Looking to take your business budget in control but don’t know how to go about it? Don’t worry – you

aren’t alone.

Many businesses struggle with the costs that they incur from getting the raw materials and producing the finished goods.

And while there are different costing methods out there, process costing remains one of the more popular ones.

So, is it the right one for you? Or should you be looking for something else? Is it what you should be looking for more productivity?

The fact that you need the right accounting method for your business is something that most businesses know.

Whether it be mitigating IRS risks or lowering your cash taxes, the right accounting method does work great.

Before we talk about that though, we will take a look at what the process costing method is.

WHAT IS PROCESS COSTING?

To understand what Process Costing is, you must first know about Cost Accounting.

This is basically a method that is used by a business to identify its total cost of production.

Input costs from each step of their production process are monitored and then matched against the actual output results generated to measure the company’s overall financial performance.

This type of method is useful as it helps with budgeting and setting up processes to improve their margins in the future.

In other words, Process Costing is one type of Cost Accounting that is widely used when the company produces mass homogenous products.

Due to this, the costs of individual units of output cannot be differentiated from each other.

This is because there is no quantifiable way to give each unit an individual cost when thousands of the same product are produced every hour.

You might have a great advertising strategy, but if you are looking for something more, you need to get down to the basics – like using the right accounting method.

THE TALE OF THE SOFT DRINK MANUFACTURER

For example, take a soft drink manufacturer.

Their factories would be manufacturing tens of thousands of liters every day.

There is no precise way to give a particular cost to just one liter of soft drink made that day. This is where process costing comes into play.

In this method, costs are accumulated in total over a fixed period of time and then summarized.

Over that period of time, there will be multiple processes that the products will go through, and a cost will be added to each process which will then be added together to get one total cost.

This cost will then be divided by the total number of products produced within that period, which will give out an average cost per unit.

Examples of this type of production would include food processing, chemical production, etc.

Let’s take the previous example of the soft drink manufacturer and put it into context.

The first process would be the production of the soda itself.

We’ll say that the direct material (DM) costs will come up to $100,000 and the conversion costs (CC) (includes the labor and factory overheads costs) will be $200,000.

For a month they can produce 100,000 bottles which would mean that the DM cost would be $1.00 and the CC would be $2.00.

These costs are then taken and added onto the next process, which would be the bottling department until you have a total cost per unit after going through all the processes.

TYPES OF PROCESS COSTING

There are three types of process costing which can be used in different situations.

  1. Weighted Average Costs – This is done by dividing the cost of goods that are available for sale by the number of products that are available for sale which will give you an average cost per unit.
  2. Standard Costs – This is similar to the weighted average method but uses a standard cost rather than the actual costs. Once this is measured, they are then matched against the actual costs incurred and are the difference is charged to another variance account. This is used when a company produces in large batches but have a varied mix of products to which they cannot assign separate costs to.
  3. First In First Out (FIFO) – This is the method of valuation where the first goods purchased are the first ones sold which is one of the best methods for a business to use as the risk of inventory going obsolete is reduced. It is a very complex calculation that uses layers of costs to account for significant changes in costs over time. This method is the most logically correct of all the process costing methods, and similarly, it is the hardest while the Weighted Average method is the easiest. 

THE 5 STEPS FOR PROCESS COSTING

Now that we have a basic idea of what process costing is let’s move on to the full method of how process is costing works.

There are basically five steps in this method that a business would have to go through:

  1. Analyze the flow of actual units
  2. Convert the inventory to determine the equivalent units
  3. Identify the total costs
  4. Calculate the average cost per equivalent unit
  5. Allocate these costs to finished units and Work in Process units 

1. Analyze the Flow of Actual Units

The first thing that the business should do is to identify the flow of units during the manufacturing process.

This type of costing relies on this distinct flow of units as it will determine exactly how the costs should be added on during the whole process.

As you read about before, when producing homogenous products there are usually several production processes involved.

Once these processes are identified, the costs will be added to each process in sequence until you get a final value that determines the cost related to that specific method of production.

