Managerial Accounting
Tenth Canadian Edition
Connect
What You Really Need To Know
Chapter 6: Systems Design: Process Costing and Service Department Overhead
A. Process costing is used in industries that produce homogeneous products such as
bricks, flour, and cement. It is also used in some assembly-type operations, as well as in
utilities producing gas, water, and electricity.
B. Process costing is similar to job-order costing in three ways:
1. Both systems have the same basic purposes, which are to assign material,
labour, and overhead costs to products and to provide a mechanism for
computing unit costs.
2. Both systems use the same basic manufacturing accounts: Manufacturing
Overhead, Raw Materials, Work in Process, and Finished Goods.
3. Costs flow through these accounts in basically the same way in both systems.
C. Process costing differs from job order costing in the following ways:
1. A single product is produced on a continuous basis, and each unit is
essentially identical.
2. Costs are accumulated by department, rather than by job.
3. The department production report (rather than the job cost sheet) is the key
document showing the accumulation and disposition of cost.
4. Unit costs are computed by department (rather than by job). This computation
is made on the department production report.
D. A processing department is any work center where work is performed on a product
and where materials, labour, or overhead costs are added. Processing departments in a
process costing system have two common features. First, the activity carried out in the
department is performed uniformly on all units passing through it. Second, the output of
the department is basically homogeneous.
E. Less effort is usually required to use a process costing system than a job-order costing
system; costs only need to be traced to a few processing departments, rather than to many
individual jobs.
F. Exhibit 6-3 provides a T-account model of cost flows in a process costing system. A
separate work in process account is maintained for each processing department.
Materials, labour, and overhead costs are entered directly into each processing
department’s work in process account.
G. Separate computations are made within each processing department for each cost
category. The cost categories may include:
1. Costs of prior departments associated with units transferred into the
department.
2. Materials costs added in the department.
3. Direct labour costs added in the department.
4. Manufacturing overhead costs applied in the department.
In process costing, direct labour costs and manufacturing overhead costs are often
combined into one cost category called conversion costs.
H. Once the costs in each category have been totalled for a department, the department’s
output must be determined so that unit costs can be computed. Units that have only been
partially completed pose a problem. A unit that is only 10% complete should not count as
much as a unit that has been completed and transferred on to the next department. This is
where the concept of equivalent units comes in.
1. Equivalent units are the number of whole, complete units one could obtain
from the materials and effort contained in partially completed units.
Equivalent units are computed using the following formula:
Equivalent
units
=
Number of
partially completed
units
×
Percentage
completion
2. Equivalent units of production is used to compute the cost per equivalent unit.
Study Exhibit 6-5 carefully to develop an understanding of the equivalent unit
concept. Under the weighted-average method, the equivalent units of
production are determined as follows:
+
=
Units transferred out to the next
department or to finished goods .......
Equivalent units in ending work in
process inventory..............................
Equivalent units of production .............
XXX
XXX
XXX
3. The equivalent units of production are computed separately for each cost
category.
I. Note the following points concerning process costing.
1. The equivalent units of production and the cost per equivalent unit must be
computed separately for each cost category.
2. Units transferred out of the department to the next department—or, in the case
of the last department, to finished goods—are always considered to be 100%
complete with respect to the work done by the transferring department.
3. The first processing department will not have a cost category for the costs of
units transferred in, but subsequent departments will have such a cost
category. Units in process in a department are considered to be 100%
complete with respect to the costs of the prior department.
J. After the equivalent units of production are computed for each cost category, the next
step is to compute the cost per equivalent unit for each cost category. Under the
weighted-average method, the formula is:
Cost of beginning Cost added
work in process + during
Cost per
inventory
the period
equivalent =
Equivalent units of production
unit
K. The final step is to compute the costs of the units transferred out during the period and
the ending work in process inventory. These costs are determined as follows:
1. Units completed and transferred out. These units are presumed to be 100%
complete. (If they were not complete with respect to the work done in the
department, they would not be transferred out.) The costs of units transferred
out are determined for each cost category within a department as follows:
×
=
Units transferred to the next department .
Cost per equivalent unit ..........................
Cost of units transferred out ....................
