Process Costing: What is it and How Does It Work

Process costing

Process costing is a method of allocating costs in the manufacturing environment where production is carried in batches and requires different stages to be completed.

As the product keeps completing the stage of production, the cost is added for each completed stage. Once, all the production activities are completed the product is ready with the full cost of the production.

Process costing is suitable for

The process costing is suitable for the manufacturing companies where identical/homogenous products are produced and there is no gap in the process of production.

The cost is allocated based on the completion of the activity for particular products. It helps to measure the value of work in process at the year-end as the cost can be traced with the completion of the stage of production.

It’s not suitable for the companies that have different products to be produced at each time. For instance, if the company produces customized products, the consumption of activities can be different for the different products. Hence, the cost can not be allocated based on the completion of the process.

Process costing system

The process costing system allocates the cost of running the process to the batch of the products. It assumes that equal cost is incurred in each unit of production in the batch.

The cost for the direct material, direct labor, and overheads is assigned to the process which is then allocated for the batch of production.

It does take into account the normal losses of production depending on the process and allocated to the costing of a product. On the contrary, the abnormal losses are taken in the cost of sales. The process costing system follows certain stages that are discussed below.

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Get the flow of actual units

The physical flow of the units can be calculated by reviewing the documents that record the flow of the completed units in and out of the production system. The actual flow can be calculated depending on the policy of the company which can be the FIFO method and AVCO method as well.

The purpose of the calculation is to come up with the units that have been complete during the period under consideration. So, the cost can be allocated by getting it from the activities/processes that have been the actual cause of the cost incurred.

Determination of equivalent units of production

The units that have been complete during the period have been completed in the above stage of the process costing. However, there are units that remain incomplete during the period that need to be considered as well.

The units that remain incomplete are analyzes to have been completed with different inputs of the process. For instance, it needs to be considered the percentage of the process with respect to material, labor, and overheads.

It can be assessed based on the expectation that how much effort is needed in order to complete the process of production. For instance, further material required to complete the process is 20%.

Hence, the percentage of the completion is 80% in respect of the direct material. The completion of the percentage is assigned to create ease in the process of cost allocation for the processed units.

Identification of the total cost and computation of the per-unit cost

The total cost added in the process needs to be computed for different items of the material and the conversion cost.

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For instance, the business needs to track the resources that have been put in the process. The total cost incurred is divided by the equivalent units of production calculated in the previous stage.

Cost analysis

The cost analysis is the final stage of the process costing. This is the review stage of the process costing and the business ensures that all the costs associated with the process costing have been allocated to the equivalent units of the production. This stage ensures that the allocation of the cost has been carried out accurately.

Process costing examples

Consider a manufacturing facility of the business for garments manufacturing company. The first process of the manufacturing is cutting process.

The cutting process involves the costs related to direct material, direct labor, and the overheads related to the cutting department. Consider the equivalent units of the production are 10,000 units and the cost per unit is USD 3 per unit in the cutting department.

Hence, the total cost of the process for the cutting department is USD 30,000 (10,000*USD 3) which can be added to the cost pool of the product for the reporting purpose as WIP of the cutting department.

Process costing vs job order costing

The process costing system is used for the items that are indifferent from each other and the production is carried in the bulk. The products produced in the process costing are standard and do not differentiate from each other.

Hence, the process costing is suitable for the business that produces goods in the batches. For instance, food, plastic, paper, soaps, detergents, and cement, etc.

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On the contrary, the job order costing is used for the production which is customized and the products are not similar to each other. The job costing is useful for the businesses like accounting & law firms, medical services, the film-making industry, and the construction industry, etc.

Advantages of process costing

The advantages of process costing include but are not limited to straightforward computation of the product cost, basic inputs in the process like direct material, direct labor, and overhead cost.

It’s not much difficult to keep a detailed record of these inputs in the process. Further, the process of the computation is easy to understand and flexible for making the changes.

Disadvantages of process costing

The calculation for the equivalent units of the production is an estimate which is not fully accurate. The inaccuracy of the work in process may result in the misstatement of the financial reporting.

Further, the basis for the allocation of the costing on a batch is arbitrary and not transparent as in the case of the job order costing.