Process Costing

Introduction Process costing is a method of costing used to ascertain the cost of production of each process, operation or stage of manufacture where processes are carried in having one or more of the following features  Where the product of one process becomes the material of another process or operation  Where there is simultaneous production at one or more process of different products, with or without by product,  Where, during one or more processes or operations of a series, the products or materials are not distinguishable from one another, as for instance when finished products differ finally only in shape or form’. There are number of industries where:  The final product merges only after two or more process such as paper-the raw material, bamboo or sabai grass or any other, is made into pulp; pulp is a made into paper and then it is finished, glazed etc. for sale;  The product of one process becomes the raw material of another

process

or

operation

(for

example

refined

groundnut oil is the material for making vegetable ghee) and  Different products may have a common prior process (for example, brass goods will require melting of brass

1

commonly for all goods). Another example is petroleum products by the same refinery. A common feature is that production goes on without interruption and normally, special production is not arranged for meeting any particular order. In a steel mill, for example, when a customer orders a certain quantity, no special arrangements will be made for him-his order will be executed out of the quantity produced in general. Thus, 100 tonnes of steel sheets of a certain size cannot be distinguished from the remaining quantity of steel sheets of that size i.e. goods are produced without waiting for any instructions or orders from customers and are put into warehouse for sale. Further,

often-important

by-products

are

produced

automatically at the end of each process. These by-products may have an importance almost equal to that of the main product. Consider kerosene oil, diesel oil, naptha and petrol which are all produced from the same crude oil, in addition to host of smaller products. In such industries the method of cost accounting used us known as Process Accounts. it may be possible to find out the total cost without distinguishing the cost of each process but it is not

desirable to do so. Wastages and by-products of

different nature may rise out of each operation or process. Each process is likely to entail different types of expenses. It 2

would thus be advisable to find out the cost of each process or operation separately. Sometimes, it is possible to either process the materials ourselves or buy them ready for use in the next process, for instance, if one wants to market perfumed castor oil, one can buy castor seed and carry out all necessary perfume and colour and bottle it and market it. The decision will depend upon the cost and the price prevailing in the market. This is another reason why cost of each process should be ascertained.

3

Definition In his “A Dictionary for Accounts”, Eric L. Kohler Defines process as: 1. Any unbroken series of acts, steps, or events or any unchanging persisting condition. 2. Hence, the sequence of operations 3. Making up a plan of production, as on an assembly line; and continuous system involving an unbroken chain of activities 4. And a more or less continuous operation on constant, as distinguished from a job order system of production.” Process costing is defined by Kohler as: “ A method of accounting whereby costs are charged top processes or operations and averaged over units produced; it is employed principally where a finished product is the result of a more or less continuous operation, as in paper mills,

refineries,

canneries

and

chemical

plants;

distinguished from job costing, where costs are assigned to specific orders, lots or units.

4

Features/Characteristics of Process Costing  Process Costing Method is applicable where the output results from a sequence of continuous or repetitive operations or processes and products are identical and cannot be segregated.  It enables the ascertainment of cost of the product at each process or stage of manufacture. The following features may be identified with process costing:  The output consists of products, which are homogenous.  Production is carried on in different stages (each of which is called a process) having a continuous flow.  Production takes place continuously except in cases where the plant and machinery are shut down for maintenance etc. Output is uniform and all units are identical during each process. It would not be possible to trace the identity of any particular lot of output to any lot of input.  The input will pass through two or more processes before it takes the shape of the output. The output of each process becomes the input for the next process until the final product is obtained, with the last process giving the final product.  The output of a process (except the last) may also be saleable in which case the process may generate some profit.

5

 The input of a process (except the first) may be capable of being acquired from the outside sources.  The output of a process is transferred to the next process

generally at cost to the process. It may also be transferred at market price to enable checking efficiency of operations in comparison to the market conditions.  Normal and abnormal losses may arise in the processes

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. So, a lot of companies prefer to use process-costing system.

When process costing is applied?

6

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.

