Process costing

Process costing
Process costing is an accounting methodology that traces and accumulates direct costs, and
allocates indirect costs of a manufacturing process. Costs are assigned to products, usually in a
large batch, which might include an entire month's production. Eventually, costs have to be
allocated to individual units of product. It assigns average costs to each unit, and is the opposite
extreme of Job costing which attempts to measure individual costs of production of each unit.
Process costing is usually a significant chapter. it is a method of assigning costs to units of
production in companies producing large quantities of homogeneous products.
Process costing is a type of operation costing which is used to ascertain the cost of a product at
each process or stage of manufacture. CIMA defines process costing as "The costing method
applicable where goods or services result from a sequence of continuous or repetitive operations
or processes. Costs are averaged over the units produced during the period". Process costing is
suitable for industries producing homogeneous products and where production is a continuous
flow. A process can be referred to as the sub-unit of an organization specifically defined for cost
collection purpose.
What is 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. Processing cost is used when nearly
identical units are mass produced. (Job costing or job order costing is a method used when the
units manufactured vary significantly from one another.)
To illustrate process costing, let’s assume that a product requires several processing operations—
each of which occurs in a separate department. The costs of Department One for the month of
June amount to $150,000 of direct materials and $225,000 of conversion costs (direct labor and
manufacturing overhead). If the number of units processed in June in Department One is the
equivalent of 100,000 units, the per unit cost of the products processed in Department One in
June will be $1.50 for direct materials and $2.25 for conversion costs. These costs will then be
transferred to Department Two and its processing costs will be added to the cost of the units.
The importance of process costing
Costing is an important process that many companies engage in to keep track of where their
money is being spent in the production and distribution processes. Understanding these costs is
the first step in being able to control them. It is very important that a company chooses the
appropriate type of costing system for their product type and industry. One type of costing
system that is used in certain industries is process costing that varies from other types of costing
(such as job costing) in some ways. In process costing unit costs are more like averages, the
process-costing system requires less bookkeeping than does a job-order costing system. Thus,
some companies often prefer to use the process-costing system.

When process costing is applied?
Process costing is appropriate for companies that produce a continuous mass of like units
through series of operations or process. Also, when one order does not affect the production
process and a standardization of the process and product exists. However, if there are significant
differences among the costs of various products, a process costing system would not provide
adequate product-cost information. Costing is generally used in such industries such as
petroleum, coal mining, chemicals, textiles, paper, plastic, glass, and food.
Reasons for use
Companies need to allocate total product costs to units of product for the following reasons:
 A company may manufacture thousands or millions of units of product in a given period
of time.
 Products are manufactured in large quantities, but products may be sold in small
quantities, sometimes one at a time (automobiles, loaves of bread), a dozen or two at a
time (eggs, cookies), etc.
 Product costs must be transferred from Finished Goods to Cost of Goods Sold as sales are
made. This requires a correct and accurate accounting of product costs per unit, to have a
proper matching of product costs against related sales revenue.
 Managers need to maintain cost control over the manufacturing process. Process costing
provides managers with feedback that can be used to compare similar product costs from
one month to the next, keeping costs in line with projected manufacturing budgets.
 A fraction-of-a-cent cost change can represent a large dollar change in overall
profitability, when selling millions of units of product a month. Managers must carefully
watch per unit costs on a daily basis through the production process, while at the same
time dealing with materials and output in huge quantities.
 Materials part way through a process (e.g. chemicals) might need to be given a value,
process costing allows for this. By determining what cost the part processed material has
incurred such as labor or overhead an "equivalent unit" relative to the value of a finished
process can be calculated.
Process cost procedures
There are four basic steps in accounting for Process cost:
 Summarize the flow of physical units of output.
 Compute output in terms of equivalent units.
 Summarize total costs to account for and Compute equivalent unit costs.
 Assign total costs to units completed and to units in ending work in process inventory.
The journal entries for process costing are the same as those for job-order costing with one
exception. The entry to transfer cost from one work-in-process account to another is:

Work-in-process inventory-second department Debit (Left)
Work-in-process-first department Credit (Right)
Operation cost in batch manufacturing
Batch costing is a modification of job costing. When production is repetitive nature and consists
of a definite number of articles, batch is used. In batch costing, the most important problem is to
determine the optimum size of the batch that follows the fact that production of two elements of
costs:
 Set up costs which are generally fixed per batch.
 Carrying costs which vadetermination of batch quantity requires considerations of some
factors:
 setting up costs per batch.
 cost of manufacturing such as (direct materials cost + direct wages + direct overhead) per
piece.
 cost of storage.
 rate of interest on the capital invested in product and rate of demand for product.
What is job order costing?
Job order costing or job costing is a system for assigning manufacturing costs to an individual
product or batches of products. Generally, the job order costing system is used only when the
products manufactured are sufficiently different from each other. (When products are identical or
nearly identical, the process costing system will likely be used.)
Since there is a significant variation in the products manufactured, the job order costing system
will create a job cost record for each item, job or special order. The job cost record will report
the direct materials and direct labor actually used plus the manufacturing overhead assigned to
each job.
An example of an industry where job order costing is used is the building construction industry
since each building is unique. The manufacturers of custom equipment or custom cabinetry are
also examples of companies that will keep track of production costs by item or job.
The job cost records also serve as the subsidiary ledger or documentation for the cost of the
work-in-process inventory, the finished goods inventory, and the cost of goods sold.

