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Process Costing

This lesson focuses on Process Costing. There are two main types of cost accounting systems. Companies select a method that best matches the flow of work in their business. These methods are used to allocate all production costs: labor, materials and overhead.

Job order costing - work is broken into jobs; each job is tracked separately auto mechanics, carpenters, painters, print shops, computer repair
Process costing - a large quantity of identical or similar products are mass produced auto assembly plants, hot dog manufacturing, any large mechanized production facility

Each cost accounting system gathers and reports on the same information. The method used depends on the needs of the business.

Process Costing traces and accumulates direct costs, and allocates indirect costs, through 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.

Why do we need to allocate total product costs to units of product?

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 must 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.

Allocating Overhead Using ABC Costing

Overhead is a large mixed group of costs that can't be directly traced to products. There are several methods of allocating overhead costs in a cost accounting system. ABC costing is one method. There are other, simpler methods as well.

Activity-based costing (ABC) - overhead costs are tracked activities that consume resources Used primarily for allocating overhead that is hard to track to specific products or departments

ABC Costing is a little more sophisticated that the single-driver method covered in the lesson on job costing. But it is really not much more difficult. ABC Costing assumes that:

  • you may have more than one cost driver that is relevant,
  • a single cost driver may incorrectly allocate costs to products or departments -- too much or too little costs, or costs allocated to the wrong department or product,
  • service type enterprises don't produce a product, but must find a way to allocate overhead costs to services provided (e.g. hospitals),
  • multi-department and multi-factory situations require more sophistocated overhead allocation methods.

Two-Stage Overhead Allocation

Stage 1
Stage 2
Allocate Total Costs to Pools
Allocate Pools to Products or Services

Nagle Manufacturing has identified 3 cost pools, each with a relevant driver. They can trace total overhead costs as follows.

Total overhead costs broken into cost pools

Using separate cost pools and drivers, Nagle Manufacturing can allocate total overhead costs more accurately to the products that consume those costs.

EXAMPLE - Occupancy Cost Pool allocation

A factory
Factory overhead

Mike's Bikes, Inc. decides to allocate factory Occupancy costs based on the square footage each department occupies. Occupancy costs include many common costs, like heat, air conditioning, water & sewer, lights, cleaning and maintenance, insurance, security and other related costs.

The company draws up a floor plan and measures how many square feet each department uses.

They had a total of $120,000 in Occupancy costs last year.

The company produced 6000 bicycles last year.

Occupancy Cost Pool Overhead Allocation

Department
Sq ft
Cost allocation formula
Allocated
to depts
Bicycles made
Overhead Per Bike
Assembly
5,000
 / 15,000 * $120,000 =
$40,000
/ 6000 =
$  6.67
Finishing
7,000
 / 15,000 * $120,000 =
56,000
/ 6000 =
9.33
Sales & admin
   3,000
 / 15,000 * $120,000 =
   24,000
/ 6000 =
   4.00
Total
15,000
$120,000
/ 6000 =
$ 20.00

NOTE: Only Assembly and Finishing costs are considered Product costs. Product costs become part of the cost of Finished Goods, which flows to Cost of Goods Sold. Sales and administrative costs are treated as Period costs against related revenue for the same time period, one year in this case. It's important to consider ALL costs when pricing a product.

Equivalent Units of Production

This is a concept that seems to confuse students. Don't worry, after working with the concepts for a couple of years they become much easier. Just kidding! But honestly, it is a difficult concept the first time or two around. Your success with this topic will largely depend on taking your time, and carefully working and reviewing a number of sample problems.

Equivalent units are mainly used in process accounting systems, but the method could also be used in a job order system. Equivalent unit calculations are used at the end of a month, to prepare monthly production reports. They are also used at the end of the year to determine ending inventory values.

The Equivalent Unit concept has to do with costs incurred, in the form of materials, labor and overhead. Let's say it costs the company $50 to produce 1 bicycle.

1/2 bike
+
1/2 bike
=
1 whole bike
Half of a bicycle
PLUS
Half of a bicycle
EQUIVALENT TO
Bicycle
$25
+
$25
=
$50

Let's say at the end of a day, two bikes are half completed, and have accumulated $25 in costs each. That is the same as one equivalent unit which has accumulated $50 in costs.

Using equivalents unit is a way to mathematically convert partially completed units of product into an equivalent number of fully completed units. Let's look at an example:

1000 units of Product X are 50% complete at the end of the month. We convert them into equivalent units as follows:

1000 units X 50% complete = 500 equivalent units

If they were 25% complete this would be the calculation:

1000 units X 25% complete = 250 equivalent units

So equivalent unit calculation is just a way to convert partly complete products into their equivalent number of fully completed products, using a little math. Remember, this is accounting; we are recording and reporting on costs, and trying to have the costs parallel the actual flow of production through the manufacturing process.

Let's look at a furniture company. They are producing a batch of 1000 wooden chairs. The wood is cut and shaped into component parts. The parts are sanded and assembled. Next paint or varnish is applied, and decorations and hardware are added. Under these circumstances, a batch of 1000 chairs could be at any stage of the production process at the end of a month. Using equivalent units would be appropriate in this example.

Of course, this doesn't make sense in every situation. Let's take a cookie bakery. They mix a batch of dough, bake the cookies, and package them all on the same day. There is no carry over of partially completed cookies from one day to the next. This company would not need to calculate equivalent units of production.

Unit Costs

A manufacturing company can make thousands of units of product in a given time periods. Some make millions of units per year. Ultimately those products have to be sold, and they are sold one at a time. So it is important for companies to know the unit cost of the products. This unit cost should include all costs when setting a selling price.

We can also analyze our production efficiency by looking at how unit costs change from month to month. We can break unit costs down into component parts as well, such as labor, material and overhead. This gives managers even more control over the manufacturing process.

We will study standard costs and budgets in a later lesson. Unit costs are very important in both of these areas. By comparing standard and actual costs per unit we can reduce waste, increase productivity, and manager resources more carefully.

Using ABC Costing Systems

Overhead costs are not treated as a single item in ABC systems. Costs are pooled by type or activity, and allocated to production using different cost drivers.

It is important to identify relevant and reliable cost drivers for different types of costs. For instance, square footage of floor space might be used to allocate heating and air conditioning costs. Costs usually go through a series of steps in the allocation process.

Just In Time Inventory Management

Just in time (JIT) inventory management systems have been widely used in the automotive manufacturing and assembly industry, as well as others. The idea is to have parts arrive at the assembly plant just in time to go into the production line when they are needed. The company does not keep an inventory of parts in storage. Very few extras are ordered, further eliminating waste.

JIT systems help companies in several ways. They reduce costs and risks associated with inventory. There is no need to warehouse parts, eliminating building, personnel and insurance costs. They reduce the risk of loss from damage, theft, obsolescence of inventory.

There's no difference in the accounting procedures associated with JIT systems. They are a way to manage the physical flow of inventory.

Using Spreadsheet Programs for Managerial Accounting

Spreadsheet programs (Excel, Lotus 1-2-3) are widely used in managerial accounting. The are very helpful for calculating ABC cost allocations. Standardized formulae can be entered into a spreadsheet. When monthly information is entered, the formulae do all the math, and calculate the final cost allocations.

A spreadsheet can be used to calculate equivalent units of production in a process costing system. They are also widely used in preparing budgets, performing incremental analysis calculations, and in C-V-P analysis for calculating break even points and creating graphs.

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