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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

the manufacturing process.

cost

control

Process

over 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.

8

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.

Elements/Components of Cost For the purpose of cost accounting, the process industry is divided into separate departments with each department representing a specific process. The Direct Material and Direct Labour Costs are collected for each department separately and the

overheads,

which

are

collected

over

all

the

departments/processes, are apportioned over the various departments/processes on some rational basis The following are the main elements/components of costs involved in the manufacturing process where process costing is adopted. 9

Direct Materials There are two types of materials that we come across in process costing.  Primary Material

Materials that are introduced in the initial process, which is passed on to the next process after completion of processing.  Secondary Material

Materials, which are introduced in the first or subsequent processes in addition to, the main material introduced in the initial process. This gets mixed up with the main material and is passed on to the subsequent processes as a part of the output. Direct Labour The direct labour cost is incurred in every process. Identification of direct Labour cost is also relatively easy in process costing industry 10

Direct Expenses Expenses in addition to Direct Material and Labor, which can be directly attributable to a particular process. These are costs relevant to specific processes. Production Overheads The overhead expenses are generally expended over all the processes involved in production. These are to be apportioned over the various processes in an amicable manner. Methodology of Recording/Accounting Costs Financial Accounting Methodology is adopted for recording costs involved. A nominal account representing each process is used to record all the costs relevant to a process. They are named "Process I a/c", "Process A a/c", "Refining Process A a/c", etc., Numbers, Alphabets or any word or phrase representing the process are used as suffixes/prefixes to distinguish the processes from one another. Stocks relevant to a process are maintained in a separate stock account. Where the output relevant to a process is sold apart from being transferred to the next process, it generates revenue. These revenues relevant to a process, are generally recorded using the process account or the stock account. Each process account is Debited with The Primary Direct Material Cost, Secondary Direct Material

11

Cost, Direct Labor Cost, Direct Expenses and proportion of Production Overheads apportioned to the process. Credited with The value of output transferred to the subsequent process or finished stocks.

Process I a/c

Dr

Quantit Particulars

Quantit

y

Amount

(in

(in Rs)

Particulars

y

Amount

(in

(in Rs)

4,00,00

Units) By Process II 10,000

6,24,00

To Other Material

0

a/c

0

To Direct

50,000

Labour/Labor

1,20,00

To Production

0

Overheads

54,000

To Direct Material

Units) 10,000

Cr

6,24,00

6,24,00

0

0

This is the simplest form of the process account that we see. There is more to process costing than preparing this simple ledger account. To have a better understanding of the various terms that we come across in process costing let us learn using an example. 12

A product is finally obtained after it passes through three distinct processes. The following information is available from the cost records.

Process I Process II Process III Total

Materials Direct

Wages

Rs.

Rs.

Rs.

Rs.

2,600

2,000

1,025

5,625

2,250

3,680

1,400

7,330 7,330

Production Overheads

500 units @ Rs. 4 per unit were introduced in process I. Production overheads are absorbed as a percentage of direct wages. The actual output and normal loss of the respective processes are given below: Normal loss Output as a (Units) percentage of input

Value of scrap (per unit)

Process I

450

10%

Rs. 2

Process II

340

20%

Rs. 4

Process III

270

25%

Rs. 5

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Prepare the process accounts and the other relevant accounts. Preparation of Process I a/c Direct Material and Labour Costs There is a primary material input into the process to the extent of 500 units costing Rs. 4 per unit i.e. at a total cost of Rs. 2,000 (500 units × Rs. 4/unit). In addition to this there is a secondary Direct Material input into the process, which cost Rs. 2,600, and Direct Labour Costs are incurred for the process, which amounted to Rs. 2,250. All these costs are debited to the process account . Apportionment of Production Overhead Production overheads are absorbed as a % of direct wages. Therefore, Rate

of

Absorption

of

Production

Overhead

Total Production

=

= =

× Overheads 100 Total Direct Wages Rs. 7,330 Rs. 7,330 100%

× 100

⇒ Production overheads are 100% of Direct Wages. ⇒ Production overheads Chargeable to a process = Direct Wages of the Process × 100% Therefore, Production Overheads chargeable to: Process I Process II