Different manufacturers will have varying types of processes which can range from just two to over a dozen which will change the way costing is done drastically from each type of business.

2. Convert the Inventory to Determine the Equivalent Units

Equivalent units are the number of units that are completed during a certain stage of production.

As the production moves along the line, it is inevitable that not all units will be completed from one stage to the next.

The units that are not fully complete when it moves on to the next process are called “Work in Process”.

These units are calculated based on their stage of completion and how many processes it has gone through until now.

This percentage will depend on the type of business and the value that they set on which process the unit should be in to be called an equivalent unit.

For example, a furniture manufacturer may identify a unit as “complete” when it passes the cutting or assembling processes but are yet to go through the polishing process.

Whereas, a wine manufacturer would not be able to call their units complete until they have passed the aging and bottling stage which would take a long time in the production process.

So if production during that stage has 4 processes and 3 are completed, then the unit would be 75% complete which could be counted as an equivalent unit for the company.

Taking all this into account, the company should then determine the total number of equivalent units produced during that period by taking the total number of Work in Process units and multiplying it with the units that are complete. (Ex. 5000 Work in Process units x 0.75 {75%} = 3750 completed units).

If you are looking to know more about process costing, here is a video that talks about it in a simpler way.

3. Identify the Total Costs

The third step is to account for all the costs that are incurred during the whole production process.

This is done by adding costs to each process to get an average individual cost per unit.

Compared to the other costing methods available, this method uses quite a basic method to calculate these costs.

These costs are divided into direct costs and indirect costs.

The direct costs are usually noted down as:

  • Direct Labor – This is the cost of employing people to work on producing the product during that particular process. Ex: Factory worker on the bottling line.
  • Direct Materials – These are the costs of the raw materials that were used to produce the units during the process.
  • Manufacturing Overheads – This includes all the other costs that will be incurred during this time that are not accounted for in Direct Costs such as depreciation, rent, property tax, and electricity.

Other examples of indirect costs would include facility maintenance, worker salaries, quality assurance, and other factory supplies which are not directly related to manufacturing.

4. Calculate the Average Cost Per Equivalent Unit

Once all the costs have been identified for each process, then it’s a simple process to calculate the average cost per unit.

All of these costs from each process are added together to get one total cost, and this value is then divided by the total equivalent unit number to get the average equivalent cost per unit.

Example

Soda Manufacturing

Soda Production (First Process) – DM ($100,000), CC ($200,000)

Bottling (Second Process) – DM ($40,000), CC ($50,000)

Labeling (Third Process) – DM ($25,000), CC ($25,000)

Sealing (Fourth Process) – DM ($10,000), CC ($10,000)

Work in Process units – 100,000 units x 0.25 (Assuming completed percentage is 75%) = 25000 units

Total Costs – DM ($175,000) + CC ($285,000) = $460,000

Average Cost per Unit = $460,000/75000 units = $6.13 per unit

5. Allocate Costs to Finished Units and Work in Process Units

If you are looking to get the most accurate value of the costs incurred, here is the thing.

It’s not just the value of the equivalent costs that must be taken into account for that period.

Even if the Work in Process is half finished, they still incurred a cost during that period which must be added on as well.

Each stage of production will always have an opening inventory and closing inventory value which includes the Work in Process units that were brought forward from the last period of production.

To show this in an example, let’s say that 10,000 units which were halfway complete from the previous production period were brought forward as opening inventory.

Soda Manufacturing

Inventory brought forward – 5000 units (10,000 units * 0.50 {completion percentage from previous period})

Opening Inventory Value = 5000 units * $6 per unit (Value to produce these units since last period) = $30,000

Current Work in Process Units – 12500 units (25,000 units * 0.50 {completion percentage from current period})

Total Average Cost for the period = 75,000 units + 12,500 units = 87,500 units

$460,000 + $30,000 (Opening Inventory Value) = $490,000

$490,000/87,500 units = $5.6 per unit

Rather than calculating the cost based only on the equivalent units, the business can get a much more accurate value by including the Work in Process units too as they were also involved in the current period of production and so consumed direct material, direct labour, and other manufacturing costs as well.

