs to products. Why only two? Because all direct materials are added to the process at one time and all conversion costs generally are added to the process evenly through time. If, however, two different direct materials were added to the process at different times, two different direct – materials categories would be needed to assign these costs to products.
Similarly, if manufacturing labor costs were added to the process at a different time from when the other conversion costs were added, an additional cost category – direct manufacturing labor costs – would be needed to separately assign these costs to products.
We will use the production of the SG-40 component in the assembly department to illustrate process costing in three cases, starting with the simplest case and introducing additional complexities in subsequent cases:
Case 1 – Process costing with zero beginning and zero ending work-in-process inventory of SG-40. (That is, all units are started and fully completed within the accounting period.) This case presents the most basic concepts of process costing and illustrates the feature of averaging of costs.
Case 2 – Process costing with zero beginning work-in-process inventory and some ending work-in-process inventory of SG-40. (That is, some units of SG-40 started during the accounting period are incomplete at the end of the period.) This case introduces the five steps of process costing and the concept of equivalent units.
Case 3 – Process costing with both some beginning and some ending work-in-process inventory of SG-40. This case adds more complexity and illustrates the effect of weighted-average and first-in, first-out (FIFO) cost flow assumptions on cost of units completed and cost of work-in-process inventory.
Weighted-Average Method
The weighted-average process – costing method calculates cost per equivalent unit of all work done to date (regardless of the accounting period in which it was done) and assigns this cost to equivalent units completed and transferred out of the process and to equivalent units in ending work-in-process inventory. The weighted – average cost is the total of all costs entering the Work in Process account (whether the costs are from beginning work in process or from work started during the current period) divided by total equivalent units of work done to date. We now describe the weighted-average method using the five – step procedures.
Step 1: Summarize the Flow of Physical Units of Output.
Step 2: Compute Output in Terms of Equivalent Units.
Equivalent units in beginning work in process + Equivalent units of work done in current period = Equivalent units completed and transferred out in current period + Equivalent units in ending work in process
Although we are interested in calculating the left-hand side of the preceding equation, it is easier to calculate this sum using the equation’s right-hand side: (1) equivalent units completed and transferred out in the current period plus (2) equivalent units in ending work in process. Note that the stage of completion of the current-period beginning work in process is not used in this computation.
Step 3: Summarize Total Costs to Account For
Step 4: Compute Cost per Equivalent Unit.
Step 5: Assign Total Costs to Units Completed and to Units in Ending Work in Process.
First-In, First-Out Method
The first-in, first-out (FIFO) process-costing method (1) assigns the cost of the previous accounting period’s equivalent units in beginning work-in-process inventory to the first units completed and transferred out of the process, and (2) assigns the cost of equivalent units worked on during the current period first to complete beginning inventory, next to start and complete new units, and finally to units in ending work-in-process inventory. The FIFO method assumes that the earliest equivalent units in work in process are completed first.
A distinctive feature of the FIFO process-costing method is that work done on beginning inventory before the current period is kept separate from work done in the current period. Costs incurred and units produced in the current period are used to calculate cost per equivalent unit of work done in the current period. In contrast, equivalent-unit and cost per – equivalent – unit calculations under the weighted-average method merge units and costs in beginning inventory with units and costs of work done in the current period.
We now describe the FIFO method using the five – step procedure.
Step 1: Summarize the Flow of Physical Units of Output.
Step 2: Compute Output in Terms of Equivalent Units
Step 3: Summarize Total Costs to Account For
Step 4: Compute Cost per Equivalent Unit
Step 5: Assign Total Costs to Units Completed and to Units in Ending Work in Process
Transferred-In Costs in Process Costing
Many process-costing systems have two or more departments or processes in the production cycle. As units move from department to department, the related costs are also transferred by monthly journal entries. Transferred-in costs (also called previous-department costs) are costs incurred in previous departments that are carried forward as the product’s cost when it moves to a subsequent process in the production cycle.
We now extend our Pacific Electronics example to the testing department. As the assembly process is completed, the assembly department of Pacific Electronics immediately transfers SG-40 units to the testing department. Conversion costs are added evenly during the testing department’s process. At the end of the process in testing, units receive additional direct materials, including crating and other packing materials to prepare units for shipment. As units are completed in testing, they are immediately transferred to Finished Goods. Computation of testing department costs consists of transferred-in costs, as well as direct materials and conversion costs that are added in testing.
The following diagram represents these facts:
Transferred-in costs are treated as if they are a separate type of direct material added at the beginning of the process. That is, transferred-in costs are always 100% complete as of the beginning of the process in the new department. When successive departments are involved, transferred units from one department become all or a part of the direct materials of the next department; however, they are called transferred-in costs, not direct material costs.
|
|
Physical Units (SG – 40s) |
Transferred-In Costs |
Direct Materials |
Conversion Costs |
|
Work in process, beginning inventory (March 1) |
240 |
$33,600 |
$ 0 |
$18,000 |
|
Degree of completion of beginning work in process |
|
100% |
0% |
62.5% |
|
Transferred in during March |
400 |
|
|
|
|
Completed and transferred out during March |
440 |
|
|
|
|
Work in process, ending inventory (March 31) |
200 |
|
|
|
|
Degree of completion of ending work in process |
|
100% |
0% |
80% |
|
Total costs added during March |
|
|
|
|
|
Direct materials and conversion costs |
|
|
$13,200 |
$48,600 |
|
Transferred in (Weighted-average ) |
|
$52,000 |
|
|
|
Transferred in (FIFO ) |
|
$52,480 |
|
|
Transferred – In Costs and the Weighted-Average Method
To examine the weighted-average process-costing method with transferred-in costs, we use the five – step procedure described earlier to assign costs of the testing department to units completed and transferred out and to units in ending work in process.