XXX
XXX
XXX
This computation is made for each cost category in the department. The
results are summed to determine the overall cost of units transferred out of the
department.
2. Units in ending work in process inventory. The costs of the units in ending
work in process inventory are determined for each cost category within a
department as follows:
×
=
Equivalent units of production in
ending work in process inventory ......
Cost per equivalent unit .........................
Cost of ending work in process
inventory ............................................
XXX
XXX
XXX
This computation is made for each cost category in the department. The
results are summed to determine the overall cost of ending work in process
inventory.
L. Note that the weighted-average method combines costs from the beginning inventory
with costs from the current period. It is called the weighted-average method because it
averages together costs from the prior period with costs of the current period.
M. Operation costing is a hybrid system containing elements of both job-order and
process costing. It is most commonly used when products use different materials but
follow the same basic processing steps. For example, a factory that assembles personal
computers might make many different models that use different components. However,
all of the models go through the assembly department, testing department, and packing
and shipping department.
1. In operation costing, products are handled in batches and each batch is
charged with its own specific materials. In this sense, operation costing is
similar to job-order costing.
2. Labour and overhead costs are accumulated by department and these costs are
assigned to the batches on an average per unit basis as in process costing.
N. Flexible manufacturing systems (FMS) have made it possible for companies to switch
from the more costly job-order costing system to the less costly process or operation
costing system.
1. This switch is made possible because FMS is proving to be highly efficient in
reducing the setup time required between products and jobs.
2. Because setup time is reduced to insignificant amounts, companies are able to
move between products and jobs with about the same speed as if they were
working in a process-type environment.
Appendix 6A: FIFO Method
A. The FIFO method is more complex than the weighted average method, but is
considered to be more accurate. The FIFO method keeps units and costs from the prior
period separate from the units and costs of the current period.
B. The production report under the FIFO method is similar to the production report under
the weighted average method. There are, however, important differences in the reports
that are easy to overlook. Refer to the Appendix A exhibits as you read the explanations
that follow below.
C. Under the FIFO method, the equivalent units of production are determined as follows:
+
+
=
Equivalent units to complete the
beginning work in process inventory ..
Units started and completed this period ..
Equivalent units in ending work in
process inventory.................................
Equivalent units of production ................
XXX
XXX
XXX
XXX
Note that the weighted-average method includes the equivalent units in beginning
inventory whereas the FIFO method does not. This is most easily seen from the following
alternative method of computing the equivalent units of production under the FIFO
method:
–
+
=
Units completed this period ....................
Equivalent
units
in
beginning
inventory .............................................
Equivalent units in ending inventory ......
Equivalent units of production ................
XXX
XXX
XXX
XXX
D. Under the FIFO method, the cost per equivalent unit is computed using only costs
added during the current period.
Cost per = Cost added during the period
equivalent unit Equivalent units of production
E. The computation of the cost of ending work in process inventory is handled identically
under the FIFO and weighted-average cost methods, although the costs per equivalent
unit will usually be different. In computing the cost of units transferred out under the
FIFO method, the units in beginning work in process inventory are kept separate from the
units started and completed during the current period as follows:
Computing the cost of units transferred out:
Cost of beginning work in process
inventory .........................................
×
=
×
=
Equivalent units of production
required to complete the units in
beginning work in process
inventory .........................................
Cost per equivalent unit ......................
Cost to complete the units in
beginning work in process
inventory .........................................
Units started and completed this
period ..............................................
Cost per equivalent unit ......................
Cost of units started and completed
this period .......................................
$XXX
XXX
$XXX
$XXX
XXX
$XXX
$XXX
For each cost category within the department, the above three costs—the cost of
beginning work in process inventory, the cost to complete the units in beginning work in
process inventory, and the cost of units started and completed during the period—are
summed to determine the cost of the units transferred out during the period. These costs
are then summed across cost categories within the department to determine the overall
cost of the units transferred out of the department during the period.
F. When comparing the weighted-average and FIFO methods, two points should be
noted:
1. From the standpoint of cost control, the FIFO method is superior to the
weighted-average method because it separates the costs of the prior period
from the costs of the current period.
