Description of process costing in accounting
January 18, 2014
Company managers need to keep track of costs in order to make wise decisions about day-to-day operations. In this article, we discuss process costing, a method of allocating costs for manufacturers of many identical products.
Sometimes the task of assigning costs to an individual product is simple and cost-effective. Raw materials and labor are relatively easy to track for yacht manufacturers. For such companies, job costing is an efficient cost allocation method. What about a company that produces hundreds of thousands of indistinguishable products? How does a Coke plant determine the cost to produce a single bottle of soda in a way that is not prohibitively time consuming or expensive? For this type of manufacturer, we use a fundamentally different cost allocation method called process costing. Instead of tracing costs to an individual product, we instead trace costs to a single process and then allocate those costs to all products moving through that process. A Coke plant, for example, might have processes like mixing, bottling, and packaging.
Process costing is accomplished through a series of mathematical steps:
- Figure out how many units we need to track for the period (includes beginning WIP inventory, units started and finished in the period, and ending WIP inventory).
- Calculate an important quantity called equivalent units of production, or EUP (this concept will be discussed more thoroughly in the next section).
- Determine all costs to allocate to units of production for the period.
- Calculate cost per equivalent unit of production.
- Separate costs between units completed and units in ending WIP inventory.
The final goal is to determine costs to report in ending WIP and goods completed (these are either moved to the next process or sent to Finished Goods Inventory and eventually Cost of Goods Sold). Keep in mind that these steps need to be followed for each process in the manufacturing line of a large factory.
We also need to choose how we will handle beginning WIP inventory. There are two assumptions we can use: weighted-average process costing or first-in first-out (FIFO) process costing. For simplicity’s sake, we will focus on the less complex weighted-average method in this article.
Consider the simple example of a Coke bottling process center that had no beginning or ending WIP inventory. All units started in the period were moved along to the packaging center. In this case, EUP is simply the number of units sent to the packaging center. Unfortunately, the calculation is rarely that easy -- at the beginning and end of a period, some products will be in various stages of completion, so we need a way to account for partially-completed units.
The good news is that equivalent units of production can easily accommodate partially-finished units. We can easily visualize that two half-finished bottles would require the same amount of work as one completed bottle. Process costing calculates cost per equivalent unit instead of just keeping track of finished units to better match costs to products that are constantly moving through the process.
Process costing requires separate treatment of materials used and conversion costs (a combination of labor and overhead costs). Recall how some units will be incomplete at the beginning and end of a period. Materials are usually added at the beginning of the process, but labor and overhead might be applied at the end. For example, assume that 1,000 units are in ending WIP inventory and they are 100% complete for materials but 20% complete for conversion costs. For the bottling center, this might mean that 1,000 bottles have been filled, but inspection of the units is only half done. When calculating EUP, we will calculate one value for materials and another value for conversion costs.