Is standard costing GAAP?
Standard costing was developed to assist a manufacturer plan and control its operations.
Generally accepted accounting principles or GAAP require that a manufacturer’s financial
statements comply with the cost principle. This means that the inventories, the cost of goods
sold, and the resulting net income must reflect the manufacturer’s actual costs.
Standard costing will meet the GAAP requirements if the variances between the standard costs
and the actual costs are properly prorated to the inventories and to the cost of goods sold prior to
issuing the financial statements.
What is a process costing system?
A process costing system is used when a business is producing a large number of identical
products. In this situation, it is most efficient to accumulate costs at an aggregate level for a large
batch of products, and then allocate them to the individual units produced. The assumption is that
the cost of each unit is the same as that of any other unit, so there is no need to track information
at an individual unit level. The classic example of a process costing environment is a petroleum
refinery, where it is impossible to track the cost of a specific unit of oil as it moves through the
refinery.
A process costing system accumulates costs and assigns them at the end of an accounting period.
At a very simplified level, the process is:
 Direct materials. Using either a periodic or perpetual inventory system, we determine the
amount of materials used during the period. We then calculate the number of units begun
and completed during the period, as well as the number of units begun but not completed
(work-in-process units). We generally assume that materials are added at the beginning of
the production process, which means that a work-in-process unit is the same as a
completed unit from the perspective of assigning material costs. We then assign the
amount of direct materials used based on the total of fully and partially produced units.
 Direct labor. Labor is accumulated by units throughout the production process, so it is
more difficult to account for than direct materials. In this case, we estimate the average
level of completion of all work-in-process units, and assign a standard direct labor cost
based on that percentage. We also assign the full standard labor cost to all units that were
begun and completed in the period. If there is a difference between the actual direct labor
cost and the amount charged to production in the period, the difference can be charged to
the cost of goods sold or apportioned among the units produced.
 Overhead. Overhead is assigned in a manner similar to what was just described for direct
labor, where we estimate the average level of completion of all work-in-process units,
and assign a standard amount of overhead based on that percentage. We then assign the
full standard amount of overhead to all units that were begun and completed in the
period. As was the case with direct labor, any difference between the actual overhead cost
and the amount charged to production in the period is either charged to the cost of goods
sold or apportioned among the units produced.

Cost assigned to units produced or in process are recorded in the inventory asset account, where
it appears on the balance sheet. When the goods are eventually sold, the cost is shifted to the cost
of goods sold account, where it appears on the income statement.
Alternative Systems
If a process costing system does not mesh well with a company's cost accounting systems, there
are two other systems available that may be a better fit. The job costing system is designed to
accumulate costs for either individual units or for small production batches. The other option is a
hybrid costing system, where process costing is used part of the time and job costing is used the
rest of the time; it works best in production environments where some of the manufacturing is in
large batches, and other work steps involve labor that is unique to individual units.

Joint product pricing
In microeconomics, joint product pricing is the firm's problem of choosing prices for joint
products, which are two or more products produced from the same process or operation, each
considered to be of value. Pricing for joint products is a little more complex than pricing for a
single product. To begin with there are two demand curves. The characteristics of each demand
curve could be different. Demand for one product could be greater than for the other product.
Consumers of one product could be more price elastic than the consumers of the other product
(and therefore more sensitive to changes in the product's price).
To complicate things further, both products, because they are produced jointly, share a common
marginal cost curve. There are complexities in the production function also. Their production
could be linked in the sense that they are bi-products (referred to as complements in production),
or they could be linked in the sense that they can be produced by the same inputs (referred to as
substitutes in production). Also, production of the joint product could be in fixed proportions or
in variable proportions.
When setting prices in a situation as complex as this, microeconomic marginal analysis is
helpful. In a simple case of a single product, price is set at that quantity demanded where
marginal cost exactly equals marginal revenue. This is exactly what is done when joint products
are produced in variable proportions. Each product is treated separately. In fact, it might even be
possible to construct separate cost functions. In the diagram below, to determine optimal pricing
for joint products produced in variable proportions, you find the intersection point of marginal
revenue (product A) with the joint marginal cost curve. You then extend that quantity, up to the
demand curve for product A, and that gives you the profit maximizing price for product A (point
Pa in the diagram). You do the same for product B, yielding price point Pb1.
Pricing of Joint Products

