Costing is an essential aspect of operations for companies that want to understand how their production absorbs costs. Only by gaining a solid understanding of the company’s cost structure can we start to control and optimize it.
We can often divide the production process into specific jobs and apply the job costing method to them. However, job costing is less appropriate when production is a continuous flow through processing departments, resulting in large quantities of homogenous products.
It’s crucial to pick the right costing method that best reflects the manufacturing process within our firm. For large manufacturing operations, the right choice is usually Process Costing. It’s suitable for companies with a more standardized production process.
On the other hand, when we manufacture products individually, it’s more appropriate to rely on the job costing method.
What is the Process Costing Method?
Process Costing is a branch of operation costing. It’s an accounting methodology that accumulates the direct costs of a production process and allocates the indirect costs proportionally to all items produced within the same period.
We work under the assumption that every product we produce has the same cost as the other ones.
The approach is useful in mass production scenarios where we make large quantities of similar products, and the costs for individual output units cannot be differentiated. Process Costing is a good fit for the food and clothing industries and oil and fuel production, chemicals, and others.
Process Costing works best in companies where production is a continuous cycle of repetitive processes and tasks. The technique’s essence is to accumulate all related costs for the total output volume and then split them over the whole volume proportionally.
How does it Work?
The Process Costing method requires no specific journal entries, which means we generally don’t need to adjust our chart of accounts when we implement it within our production operations. Therefore, we can easily switch from job costing to process costing or work with a hybrid system between the two.
In Process Costing, there is a flow of costs that usually starts with the direct materials. The labor and overhead costs are gradually absorbed after that while the direct materials are converted into finished products.
Within this costing technique, we assign costs to the Process itself. We look at batches of products and allocate the average cost per unit. It’s the opposite of job costing, which aims at calculating individual cost per product.
Here’s a diagram to illustrate the Process Costing technique.
The transfer price from Process to Process includes the profit for the previous Process, not only the cost of parts and materials. Once parts and materials go through all production processes, we have our finished goods. Whenever a sale occurs, we transfer the cost of finished products to our Cost of Goods Sold account.
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The method takes the total costs for the Process and averages them out to all produced units. We can define the calculation with the following formula:
Losses and Gains
With any production process, outputs rarely match inputs. Usually, there is some loss of materials during the manufacturing stages.
Ordinary losses are the expected wastage in normal operating conditions. This can be due to testing, defective items, or others. These occur at various production stages and are a part of the unit cost.
In some specific circumstances like having faulty equipment or experiencing staff errors, we may have a loss above the normally expected loss.
In other cases, we can have abnormal gains when the actual loss is less than the expected normal loss. This we can achieve by improving the efficiency of our workers, or by introducing better equipment.
Types of Process Costing
We can use several methods to calculate the total incurred costs and produced units during the period. We can either use one of these approaches or a combination between them.
When we have a large mix of products, it can be hard to assign actual costs in a timely manner. In such cases, we can use standardized costs to calculate the total production cost for all units. We estimate it based on historical cost data and apply it to production. At the end of the period, we compare the actual cost to the standard cost, and we charge the difference to a variance account.
First-in First-out (FIFO)
This method is useful when there are significant changes in costs from period to period, which require re-pricing or cost optimizations. It is a bit more complicated, as it creates separate layers of costs. It assigns different costs to WIP units from the previous period, and products started in the current period. FIFO assigns costs in the order of production. Items produced first absorb costs first, and are the first we ship.
Weighted Average Cost
This method assumes all costs are accumulated and assigned to all produced units, even from previous periods. It’s the easiest one to calculate, and we use it when no standard costs are available when cost items show close to no fluctuations, so there’s no benefit in using FIFO.
When to use Process Costing
This cost accounting method is very suitable for companies where products are manufactures in large quantities and sold in small quantities, even one by one. It’s ideal for businesses that keep finished goods and transfer them to Cost of Goods Sold (COGS) when they sell the products. This requires an accurate cost per unit to match COGS to the related revenue.
Process Costing provides feedback and insights to the company’s management and helps with cost control. The company’s management should follow per-unit cost in real-time, as with large production volumes, even the slightest change can have significant implications for profitability.
Characteristics of Companies Employing Process Costing
- There are multiple departments/divisions, and each is a stage of production;
- Production is continuous, meaning processes flow sequentially;
- The output of a process is the input to the next Process;
- The output of the last Process becomes Finished Goods;
- The final product is homogenous;
- We charge direct and indirect costs to the Process itself.
5 Steps of Process Costing Accounting
To apply the Process Costing method in our company’s cost accounting, we follow five steps. These can differ depending on the business structure and the industry, but in general, we can describe them as follows.
1. Inventory analysis
We start by evaluating the cost flow of inventory within the business. We determine the costs of each Process that is part of our production cycle. Then we calculate the opening balance of inventory, what was produced during the period, and what is left as Work in Progress (WIP).
2. Convert WIP to equivalent units
The next step is to convert in-process inventory in the opening balance to equivalent units. For example, if we had 100 items in-process at 60% completion, we consider these equal to 60 entirely produced units.
3. Calculate total costs
We aggregate all costs incurred through the manufacturing process. These costs (both direct and indirect) include the cost of the WIP inventory at the beginning of the period and the period’s costs. We apply these over the inventory produced in the period and the equivalent units of the WIP at the end of the period.
4. Cost per unit
Now that we have all costs for producing complete and incomplete units, we divide it over the finished items and the equivalent units of work in progress. For example, if we make 500 units and have an ending WIP balance of 100 units at a 70% completion rate, we will calculate the cost per unit over 570 units.
5. Assign costs to complete and in-process units
We split the cost between Finished Goods and Work in Progress based on the cost per unit and the respective unit volumes.
Process Costing vs. Job Costing
The most notable difference between job and Process costing is the WIP calculation. In Job Costing, we estimate the percentage of completion for each partially finished job. On the other hand, in Process Costing, we cost the processes up to the current production stage.
When we calculate Work in Progress under Job Costing, we take each job to the level it’s complete and aggregate the costs in our WIP account.
On the other hand, in Process costing, we have a single step alongside the various production processes. The accumulated cost at this point of completion is what we transfer to the WIP account.
Production costing is a vital part of business operations. Picking the costing method that best reflects our firm’s manufacturing process is critical to understanding our cost structure. Only then can we start to control it and optimize it.
Process costing is the most common cost accounting method applied within manufacturing companies that produce large volumes of similar products. It helps us assign accurate costs to our products and ensures we have the right input information for our pricing and cost analysis.
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