Definition of Process Costing

Process costing is a term used in cost accounting to describe one method for collecting and
assigning manufacturing costs to the units produced. A processing cost system is used when nearly
identical units are mass produced. (Job costing or job order costing is a system used to collect and
assign manufacturing costs to units that vary from one another.)
Example of Process Costing
Let's assume that a company manufactures large quantities of an identical product. The product
requires several processing operations, each of which occurs in a separate department. In the first
department, the following processing costs were incurred during the month of June:

 Direct materials of $150,000

 Conversion costs of $225,000
If the equivalent of 100,000 units were processed in June, the per unit costs will be $1.50 for direct
materials and $2.25 for conversion costs. These costs will then be transferred to second department
where its processing costs will be added.

Process costing vs. job costing

Unlike process costing, job costing assigns expenses to specific jobs or batches of
products. The main differences between process costing and job costing include:

 Size of job: process costing is more suited to large-scale production runs than job
costing, which is more suited to tracking small production runs with fewer units.
 Type of product: whereas process costing is used for standardised, mass-produced
products, job costing is usually used for custom or unique products.
 Billing customers: using job costing, it is possible to bill customers specific costs
for commissioned produced. This is less straightforward using process costing, as costs
are aggregated.
 Record keeping: Process costing combined costs and therefore requires less
recording keeping than job costing, which traces labour, materials, and overhead to
specific jobs, batches, or units.

Process Costing Overview

Process costing is used when there is mass production of similar products, where the costs
associated with individual units of output cannot be differentiated from each other. In other
words, the cost of each product produced is assumed to be the same as the cost of every other
product. Under this concept, costs are accumulated over a fixed period of time, summarized,
and then allocated to all of the units produced during that period of time on a consistent basis.
When products are instead being manufactured on an individual basis, job costing is used to
 accumulate costs and assign the costs to products. When a production process contains some
mass manufacturing and some customized elements, then a hybrid costing system is used.

Examples of the industries where this type of production occurs include oil refining, food
production, and chemical processing. For example, how would you determine the precise cost
required to create one gallon of aviation fuel, when thousands of gallons of the same fuel are
gushing out of a refinery every hour? The cost accounting methodology used for this scenario is
process costing.

Process costing is the only reasonable approach to determining product costs in many
industries.   It uses most of the same journal entries found in a job costing environment, so there
is no need to restructure the chart of accounts to any significant degree.  This makes it easy to
switch over to a job costing system from a process costing one if the need arises, or to adopt a
hybrid approach that uses portions of both systems.

Example of Process Cost Accounting

As a process costing example, ABC International produces purple widgets, which
require processing through multiple production departments. The first
department in the process is the casting department, where the widgets are
initially created. During the month of March, the casting department incurs
$50,000 of direct material costs and $120,000 of conversion costs (comprised of
direct labor and factory overhead). The department processes 10,000 widgets
during March, so this means that the per unit cost of the widgets passing through
the casting department during that time period is $5.00 for direct materials and
$12.00 for conversion costs. The widgets then move to the trimming department
for further work, and these per-unit costs will be carried along with the widgets
into that department, where additional costs will be added.

Types of Process Costing

There are three types of process costing, which are:

1. Weighted average costs. This version assumes that all costs, whether from a preceding
period or the current one, are lumped together and assigned to produced units. It is the simplest
version to calculate.
2. Standard costs. This version is based on standard costs. Its calculation is similar to
weighted average costing, but standard costs are assigned to production units, rather than actual
costs; after total costs are accumulated based on standard costs, these totals are compared to
actual accumulated costs, and the difference is charged to a variance account.

3. First-in first-out costing (FIFO). FIFO is a more complex calculation that creates layers
of costs, one for any units of production that were started in the previous production period but
not completed, and another layer for any production that is started in the current period.

There is no last in, first out (LIFO) costing method used in process costing, since the underlying
assumption of process costing is that the first unit produced is, in fact, the first unit used, which
is the FIFO concept.

Why have three different cost calculation methods for process costing, and why use one version
instead of another?  The different calculations are required for different cost accounting needs. 
The weighted average method is used in situations where there is no standard costing system, or
where the fluctuations in costs from period to period are so slight that the management team has
no need for the slight improvement in costing accuracy that can be obtained with the FIFO
costing method.  Alternatively, process costing that is based on standard costs is required for
costing systems that use standard costs.  It is also useful in situations where companies
manufacture such a broad mix of products that they have difficulty accurately assigning actual
costs to each type of product; under the other process costing methodologies, which both use
actual costs, there is a strong chance that costs for different products will become mixed
together.  Finally, FIFO costing is used when there are ongoing and significant changes in
product costs from period to period – to such an extent that the management team needs to
know the new costing levels so that it can re-price products appropriately, determine if there are
internal costing problems requiring resolution, or perhaps to change manager performance-
based compensation .  In general, the simplest costing approach is the weighted average method,
with FIFO costing being the most difficult.

Cost Flow in Process Costing

The typical manner in which costs flow in process costing is that direct
material costs are added at the beginning of the process, while all other costs
(both direct labor and overhead) are gradually added over the  course of the
production process. For example, in a food processing operation, the direct
material (such as a cow) is added at the beginning of the operation, and then
various rendering operations gradually convert the direct material into
finished products (such as steaks).

Using the process costing method

There are five steps in the process costing method that can be used to assign
relevant costs to inventory, as it is started and completed at the beginning, during
and the end of an accounting or production period. By following the steps of the
process costing method, you can calculate the total costs associated with any
inventory and production processes that occur within your company.