If the products are produced in fixed proportions (example: cow hides and cow steaks), then one
of the products will very likely be produced in quantities different from the profit maximizing
amount considered separately. In fact the profit maximizing quantity and price of the second half
of the joint product, will be different from the profit maximizing amount considered separately.
In the diagram, product B is produced in greater amounts than the profit maximizing amount
considered separately, and sold at a lower price (point Pb2) than the profit maximizing price
considered separately (point Pb1). Although price is lower and output is higher, marginal cost is
also higher. Yet this is a profit maximizing solution to this situation. Quantity supplied of
product B is increased to the point that marginal revenue becomes zero (i.e.: the point where the
marginal revenue curve intersects the horizontal axis).
Joint Products and By-products
In a common manufacturing process if the output is more than one type, the resulting products
are called
a) Joint products
b) By products
There is no precise criterion to distinguish between joint products and by-products. It could be
made based on several factors like the company’s policy, sales value, market demand,
profitability etc. The most commonly used criterion is ‘sales value’.
When the products manufactured in a common process have substantial sales value they are
called Joint Products and when their sales value is relatively low compared to the main
products they are called By-products. It may be noted that if the sales value is insignificant the
products are treated as Scrap and not By-products. With increase in demand and market value
By-products may be re-classified as Main products.
Split-off point
In the manufacture of joint products, a common input is processed in the joint process. The point
were the products are recognized separately is called the ‘split off point’. Joint products are
either saleable in the market at the split off stage itself or they are further processed before being
sold. Further processing is done separately for the products.

Apportionment of Joint Cost
It is essential to apportion the joint cost for computing the total cost of the joint products. There
are various methods used in apportionment of joint cost. Some of the widely accepted methods
are below
a) Based on Output
b) Based on Sales Value
c) Based on Net Realizable Value
(Net Realizable Value = Sales Value after further processing – Further Processing Costs)
Example:
Dr. PQR Labs manufactures two products ‘Calocil’ and ‘Calopol’ in a joint process incurring $
54,000 up to the split off point. Following details are available at spit off point
- Product 1 – Calocil
Quantity (Kgs) 200
Selling Price per kg ($) 460
- Product 2 – Calopol
Quantity (Kgs) 70
Selling Price per kg ($) 200
Calculate the share of joint cost of the products based on
i) Output ii) Sales value at split off point

Joint cost apportionment (Output basis)
Product Quantity (Kgs) Share of joint cost ($)
Calocil 200 $40,000 (54000 /270 x 200)
Calopol 70 $14,000 (54000 / 270 x 70)
Total 270 $54,000
Joint cost apportionment (Sales Value basis)
Product Quantity (Kgs) Selling Price
per kg ($)
Sales Value ($) Share of joint cost($)
Calocil 200 460 94,000 $47,000 (54,000/108,000 x 94,000)
Calopol 70 200 14,000 $7,000 (54,000/108,000 x 14,000)
Total 270 108,000 $54,000
Example Problem:
A chemical manufacturing company makes three joint products (Rolta, Volta and Zolta) from the
same common process. The following process account relates to the monthly results of the
common process:
Common Process Account
Litres $ Litres $
Materials 100,000 500,000 Normal loss 15,000 6,000
Conversion costs: Output – Rolta 25,000 ?
Variable 200,000 Output – Volta 15,000 ?
Fixed 360,000 Output – Zolta 45,000 ?
Total 100,000 1,060,000 Total 100,000 1,060,000
Each one of the products can be sold immediately after the common process, but each one of
them can be further processed individually before being sold. The following further processing
costs and selling prices per litre are expected:

The company uses Net Realizable Value method to apportion joint costs. Calculate the value of
output for all the three products. Also determine an optimal process plan for the above.
Solution:
Step 1: Calculation of Joint cost
Materials 500,000
Variable Conversion Costs 2,00,000
Fixed Conversion Costs 3,60,000
Total 1,060,000
Less: normal losss 6,000
Net Joint cost 1,054,000
Step 2: Apportionment of joint cost (Net realizable value method)
Product Output (Lts)
Selling price after
further
processing
$/ltr (A)
Further variable
processing cost
$/ltr (B)
Net realizable
Value
$/ltr (A – B)
Total NRV
(Output x NRV per
ltr)
Rolta 25,000 8.10 1.75 6.35 158,750
Volta 15,000 6.35 1.00 5.35 80,250
Zolta 45,000 7.00 0.60 6.40 2,88,000
Total 85,000 5,27,000
Product Total NRV Share of joint cost

Rolta 158,750 317,500 (158750 / 527000 x 1054000)
Volta 80,250 160,500 (80250 / 527000 x 1054000)
Zolta 2,88,000 576,000 (288000 / 527000 x 1054000)
Total 5,27,000 1,054,000
Value of output
Rolta – 317,500
Volta – 160,500
Zolta – 576,000
Optimal Process Plan:
To determine the optimal process plan (i.e. which products need to be sold at the end of common
process and which should be sold after further processing) we need to compare the selling price
of the products at the end of common process and net realizable value of the products.
The comparison for the above case would be as below
Product Net realizable Value $/ltr
Selling price after
common process
$/ltr
Rolta 6.35 6.20
Volta 5.35 5.10
Zolta 6.40 6.90
Methods for Accounting by-products
The following are some of the methods used for accounting the by-products
i) Credit the sale value of by-product to costing Profit and Loss
ii) Credit the sale value of by-product to Joint Process account
iii) Reverse cost method (Sales value of by product Less estimated profit and selling expenses is
credited to Joint process account

Process costing

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