Process Costing

What is Process Costing?

Process costing is method of costing wherein the products go through two or more processes and the costs are assigned/charged to individual processes or operations which is averaged over the number of units produced during the said period. It is used commonly in manufacturing units like paper, steel, soaps, medicines, vegetable oils, paints, rubber, chemical, etc. use this method widely.

A product may be manufactured through one process or more than one processes. In case two or more processes are involved in manufacturing one finished product, the question arises is “which process has consumed the expense?” The answer lies within process costing. It helps identify the specific cost assigned to each process. It enables the management for further decision making.

Types

Types of Process Costing.jpg

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#1 – Weighted Average Method of Process Costing

Here the actual cost is divided by the weighted averageWeighted AverageThe weighted average formula is simply summing up the products of each value with its respective weightage. Here, more significance is given to the weightage of the values rather than the variables themselves.read more of products produced during the year. This calculation is simple as compared to any other method. A weighted average of units means the summation of the product of the rate and quantity of each item.

#2 – Standard Cost

Here the actual cost of units is not considered; instead, it follows a standard costing methodStandard Costing MethodStandard cost is an estimated cost determined by the company for the production of the goods and services or for performing an operation under normal circumstances and are derived by the company from the historical analysis of the data or from the time and the motion studies.read more. Standard cost assumes the cost of certain materials as per management estimate. Any difference in standard & actual costs is recorded separately under variance account.

#3 – First-In-First-Out

This method assigns the expense of first inputs to the processes in the order of production. It does not precisely identify as to which a lot of raw material is taken for production and its procurement rate.

Steps of Process Costing

Process Costing

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Step#1 – Record of Inventory

This step involves the identification of inventory at the end of each process. The organisation can identify such inventory either by physically counting the units or through a software inbuilt in the manufacturing process. The costs of inventory under each process are also identified at this change.

Step #2 – Conversion of Work in Process Inventory

Apply the percentage of completionPercentage Of CompletionThe percentage of completion method is an accounting method for recognizing revenue and expenses for long-term projects that span over more than one accounting year. The revenue is recognized yearly as a percentage of work completed during that year. Revenue to be recognized = (Percentage of Work Completed in the given period) * (Total Contract Value) read more to the units which are under any process & not yet completed the production. Say 80,000 units of soaps are under process & these are 60% completed. Then the equivalent completed units are 80,000*60% i.e. 48,000 units.

Step #3 – Calculation of Inventory Costs

Here, the organisation calculates the direct costDirect CostDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc.read more and indirect costsIndirect CostsIndirect cost is the cost that cannot be directly attributed to the production. These are the necessary expenditures and can be fixed or variable in nature like the office expenses, administration, sales promotion expense, etc.read more incurred by the plant in the production phase. These costs are accumulated from the first process to the last process. The said is then bifurcated into an inventory of complete products & inventory of products which are under process.

Step #4 – Calculation of Per-Unit Cost of Inventory

We calculate this by dividing the total cost by equivalent completed units in the production phase. The cost per unit calculated here reflects the cost of only completed units. The basis of equivalent units can be the weighted average, standard cost or first-in-first-out inventory methodFirst-in-first-out Inventory MethodUnder the FIFO method of accounting inventory valuation, the goods that are purchased first are the first to be removed from the inventory account. As a result, leftover inventory at books is valued at the most recent price paid for the most recent stock of inventory. As a result, the inventory asset on the balance sheet is recorded at the most recent cost.read more.

Step #5 – Allocation of Costs

The per-unit costs are then split according to the number of units completed & units which are under process.

Examples of Process Costing

You can download this Process Costing Excel Template here – Process Costing Excel Template

 The entity has provided the following information & wants to calculate the cost involved in each manufacturing step. Also, it intends to calculate the value of closing inventory.

Process Costing Example 1

Solution:

Process Costing Example 1-1
Process Costing Example 1-2
Process Costing Example 1-3

When Is Process Costing System Suitable?

Process costing is suitable for industries where the product is in a continuous manner and the end products are identical. Also, the entire process of production is standardised. In such industries the production cycle is standardised & even the quantum of the normal loss of inputs & outputs are also quantified earlier. In case of abnormal expense, it is a charge to profit & loss account directly and not to any individual process.

Industries such as cement, soaps, steel, paper, chemicals, medicines, vegetable oils, rubber, etc. use this method to assign the costs.

Features

  • Each plant is divided into several processes/centres. Each such division is a stage of production or process. Thus, we first clearly identify the cost centres.
  • Direct & indirect costs assigned and accumulated to each process in the factory.
  • The output of one process may become input for another process.
  • The finished products are identical & cannot be easily distinguished unless batch coding is done.
  • The production process is continuous for all days in the year except regular breakdown hours required during the year for maintenance of the machinery.
  • The total cost of production is divided among each process on a suitable basis.
  • The company requires to keep records for each production process, such as units or costs introduced in each process and passed on to the next stage of production.
  • The production may result in joint-products or by-products.

Conclusion

Process cost allows an organisation to assigns the cost to different steps in the production phase. It helps management in decision making. The organisation can use this method to identify the relevant costs (i.e. direct and indirect costs) for each process and no abnormal expenses are charged to any process.

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