2. If there are no beginning inventories, there will be no difference in costs
reported using the FIFO and weighted-average methods. Because lean
production reduces inventories to a minimum, adopting lean production will
reduce the differences in costs computed under the two methods.
What To Watch Out For (Hints, Tips and Traps)

Although a process costing system may seem complex, a brief overview of
process costing in its simplest form (weighted-average method) follows:
A. In process costing, costs are accumulated in processing departments.
B. A separate departmental production report is compiled for each processing
department. This report provides the details of how costs are assigned to units
that pass through the department.
C. Costs to be accounted for in each processing department consist of:
1. Costs of the beginning work in process inventory in the department.
2. Costs added during the period.
a. Costs of units transferred in from a preceding department.
b. Costs added in the department itself (materials + labour +
overhead).
D. Costs are accounted for by assigning them to:
1. Ending work in process inventory in the department.
2. Units transferred out to the next department (or to finished goods).
E. In process costing, each unit is assigned the average cost of units processed
through the department.
F. Two things must be known to compute the average cost per unit in a
department:
1. The total cost.
2. The total number of units processed.
G. Partially completed units are converted to equivalent (whole) units.
For example, 200 units in ending inventory are 25% complete with respect to
conversion costs.
H. The two common methods of computing average costs per unit are the
weighted-average method and the FIFO method. The FIFO method is
discussed in Appendix 6A.

A key aspects of applying the concepts of this chapter in practice deals with a
concept known as equivalent units of production (pay particular attention to the
computations in Exhibit 6-5) and preparing a production report, using either the
weighted-average method or the FIFO method. The production report is complex
and you will need to devote time to learning how it is constructed. Exhibit 6-7
provides a detailed example of a production report using the weighted-average
method. (A production report prepared using the FIFO method follows the same
concepts presented for the weighted-average method; however you must use the
FIFO calculation illustrated in Appendix A.)
A. The purpose of the production report is to summarize all of the activity that
takes place in a department’s work in process account for a period. A
production report has three parts:
1. A quantity schedule, which shows the flow of units through the
department, and the computation of equivalent units for each cost category
for the period.
2. A statement showing computation of the cost per equivalent unit for each
cost category for the period.
3. A reconciliation of all cost flows into and out of the department during the
period.
Refer to Exhibit 6-7 as you go through the explanation of the production
report below.
B. The purpose of the quantity schedule on the production report is to show the
flow of units through a department. The schedule shows the number of units
to be accounted for in a department and it shows how those units have been
accounted for.
1. The format of the quantity schedule under the weighted-average method
is:
Units to be accounted for:
Work in process, beginning ...........................
XXX
Started into production ..................................
XXX
Total units ......................................................
XXX
Units accounted for as follows:
Transferred out to the next
department or to finished goods ...............
XXX
Work in process, ending .................................
XXX
Total units ......................................................
XXX
2. The equivalent units for the units transferred out and for the ending work
in process inventory are listed next to the quantity schedule on the
production report.
C. The second step in preparing a production report is to compute the cost per
equivalent unit for each cost category. Under the weighted-average method,
this involves adding the costs from the beginning inventory to any costs added
during the period to arrive at total cost. This figure is then divided by the
equivalent units of production (from the quantity schedule) for the cost
category to determine the cost per equivalent unit.
D. The final step in a production report is to prepare a reconciliation of all costs.
Costs are accounted for as either transferred out during the period or assigned
to the ending work in process inventory. Costs are determined as follows:
1. Units transferred out. These units are presumed to be 100% complete. (If
they were not complete with respect to the work done in the department,
they would not be transferred out.) The costs of units transferred out are
computed by multiplying the number of units transferred out by the cost
per equivalent unit for each cost category. These costs are then summed.
To simplify, a total equivalent cost per unit is usually calculated by
summing the individual amounts for each cost category. This total is then
multiplied by the number of units transferred out.
2. Units in ending work in process inventory. Within each cost category, the
number of equivalent units is multiplied by the cost per equivalent unit for
that cost category. These costs are then summed.
E. Study Exhibit 6-7 carefully; it shows how the weighted average method
works. Note that this method combines costs from the beginning inventory
with costs from the current period. It is called the weighted average method
because it averages together costs from the prior period with costs of the
current period.