Process CostingExplained & Defined

Written By:
Adiste Mae

Reviewed By:
FundsNet Staff

Process Costing is a cost accounting technique employed by companies that mass produce similar or identical products.

Manufacturing companies such as those belonging to oil refining, chemical production, and food companies use this type of cost accounting.

Costing for an individual item is impossible for these industries, which is why tracking costs at each stage of production makes more sense.

What is Process Costing?

To understand how the process costing works, take for example a paper manufacturing business.

Before it can sell paper, wood pulps undergo a series of production stages.

To determine the total production cost, the total cost in each of its production stages is computed and then summed up.

The total cost of each of the stages is then divided by the total number of units produced. This is the cost per unit.

Understanding Process Costing

When companies produce similar or identical products, it is impractical to compute the cost of each item.

Using the process costing method, the direct costs and indirect costs are determined for each stage of production.

Direct costs are incurred directly during the production process such as direct materials and direct labor costs.

Indirect costs are those that are not directly incurred to create the product such as rent, administrative expenses, salaries, equipment maintenance, etc.

Oftentimes, manufacturing companies also break down the production costs further to determine the direct cost and conversion cost.

For each of the stages of production, a report is prepared that shows the direct materials used, direct labor incurred, and other overhead costs.

A company then collects all the costing information and analyzes the data to determine the product cost.

Process Costing vs Job Costing

Manufacturing companies use two different product costing methods – process costing and job costing.

Where process costing is mainly used for companies that produce homogeneous products, job costing is used for products that are customized and need to be priced individually.

For each unit of a custom-made product sold, the direct and indirect costs are tracked to the individual item.

Importance of Process Costing

It is essential for companies that mass-produce identical products to understand how their costing process works and identify the right pricing for their products.

It also helps them determine whether the actual costs incurred are in line with the projections set.

The costs incurred at each stage of the production process allow companies to analyze the available data and reduce costs wherever they can.

Why Use Process Costing

To properly account for the Cost of Goods Manufactured of homogeneous products in the Income Statement, Process Costing is used.

Costing for each unit is an almost impossible and time-consuming task if process costing is not used.

Companies use process costing for different reasons and it includes inventory control, profit margin monitoring, and uniformity in reporting.

Inventory Control

The IRS requires companies to submit their inventory reports.

For manufacturing companies that deal with a lot of materials in their production process, the process costing method helps in simplifying the reporting process.

Profit Margin Monitoring

The costing method used directly affects the profit margin of companies.

This is especially true for manufacturing companies that have high production volumes and high manufacturing costs but with a low margin.

When done right, an effective costing method can make a huge difference in the company’s profitability.

Reporting Uniformity

With each stage of production recording costs directly incurred in producing the items, there is uniformity in the cost codes and the manner of reporting.

This method helps companies track expenses and achieve uniformity in their reports.

Process Costing Method

• Analyze Inventory

The following inventory record needs to be captured in the first step of the process costing method: beginning inventory, inventory started, inventory completed, and ending inventory.

• Calculate Equivalent Units

The Equivalent Units concept is helpful to account for unfinished units at the end of an accounting period.

For example, at the end of the period, there are still 5,000 units that are only 90% complete.

Using the process costing method, it is equivalent to 4,500 units (5,000 x 90%).

• Calculate Applicable Costs

The sum of all costs is computed in each of the stages of production, which includes the direct materials and conversion cost.

• Calculate the Cost Per Unit

To calculate the cost per unit, the summed-up cost of all the stages will be divided by the number of units produced (completed and equivalent units).

For example, the total cost for all production stages is $33,195 while the total units produced are 18,000 (15,000 completed and 3,000 incomplete units).

The cost per unit is, therefore, $1.84 ($33,195 / 18,000 units).

• Allocate the Costs to Complete and Incomplete Products

Since the cost per unit is already known, the units in ending inventory and work-in-progress inventory can also be allocated their corresponding value.

In the above example, the 3,000 incomplete units have a corresponding value of $5,520 (3,000 x $1.84).

Types of Process Costing

Businesses can choose the process costing method that best fits the needs of their business.

They can opt to choose between the Weighted Average, Standard Cost, or the First In, First Out (FIFO) method.

Weighted Average Costs

This method is the preferred choice when using process costing because of its simplicity and straightforward approach.

The costs of each stage in production are added and then divided by the total number of units produced, which includes the completed units, transferred-out units, and equivalent units.

When costs have minor fluctuations, this is a more appropriate method to use.

Standard Costs

With standard costing, companies do not use actual costs and instead use estimated standard costs to determine the product cost.

This is especially done for companies that make a multitude of products and identifying the actual costs for the products tends to be time-consuming.

When the production is complete, the actual cost will then be compared to the standard cost and the difference will then be recorded in a variance account.

First In, First Out (FIFO)

When costs fluctuate from one period to the next, it makes sense to use the FIFO method. However, this is a more complicated method because it uses product costing that is more precise.

The assumption in this method is that the units that are under work in progress (WIP) at the beginning of the period will be completed first.

The costs that were incurred in the previous period are not included in the WIP at the start of the period.

Example of Process Cost Accounting

Company XYZ manufactures flavored drinks.

Their production stages include the following: filling, labeling & packaging stage.

The filling department was able to process 75,000 bottles and has incurred $30,000 of direct materials and $90,000 of conversion costs.

For this, the per unit cost of the filling department is $1.60 ($120,000 / 75,000 bottles).

The labeling department has incurred a total of $30,000 and the packaging department incurred $36,000.

The per unit cost for each department is $0.40 and $0.48, respectively.

Therefore, the total cost to produce each unit is $2.48 ($1.60 + $0.40 + $0.48).