It is also the same with the opening stock from the previous period as they were only halfway complete but then fully completed in the current period but not up to the full extent.

By adding a cost to both the equivalent and work in process units, the company can make sure that they are not leaving any of the costs unturned and will give a more accurate view of exactly how much the units from that period would cost them.

As can be seen in the example, the cost reduced from $6.13 per unit to $5.6 with the inclusion of the work in process units which can be quite a large amount when dealing in mass production of products.

THE ADVANTAGES AND DISADVANTAGES OF PROCESS COSTING

Now that we understand exactly how Process Costing works and when it’s best to be used let’s go through some of the pros and cons of using this method.

What are the Advantages of this Cost Accounting Method?

Flexible

By using this method, the business has a certain level of flexibility open to them when it comes to the production process. They can increase or reduce the number of processes that a product goes through depending on their needs.

For example, a business trying to improve their product may add another process in the production which will further refine their product and give it a better overall outlook. This process can be easily integrated into the system as all they have to do is identify the costs of this process separately and then add it onto the overall cost total.

In the same way, if the business is looking to cut down their costs, then they can monitor their processes separately and figure out a way to reduce one of the processes in such a way that they eliminate the cost from that process completely.

This will not be difficult to do as each process has the cost noted down separately.

By having this kind of flexibility, the business can make sure that they are running in the most cost-effective manner in the industry.

Easy to Use

This method is really simple to use as it does not involve any complex functions.

Basically, all it contains is calculating total cost per process and then dividing it by the total number of units produced.

It is also easy to allocate costs for each process as they are all taken separately and account for only a small part of the whole production process.

A Standardized Affair

Because the whole production process is standardized, managing and supervising the whole thing is quite easy as there is not much variation for things to go wrong.

Disadvantages that You Need to Take a Note of

Costing Mistakes

One major factor is the inaccuracy that can occur when it comes to setting costs.

There are chances where indirect costs that are not related to the production of the units may be included in the total costs.

This will lead to a false increase in the cost per unit and thus will fall on the consumers in the form of higher prices which may be above the market average.

This will lead to fall in sales revenue of the company as the consumers will switch from your product to another competitor.

Another issue may be that certain processes may not be included in the total cost (especially if the production process includes a lot of processes) which will result in under-costed products.

This would affect the profitability of the business as they unknowingly sell their products at a lower rate.

Time Consuming

This process can take quite a bit of time to complete due to the identification of equivalent and work in process units.

The business will have to calculate how far along all of their production units are so that they can put them under the correct category.

All of these units will have to be traced through the entire production line to ensure that the correct value is placed on them.

For instance, the value that it is placed at is a guess made by the employees of the business. If these are not guessed correctly, it will again cause discrepancies in the overall profitability of the business.

Since the process costs that are taken into account are average costs, it may not be the best option to get accurate information for company analysis and performance measurement as a whole.

Also, as the whole process works in sequence, there is the possibility that if one mistake in costing takes place at one of the beginning processes, it will be carried forward to the other processes from there onwards which again leads to inaccuracy of data.

IS IT THE RIGHT COST ACCOUNTING METHOD FOR YOUR BUSINESS?

This type of costing method is only valid for one type of business which produces homogenous products in vast quantities.

Most of the businesses in today’s world do not produce only one type of product but usually have a lot of variety to stay competitive.

That would make this method of costing redundant in the current market.

Unlike the other costing methods, this will only give you data on the cost of production and not on other factors such as the efficiency of their production process, machinery or employees.

In conclusion, process costing is one of the easiest and simple methods to do the costing for a business that specializes in producing mass homogenous products.

However, it has a lot of problems in terms of accuracy and effectiveness as it would not work in a highly competitive environment which is today’s business world.

5 Steps for Process Costing Method

5 Steps for Process Costing Method - #ProcessCostingMethod #StepsForProcessCosting #Accounting #Cleverism

Share your thoughts and experience

E-mail is already registered on the site. Please use the Login form or enter another.

You entered an incorrect username or password

Sorry, you must be logged in to post a comment.