= = =

Rs. 2,250 × 100% Rs. 2,250 Rs. 3,680 × 100% 14

= = =

Process III

Rs. 3,680 Rs. 1,400 × 100% Rs. 1,400

If there are no losses either normal or abnormal, then the output would be equal to the quantity input i.e. 500 units and its value is the total cost incurred in the process. This output would be transferred to the next process i.e. the Process II account. In such a case, the process account would be as follows: Dr

Particulars

Process I a/c Quantit

Quantit

y

Amount

y

Amount

(in

(in Rs)

(in

(in Rs)

Particulars

Cr

Units) To Material (Primary) 500

2,000

Units) By Process II 500

To Material

2,600

a/c

(Secondary)

2,250

To Direct Labour

2,250

9,100

To Production Overheads 500

9,100

500

9,100

Taking Losses into consideration If we are to consider the information relating to losses, then we need to think of the information relating to the process account in different terms. Gross Input [GI] The Quantity of Material that is input into the process. This is the number of units of the primary material introduced into the process. {Here it is 500 units.} 15

The secondary material introduced into the process may or may not result in an increase in the number of units. {Here it does not.} Normal Loss [NL] The Quantity of Loss that is acceptable to the production process. There may be a number of methods for calculating the loss. What we need to consider is the quantity of loss that is accepted as normal. {Here it would be 50 units (10% of input ⇒ 500 units × 10% = 50 units) Normal Output [NO] The output that should be obtained if the production is carried out under normal circumstances [Normal Output = Gross Input − Normal Loss] {Here it would be 450 units (500 units − 50 units)} Actual Output [AO] The Output that is actually achieved in the production process, where no information relating to this is given, we assume it to be equal to Normal Output. {Here it is given to be 450 units. Abnormal Loss [AL] Where the Actual Output is less than the Normal

Output

we encounter abnormal loss. ["Abnormal Loss" = "Normal Output" − "Actual Output"] {Since Normal Output (450 units) = Actual Output (450 units), there is no abnormal loss here}

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Abnormal Gain [AG] Where the Actual Output is more

than

the Normal Output

we encounter abnormal gain. ["Abnormal Gain" = "Actual Output" − "Normal Output" ] {Since the Normal Output (450 units) = Actual Output (450 units here, there is no abnormal gain even} Total Cost [TC] The total cost that is incurred in relation to the process. This is the total amount of debits made to the process account. {Here it is Rs, 9,100 (= Rs. 2,000 + Rs. 2,600 + Rs. 2,250 + Rs. 2,250)} Normal Loss Realization [NLR] The amount that is realizable by the sale of normal loss units. This will be the market value of the normal loss units. [Normal Loss Realization = Normal Loss in Units × Realizable Rate per unit] {Here it is Rs, 100 (= 50 units × Rs. 2/unit)} The normal loss may or may not have realizable value. Say, for example there will be loss of weight in the production process, then the loss in weight is normal but it has no physical form and is not realizable. Normal Cost [NC] The cost that should have been incurred for the production process had they been normal. It is the total cost reduced by the

normal

loss

realization.

[Normal Cost = Total Cost − Normal Loss Realization] 17

{Here it is Rs, 9,000 (= Rs. 9,100 − Rs. 100)} The normal loss may or may not have realizable value. Say, for example there will be loss of weight in the production process, then the loss in weight is normal but it has no physical form and is not realizable. Even where the loss is physically present its market value may be zero (like in the case of ash) Normal Cost of Normal Production (Per Unit) [NCNP/Unit] The Normal Cost per unit of Normal Output. This is the most important value that we derive which would be useful in the valuation of outputs and losses in processes.

