Chapter 4 – Systems Design: Process Costing
Process costing is the most commonly used in industries that convert raw materials into
homogeneous (i.e., uniform) products, such as bricks, soda, or paper, or a continuous basis
(Reynolds Aluminum – aluminum ingots, Scott Paper – toilet paper, General Mills – flour,
Exxon – gasoline and lubricating oils, Coppertone – sunscreens, and Kellogg – breakfast
cereals). In addition, process costing is sometimes used in companies with assembly operations.
A form of process costing may also be used in utilities that produce gas, water, and electricity.
I.
II.
Comparison of Job-Order and Process Costing
A. Similarities between Job-Order and Process Costing
i.
Both systems have the same basic purposes—to assign material, labor, and
manufacturing overhead costs to products and to provide a mechanism for
computing unit product costs
ii.
Both systems use the same basic manufacturing accounts, including
Manufacturing Overhead, Raw Materials, Work in Process, and Finished
Goods
iii.
The flow of costs through the manufacturing accounts is basically the
same in both systems
B. Differences between Job-Order and Process Costing
i.
Process costing is used when a company produces a continuous flow of
units that are indistinguishable from one another. Job-order costing is
used when a company produces many different jobs that have unique
production requirements
ii.
Under process costing, it makes no sense to try to identify materials, labor,
and overhead costs with a particular customer order (as we did with joborder costing), since each order is just one of many that are filled from a
continuous flow of virtually identical units from the production line
iii.
Process costing systems compute unit costs by department
Cost Flows in Process Costing
A. Process Departments
i.
Processing Department – an organizational unit where work is performed
on a product and where materials, labor, or overhead costs are added to the
product (a Nalley’s potato chip factory might have three processing
departments—one for preparing potatoes, one for cooking, and one for
inspecting and packaging)
ii.
The activity in the processing department must be performed uniformly on
all of the units passing through
iii.
The output of the processing department must be homogeneous; in other
words, all of the units produced must be identical
B. The Flow of Materials, Labor, and Overhead Costs
i.
In a process costing system, instead of having to trace costs to hundreds of
different jobs, costs are traced to only a few processing departments
ii.
A separate Work in Process account is maintained for each processing
department
iii.
The completed production of the first processing department is transferred
to the Work in Process account of the second processing department
iv.
III.
After further work, the completed units are then transferred to Finished
Goods
v.
Materials, labor, and overhead costs can be added in any processing
department—not just the first
C. Materials, Labor, and Overhead Cost Entries
D. Materials Cost – As in job-order costing, materials are drawn from the storeroom
using a materials requisition form
E. Labor Costs – In process costing, labor costs are traced to departments—not to
individual jobs
F. Overhead Costs
i.
In process costing, as in job-order costing, predetermined overhead rates
are usually used
ii.
Manufacturing overhead cost is applied to units of product as they move
through the department
G. Completing the Cost Flows
i.
Once processing has been completed in a department, the units are
transferred to the next department for further processing
ii.
After processing has been completed, the costs of the completed units are
transferred to the Finished Goods inventory account
iii.
Finally, when a customer’s order is filled and units are sold, the cost of the
units is transferred to Cost of Goods Sold
iv.
To summarize, the cost flows between accounts are basically the same in a
process costing system as they are in a job0order costing system. The
only difference at this point is that in a process costing system each
department has a separate Work in Process account
Equivalent Units of Production – After materials, labor, and overhead costs have been
accumulated in a department, the department’s output must be determined so that unit
product costs can be computed. The difficulty is that a department usually has some
partially completed units in its ending inventory. These partially completed units are
translated into an equivalent number of fully completed units. In process costing, this
translation is done using the following formula: Equivalent units = Number of
partially completed units x Percentage completion. Roughly speaking, the equivalent
units is the number of complete units that could have been obtained from the
materials and effort that went into the partially completed items. These equivalent
units would be added to any units completed during the period to determine the
period’s output for the department—called the equivalent units of production.
Equivalent units of production for a period can be computed in different ways
(weighted-average method and FIFO method). FIFO Method of process costing – a
method in which equivalent units and unit costs relate only to work done during the
current period. Weighted-Average Method – blends together units and costs from the
current period with units and costs from the prior period
A. Weighted-Average Method
i.
Under the weighted-average method, a departments equivalent units are
computed as follows (a separate calculation is made for each cost category
in each processing department): Equivalent units of production = Units
IV.
transferred to the next department or to finished goods + Equivalent units
in ending work in process inventory
ii.
Conversion cost, as defined in Chapter 2, is direct labor cost plus
manufacturing overhead cost. In process costing, conversion cost may be
treated as a single element of product cost
Compute and Apply Costs
A. Cost per Equivalent Unit—Weighted-Average Method (a separate calculation is
made for each cost category in each processing department) – Cost per equivalent
unit = (Cost of beginning work in process inventory + Cost added during the
period)/ Equivalent units of production
B. Applying Costs—Weighted-Average Method
i.
The costs per equivalent unit are used to value units in ending inventory
and units that are transferred to the next department
ii.
In each case, the equivalent units are multiplied by the cost per equivalent
unit to determine the cost assigned to the units
iii.
This is done for each cost category—in this case, materials and conversion
iv.
The equivalent units for the units completed and transferred out are simply
the number of units transferred to the next department because they would
not have been transferred unless they were complete
v.
When the products are completed in this last department, their costs are
transferred to finished goods