1. Analyze the inventory

2. Convert inventory costs
3. Calculate applicable costs
4. Calculate the cost per unit
5. Designate costs for complete and incomplete products

1. Analyze the inventory

The first step in calculating process costing is to analyze the inventory by
evaluating cost-flow of the inventory. By determining costs of each process of
production, a company can determine the amount of inventory that was
accounted for at the start of the period, the amount that was completed during
the accounting period and how much of the inventory was left as in-process at the
end of the accounting period.
2. Convert inventory costs
The second step in calculating process costing is to convert any inventory that
was considered as in-process at the end of the period to an amount of equal units.
For example, if a manufacturing company that produces ink cartridges
determined 4,200 cartridges were in-process at the end of the accounting period,
and each of these cartridges were 50% completed, then the company would
consider that inventory as equal to 2,100 cartridges produced.
3. Calculate applicable costs
Then, after converting any inventory to its equivalent amount in produced units,
calculate the total costs, both indirect and direct, that are accumulated through
the manufacturing process. This amount is then applied between the inventory
that is completed and the inventory that was left in-process. Both indirect and
direct costs of production include the costs of the inventory at the starting period
and the costs accumulated during the period.
4. Calculate the cost per unit
Once you have calculated all costs associated with the production process for
complete and in-process inventory, calculate the costs per unit. This includes the
costs for completed units and equivalents of finished units at the end of the
accounting period. For instance, if the company that manufactures ink cartridges
completed 3,000 cartridges and left 2,000 cartridges 50% complete, the
company would divide the costs by 4,000.
5. Designate costs for complete and incomplete products
Finally, split up the costs by allocating the appropriate amounts to the number of
products completed, as well as to the inventory that was considered in-process at
the end of the period.

In process costing it is the process that is costed (unlike job costing where each job is
costed separately). The method used is to take the total cost of the process and
average it over the units of production.

Important terms to understand

In a manufacturing process the number of units of output may not necessarily be the
same as the number of units of inputs. There may be a loss.

Normal loss
This is the term used to describe normal expected wastage under usual operating
conditions. This may be due to reasons such as evaporation, testing or rejects.

Abnormal loss
This is when a loss occurs over and above the normal expected loss. This may be due
to reasons such as faulty machinery or errors by labourers.

Abnormal gain
This occurs when the actual loss is lower than the normal loss. This could, for example,
be due to greater efficiency from newly-purchased machinery.

Work in progress (WIP)

This is the term used to describe units that are not yet complete at the end of the period.
Opening WIP is the number of incomplete units at the start of a process and closing
WIP is the number at the end of the process.

Scrap value
Sometimes the outcome of a loss can be sold for a small value. For example, in the
production of screws there may be a loss such as metal wastage. This may be sold to a
scrap merchant for a fee.
Equivalent units
This refers to a conversion of part-completed units into an equivalent number of wholly-
completed units. For example, if 1,000 cars are 40% complete then the equivalent
number of completed cars would be 1,000 x 40% = 400 cars. Note: If 1,000 cars are
60% complete on the painting, but 40% complete on the testing, then equivalent units
will need to be established for each type of cost. (See numerical example later.)

How to approach process accounting questions

Note: Although this proforma includes both losses and WIP, the Paper F2/FMA syllabus
specifically excludes situations where both occur in the same process. Therefore, don’t
expect to have to complete all of the steps in the questions.

Normal loss example Mr Bean’s chocolate Wiggly bars pass through two processes.
The data for the month just ended are:

Mr Bean allows the staff to eat 5% of the chocolate as they work on Process 1. There
was no work in progress at the month end. Prepare the two process accounts and
calculate the cost per kg.
 Workings

1. The staff normally eat 5% of the chocolate, so the normal loss is 4,000 x 5% =
200kg

There is no work in progress or scrap value or abnormal losses or gains, so we can now
balance the account to obtain the amounts transferred to Process 2.

2. Number of kg transferred = kg input less normal loss = 4,000 – 200 = 3,800kg

Abnormal gain example

There is a heat wave and staff have eaten less chocolate. At the end of Process 1,
3,810 units are transferred to Process 2.

Cost of units transferred to Process 2 = $2.89 x 3,810 = $11,029 (using $2.894736842

to avoid rounding differences).
 Cost of abnormal gain = $2.89 x 10 = $29.
[Remember to open an abnormal gain T account and credit it with $29]

Scrap value example

Mr Bean can no longer afford to give his staff 5% of the bars. He decides to offer the
bars to his staff at a discount. They pay 40c for every kg that they eat. As a result of
this, there is another abnormal gain of 10kg, so 3,810 units are transferred to Process 2.

Workings

Here we need to calculate the scrap value. The value of units transferred to Process 2
is a balancing figure.

1. Number of kg of normal loss scrap amount per kg = 200 x 0.4 = $80 [Dr Scrap A /
C $80, Cr Process A / C $80]

Be careful here! The scrap value also affects the abnormal gain or loss accounts. Since
the staff didn’t eat the number of bars that they were entitled to, the scrap value (the 40c
per bar) is lower than 200 40c. In fact, it is 10 x 40c = $4 lower (the abnormal gain). This
needs to be reflected in the scrap account and the abnormal gain account.
Work in progress example
Assuming at the month end there are now part-completed bars (work- in-progress).
Assuming also that he stopped charging staff for the bars that they had eaten. The data
for Process 2 was as follows:

For questions that include WIP, we need to calculate equivalent units. First, we need to
choose the method of valuing WIP. In an exam, use the first in first out (FIFO) method if
the percentage completion of each element of opening WIP is given. Use the weighted
average (WA) method if the value of each element of opening WIP is given. [Note that
the two methods give different valuations for the closing WIP.]

In the weighted average method, no distinction is made between units of opening

inventory and new units introduced to the process during the accounting period.