Transferred-In Costs and the FIFO Method
To examine the FIFO process-costing method with transferred-in costs, we again use the five – step procedure. Exhibit 4 – 10 shows Steps 1 and 2. Other than considering transferred – in costs, computations of equivalent units are the same as under the FIFO method for the assembly department shown in Exhibit 4 – 6.
Points to Remember About Transferred – In Costs
Some points to remember when accounting for transferred-in costs are as follows:
- Be sure to include transferred – in costs from previous departments in your calculations.
- In calculating costs to be transferred on a FIFO basis, do not overlook costs assigned in the previous period to units that were in process at the beginning of the current period but are now included in the units transferred. For example, do not overlook the $51,600 in Exhibit 4 – 11.
- Unit costs may fluctuate between periods. Therefore, transferred units may contain batches accumulated at different unit costs. For example, the 400 units transferred in at $52,480 in Exhibit 17-11 using the FIFO method consist of units that have different unit costs of direct materials and conversion costs when these units were worked on in the assembly department (see Exhibit 4 – 7). Remember, however, that when these units are transferred to the testing department, they are costed at one average unit cost of $131.20 ($52,480 /400 units), as in Exhibit 4 – 11.
- Units may be measured in different denominations in different departments. Consider each department separately. For example, unit costs could be based on kilograms in the first department and liters in the second department. Accordingly, as units are received in the second department, their measurements must be converted to liters.
Standard – Costing Method of Process Costing
Benefits of Standard Costing
Companies that use process-costing systems produce masses of identical or similar units of output. In such companies, it is fairly easy to set standards for quantities of inputs needed to produce output. Standard cost per input unit can then be multiplied by input quantity standards to develop standard cost per output unit.
The weighted-average and FIFO methods become very complicated when used in process industries that produce a wide variety of similar products. For example, a steel – rolling mill uses various steel alloys and produces sheets of various sizes and finishes. The different types of direct materials used and the operations performed are few, but used in various combinations, they yield a wide variety of products. Similarly, complex conditions are frequently found, for example, in plants that manufacture rubber products, textiles, ceramics, paints, and packaged food products. In each of these cases, if the broad averaging procedure of actual process costing were used, the result would be inaccurate costs for each product. Therefore, the standard – costing method of process costing is widely used in these industries.
Under the standard – costing method, teams of design and process engineers, operations personnel, and management accountants work together to determine separate standard costs per equivalent unit on the basis of different technical processing specifications for each product. Identifying standard costs for each product overcomes the disadvantage of costing all products at a single average amount, as under actual costing.
Hybrid Costing Systems
Product – costing systems do not always fall neatly into either job-costing or process-costing categories. Consider Ford Motor Company. Automobiles may be manufactured in a continuous flow (suited to process costing), but individual units may be customized with a special combination of engine size, transmission, music system, and so on (which requires job costing). A hybrid – costing system blends characteristics from both job-costing and process costing systems. Product – costing systems often must be designed to fit the particular characteristics of different production systems. Many production systems are a hybrid: They have some features of custom-order manufacturing and other features of mass-production manufacturing. Manufacturers of a relatively wide variety of closely related standardized products (for example, televisions, dishwashers, and washing machines) tend to use hybrid – costing systems. The next section explains operation costing, a common type of hybrid costing system.
Overview of Operation – Costing Systems
An operation is a standardized method or technique that is performed repetitively, often on different materials, resulting in different finished goods. Multiple operations are usually conducted within a department. For instance, a suit maker may have a cutting operation and a hemming operation within a single department. The term operation, however, is often used loosely. It may be a synonym for a department or process. For example, some companies may call their finishing department a finishing process or a finishing operation.
An operation – costing system is a hybrid-costing system applied to batches of similar, but not identical, products. Each batch of products is often a variation of a single design, and it proceeds through a sequence of operations. Within each operation, all product units are treated exactly alike, using identical amounts of the operation’s resources. A key point in the operation system is that each batch does not necessarily move through the same operations as other batches. Batches are also called production runs.
In a company that makes suits, management may select a single basic design for every suit to be made, but depending on specifications, each batch of suits varies somewhat from other batches. Batches may vary with respect to the material used or the type of stitching. Semiconductors, textiles, and shoes are also manufactured in batches and may have similar variations from batch to batch.
An operation – costing system uses work orders that specify the needed direct materials and step – by – step operations. Product costs are compiled for each work order. Direct materials that are unique to different work orders are specifically identified with the appropriate work order, as in job costing. However, each unit is assumed to use an identical amount of conversion costs for a given operation, as in process costing.
A single average conversion cost per unit is calculated for each operation, by dividing total conversion costs for that operation by the number of units that pass through it. This average cost is then assigned to each unit passing through the operation. Units that do not pass through an operation are not allocated any costs of that operation. Our examples assume only two cost categories – direct materials and conversion costs – but operation costing can have more than two cost categories. Costs in each category are identified with specific work orders using job-costing or process costing methods as appropriate.
Managers find operation costing useful in cost management because operation costing focuses on control of physical processes, or operations, of a given production system. For example, in clothing manufacturing, managers are concerned with fabric waste, how many fabric layers that can be cut at one time, and so on. Operation costing measures, in financial terms, how well managers have controlled physical processes.