Normal Cost of Normal Production (Per Unit)

=

Normal Cost Normal Output

NCNP/un it

NC = NO

Principle for Valuation of Output Since we assumed that there were no losses we can easily say that the value of output is the total cost incurred and therefore derive its value. But when there are losses and their realizations, valuing output in this manner is not advisable. There is one universal principle that is followed, whether be it in financial accounting or cost accounting, which is as follows: 1000 units of material have been input into a production process at a total cost (material, labour, overheads) of Rs. 1,00,000 i.e. @ Rs. 100 per unit. 100 units of material have been lost in the production process. These 100 loss units would fetch a price of Rs. 1 per unit if sold in the market. 18

Considering the loss as normal Say, the production process is such that this loss of 100 units can be considered normal (this proportion of loss would be incurred every time the production is taken up) In such a situation, the cost incurred for getting an output of 900 units (1000 - 100) can be interpreted in the following ways: The cost incurred For 900 units is Rs. 90,000 (900 × 100) For 900 units is Rs. 1,00,000 being the total cost incurred. This would result in the unit output cost working out to Rs. 111.11 (1,00,000 ÷ 900) For 900 units is Rs. 99,900 (1,00,000 − 100) being the total cost incurred reduced by the amount realized on selling the loss units. This would result in the unit output cost working out to Rs. 111 (99,900 ÷ 900) The last idea would be the most appropriate one for deciding the cost per unit of output. The idea relating to cost should also be created based on what happens if we consider a similar transaction immediately. Suppose we need another lot of 900 units of this product, how many units have we to introduce into the production process? Surely, 1,000 units as 100 units will be lost in production process for sure (since the loss is being termed normal). Therefore the amount that we have to spend would also be equal to the total cost relevant to 1,000 units i.e. Rs. 1,00,000.

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However, since the loss units are capable of being sold for Rs. 1 each every time such loss occurs, using this realization can set off the cost incurred in which case the net cost to be incurred for getting the output of 900 units is Rs. 99,900.

Quantit y (Units) Gross Input Less: Normal Loss Net Output

Oil

1,000

Value (Rs.) 1,00,00 0

Rate (Rs./Unit ) 100.00

100

100

900

99,900 111.00

Refinery 20

1.00

Processes

Oil refineries have normally 3 processes 1. Crushing process 2. Refining process 3. Finishing Process Crushing process In this process raw material i.e. oil seeds or coconut or kernels etc. are used. Other expenses of the process are debited. Sale of bags or sacks is credited. Oil cakes or oil residue are sold as a by-product. The output is crude oil transferred as input in the next process. There may be loss in weight in the process. Refining Process Crude oil from Crushing process is debited. Other materials, wages and overheads of the process are debited. Loss-Inweight if any, is credited. The output is refined oil. Fats and residual oil may be obtained as by-products, which are credited. The output being refined oil is transferred to the next process i.e. Finishing Process. Finishing Process Refined oil obtained from Refining Process is debited. Other materials Wages and overheads of the process are debited. Sale of by-product and loss –in- weight are credited. Sundry sales of finished oil process are debited. The balance of this product is credited as cost of production of refined oil. Cost of drums or barrels or tins for storage of refined oil is also debited to find out cost of stored finished oil. 21

Illustration: In an oil refinery, the product passes through three

different

processes.

The

following

information

is

available for the month of January.

Crushing

Refining

Finishing

Process Rs.

Process Rs.

Process Rs.

9,00,000 32000 4800 2000 2400

23600 4000 7600 4000

23500 6000 3800

Raw materials (500 tons Copra) Wages Power Sundry Materials Factory Expenses

Cost of drums for storing finished oil was Rs. 84100. 200 tons of oil cakes were sold for Rs. 60,000 and 275 tons of crude oil was obtained. Sundry by-product (25tons) of Crushing process fetched Rs. 3,600. By-product after refining the oil was sold for Rs. 3600 (20 tons) and 250 tons of refining oil was obtained. 240 tons of finished oil was stored in drums and 10 tons were sold For Rs. 4,800. The establishment expenses for the period amounted to Rs 14,000 which is to be charged to the 3 processes in proportion 3:2:2 Prepare accounts for all the processes. Crushing Process Account (For the month of January) 22

Particulars

Tons

To Raw materials

Rs.

