Chapter 13: Process costing

Companies that mass-produce identical units, such as paint, soft drinks, steel or puzzles, do not track costs per job but per process. This chapter explains how costs flow through a process costing system, how equivalent units of production deal with unfinished goods, and how to prepare a production cost report with the weighted-average method (and briefly the FIFO method). The example is Puzzle Me, a puzzle maker, which the case class "Accounting is magic" also used.

How costs flow in process costing

In process costing each department or process has its own work-in-process account. Costs are added in each process, and at the end of the period the cost of the units completed is transferred to the next process and finally to finished goods. Puzzle Me has two processes: Assembly (glue a picture onto cardboard) and Cutting (cut the board into pieces and box it).

If the two processes together incur $265,000 to make 50,000 puzzles, the unit cost is 265,000 / 50,000 = $5.30. Unit costs are used to control costs, set prices and value work-in-process, finished goods and cost of goods sold.

Equivalent units of production

At the end of a period some units are still unfinished. The costs of the period must be divided between the units completed and transferred out and the units still in ending work-in-process. Equivalent units of production (EUP) express partly finished units as a number of fully finished units:

The percentage differs per cost category. Direct materials are often added at one point (start or end of the process), while conversion costs (direct labour + manufacturing overhead) are usually added evenly. Puzzle Me's Assembly Department completed 40,000 units (100% for everything) and has 10,000 units in ending WIP that are 100% complete for materials (added at the start) and 25% for conversion:

• Direct materials: 40,000 + 10,000 × 100% = 50,000 EUP.
• Conversion costs: 40,000 + 10,000 × 25% = 40,000 + 2,500 = 42,500 EUP.

The production cost report: four steps (weighted-average method)

A production cost report summarises the physical flow and the cost flow of a department. Two terms are central: to account for (what was in process at the start plus what was started or added) and accounted for (what happened to it: completed and transferred out, or still in process). The two must always be equal.

1. Summarise the flow of physical units. Assembly had 8,000 units in process on 1 July and started 42,000: 50,000 to account for. Accounted for: 40,000 transferred out + 10,000 in process = 50,000.
2. Compute equivalent units: 50,000 for materials and 42,500 for conversion (see above).
3. Compute the cost per equivalent unit. The weighted-average method puts the costs of beginning WIP and the costs added during the period into one cost pool.
4. Assign costs to units completed and to ending WIP: EUP × cost per EUP.

Step 4: units completed and transferred out: 40,000 × (2.80 + 1.60) = $176,000. Ending WIP: 10,000 × 2.80 + 2,500 × 1.60 = 28,000 + 4,000 = $32,000. Together $208,000: everything to account for is accounted for.

A later department: transferred-in costs

The Cutting Department receives the boards from Assembly. Their cost travels along as transferred-in costs: costs incurred in an earlier process and carried into a later process as part of the product's cost. Transferred-in units are always 100% complete for transferred-in cost. In Cutting, conversion is added evenly and the boxes (direct materials) are added at the end, so units in process have 0% of the materials.

Cutting had 5,000 units in process and received 40,000 (45,000 to account for); it completed 38,000 and has 7,000 in process, 30% complete for conversion.

Units completed: 38,000 × (4.40 + 0.50 + 0.40) = 38,000 × 5.30 = $201,400, the cost of goods manufactured. Ending WIP: 7,000 × 4.40 + 0 + 2,100 × 0.40 = 30,800 + 840 = $31,640. Total $233,040.

Journal entries in process costing

Costs are accumulated, assigned, allocated and adjusted as in job costing, but with one WIP account per department:

• Materials purchased $175,000: Dr Raw materials, Cr Accounts payable.
• Materials used: Dr WIP Assembly 130,200, Dr WIP Cutting 19,000, Dr Manufacturing overhead 2,000 (indirect), Cr Raw materials 151,200.
• Labour: Dr WIP Assembly 22,090, Dr WIP Cutting 3,840, Dr Manufacturing overhead 1,500, Cr Wages payable.
• Other overhead (depreciation 30,000 and 19,000 paid in cash) to Manufacturing overhead.
• Overhead allocated with a predetermined rate: Dr WIP Assembly 42,000, Dr WIP Cutting 11,000, Cr Manufacturing overhead 53,000.
• Transfer from Assembly to Cutting: Dr WIP Cutting 176,000, Cr WIP Assembly 176,000.
• Transfer to finished goods: Dr Finished goods 201,400, Cr WIP Cutting 201,400.
• Sale of 35,000 puzzles at $8: Dr Accounts receivable 280,000, Cr Sales revenue 280,000; Dr Cost of goods sold 185,500 (35,000 × 5.30), Cr Finished goods 185,500.
• Adjust over- or underallocated overhead to cost of goods sold.

Actual overhead was 2,000 + 1,500 + 30,000 + 19,000 = $52,500 and allocated overhead $53,000, so overhead was overallocated by $500 and cost of goods sold is reduced by 500.

The FIFO method (appendix)

The first-in, first-out method treats beginning WIP separately: it assumes those units are finished first, and it computes the cost per EUP with current period costs and work only. For Assembly: the 40,000 units completed consist of 8,000 from beginning WIP and 32,000 started and completed. Beginning WIP already had all its materials and 60% of its conversion. EUP for the current period:

• Direct materials: 0 (beginning WIP) + 32,000 + 10,000 = 42,000; cost per EUP 130,200 / 42,000 = $3.10.
• Conversion: 8,000 × 40% + 32,000 + 10,000 × 25% = 3,200 + 32,000 + 2,500 = 37,700; cost per EUP 64,090 / 37,700 = $1.70.

The weighted-average method mixes last month's and this month's costs; FIFO shows this month's cost performance separately. The two methods give somewhat different values for units transferred out and ending WIP.

Using the production cost report

Managers use the report to control costs (compare cost per EUP with budgets and earlier periods), evaluate department performance, price products, identify the most profitable products and prepare the financial statements. Products suited to process costing: light bulbs, nail polish, food processors, potato chips, magazines. Suited to job costing: a handmade painting, a lawsuit, a customised bouquet.