Particulars

500 9,00,000 By Sale of oil cakes

To wages

32,000 By sundry by-product

To power To Sundry

Tons

Rs.

200

60,000

25

3,600

4,800 By crude oil

materials To factory

2,000 transferred

expenses

2,400 to Refining Process

To office on cost

6,000 (@Rs.3213.09 per ton) 500 9,47,200

275 8,83,600 500 9,47,200

Refining Process Account Dr

(For the month of January)

Particulars

Tons

Rs.

To Crude Oil transferred from crushing process

Cr

Particulars

Tons

Rs.

By Sale of oil cakes

20

3,600

275 8,85,600 By Loss in weight By Refined oil

To Sundry materials

5

7,600 transferred

To wages

23,600 to finishing Process

To power

4,000 (@Rs.3, 692.8 per ton).

To factory expenses

4,000

To office on cost

4,000 275 9,26,800

25 9,23,200

275 9,26,800

Finishing Processes Account (For the month of January) Particulars

Tons

Rs.

Particulars

Tons

Rs.

10

4,800

To refined Oil transferred from Refining process

250 9,23,200 By Sundry Sales 23

By cost of finished Oil c/d (@Rs. 39,82,08 To wages To power

23,500 per ton) 6000

To factory expenses To office on cost

240 955,700

3,800 4,000 250 9,60,500

250 9,60,500

To Cost of Finished b/d

240 9,55,700

To cost of Drums

84,100 10,39,80 240 10,39,800

EXECUTIVE SUMMARY

24

240

0

Process costing is used in production processes where relatively large numbers of nearly identical products are manufactured. The purpose of a process-costing system is the same as that of a job-order costing system-to accumulate costs and assign these costs to units of product. Product costs are needed for planning, cost control, decision making, and reporting to various outside organizations. The flow of costs in process-costing systems and job-order costing systems is the same. Costs of direct material, direct labor, and manufacturing overhead are added to a Work-in-Process Inventory account. Direct labor and manufacturing overhead are often combined into a single cost category termed conversion costs. When products are completed, the costs assigned to them are transferred either to Finished-Goods Inventory or to the next production department's Work-in-Process Inventory account. In sequential production processes, the cost of the goods transferred from one production department to another is called transferred-in cost. There are some important differences between joborder and process-costing systems. Chief among these is that job-order costing systems accumulate production costs by job or batch, whereas process-costing systems accumulate costs by department. Another important difference is the focus on equivalent units in process costing. An equivalent unit is a measure of the amount of productive input that has been applied to a fully or partially completed unit of product. In process costing, production costs per equivalent unit are calculated for direct-material and conversion costs. The key document 25

in a process-costing system is the departmental production report, rather than the job-cost sheet used in job-order costing. There are four steps in preparing a departmental production report: (1) analyze the physical flow of units, (2) calculate the equivalent units, (3) compute the cost per equivalent unit, and (4) analyze the total costs of the department. In the weighted-average method of process costing, the cost per equivalent unit, for each cost category, is a weighted average of (1) the costs assigned to the beginning work-in-process inventory and (2) the costs incurred during the current period. Job-order and process costing represent the polar extremes of product-costing systems. Operation costing is a hybrid of these two methods. It is designed for production processes in which the direct material differs significantly among product lines but the conversion activities are essentially the same. Direct-material costs are accumulated by batches of products using job-order costing methods. Conversion costs are accumulated by production departments and are assigned to product units by process-costing methods.

CONCLUSION Companies need to allocate total product costs to units of product for the following reasons:

26

• 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, 27

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.

Bibliography 28



http://lsb.scu.edu/~schamberlain/ch17sol.pdf#search='process

%20costing'  http://soba.fortlewis.edu/lsc/acc226-f03/chapters.htm  http://www.futureaccountant.com/process-costing/studynotes/characteristics-features-application-industry.php  Wikipedia encyclopedia

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