Peter Hann is a UK accountant and writes on finance, investment and tax topics.
When Is Process Costing Useful?
Some industrial products are countable. These come off the production line in separate units, and the accountant can add how many have been produced. Another type of product is uncountable. These substances do not come in discrete packages of one, two or three but are in the form of liquids, grains or particles.
Process costing is very useful for producing meaningful data for all types of industrial processes, whether they lead to the production of quality widgets or produce masses of liquid or sludge.
When Output Feeds Input
Process costing is useful when an industrial process goes through a number of stages, and the output of one stage of the process becomes the input for the next. It looks at the inputs, the process and the wastage in that process, measures quantities and puts a value on each unit of output.
When You Need to Measure Uncountable Products
Process costing can measure a product that you cannot count on your fingers. It can be applied to any industrial process where there is mass production of a homogeneous output. There may not necessarily be any widgets lined up in their boxes, bins or pallets. What you may have is an amorphous mass—a sludge, slush or fudge that may be a work-in-progress for the next stage of the process or an end product to be piped, shipped or otherwise transported to an eager or apprehensive customer.
This sludge could be oil, paint, paste, soap or molasses, but it is vital for the manufacturer to cost it correctly in the same way as the widget-maker arrives at a cost for each unit of stock. Process costing can arrive at a value for outputs that cannot be counted by taking into account the cost of inputs and the losses through wastage.
As the process of manufacture is normally continuous throughout the year, the costing process takes account of the changes in input prices, wastage and output volumes over time. Costs are accumulated over a specified period of time, computed using a process costing exercise and allocated to the units of output.
When There Are By-Products
There may be by-products along the way. Some substances will be removed in the course of manufacture and sold as a separate product, while further inputs may be added to the remaining substance. In the sugar refining process, the sugarcane is crushed into a liquid that is mixed with lime; then, after solids are settled out, the juice is concentrated into a syrup. After sugar crystallizes from the syrup, the molasses are separated out by centrifuging and may then be sold as a separate product.
The bleached colour of the refined sugar is then achieved by a process involving the input of sulphur dioxide. There are solid by-products of the process known as “bagasse” that may be used as fuel, sold as animal feed or used in paper production. Through process costing, the accountant arrives at a value for the cost of each of the by-products and for the remaining work in progress.
When Accurate Costing Is Essential (Always)
Accurate costing is an essential prerequisite for sensible management decisions. Process costing deals with this complexity and lets the manufacturer cost the outputs in a way that is useful to the business. If the management understands the costs involved, this can help them to set prices and budgets in a realistic way. The result is greater efficiency.
Accurately costing the output depends on maintaining a grip on the wastage and other losses and understanding the losses that take place during the process. During an industrial process there are losses due to waste, spoilage and evaporation of liquids. Some of the product may be taken out for testing purposes to ensure it is up to the required quality standards, and some of the product may be rejected as below par.
A business will gain some idea, based on experience and measurement, of the normal wastage involved in the manufacturing process. This can be taken into account in the process costing exercise.
Abnormal Losses and Gains
In addition to this normal loss, there may be abnormal losses caused by adverse conditions, faults or errors. This abnormal loss also needs to be measured. In some cases, the loss from wastage may be partly offset by the sale of a defective product, for example, for scrap value.
There could also be an abnormal gain resulting from a reduction of normal wastage, perhaps as a result of the introduction of new technology. Over time such technology changes may lead to a lower estimate for normal wastage that can be included in the calculations.
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Whatever the nature of the product, widgets or sludge, there must be a way of measuring the quantities input into the process and the units of output. This allows the calculation of the input costs and permits this cost to be allocated across the units of output.
If at each stage of the process, some of the output product is siphoned off for separate use or sale, while the rest forms the input for another process, each part of the output may then be costed correctly.
Depending on the nature of the product, the work in progress will consist of incomplete units that are not all in the same state. The costing process, therefore, requires a concept of equivalent units. In other words, twenty units that are 50% finished are equivalent to ten complete units, and so on.
Where the work in progress consists of incomplete units in varying states of readiness, this calculation will become more complex, and judgment will often be required in assigning a quantity or percentage to each category of work in progress.
Costing Is a Means to an End
The important point to bear in mind is that costing is a means to an end; that end is to provide useful information to management. The exercise of judgment is, therefore, more important than blindly following the figures and calculations. The calculation of equivalent units, in particular, must be based on realistic assumptions and must be updated for changes in processes and technologies.
Approaches to Process Costing
The use of weighted average costs that are then assigned to the units of output is the most straightforward way of approaching process costing. Where the business uses a standard costing system, this can be used for process costing. Standard costing assigns expected values to the costs of production in the period and then involves a separate calculation of variances between actual and expected costs.
FIFO and LIFO Methods
It would also be possible to use a first in first out (FIFO) method but this would involve assigning one set of costs to the product begun in a previous period and still in the course of production while assigning a different set of costs to the production of the current period. Last in, first out (LIFO) could not be used as the flow of production dictates that the first amounts of input go directly into the production process. The input of raw material at the beginning of the process is then acted upon by direct labour, whose costs are added during the production process, with the cost of overheads being applied as the process unfolds.
As mentioned before, the process costing is performed for the purposes of the enterprise and not the other way around. The method of application of process costing will therefore be the method most suited to the situation and needs of the enterprise.
There will be a process account for each stage of production, with the output from each stage becoming either an end product, one of the inputs for the next stage of production or both. Once the objective of process costing is known, there is no mystery about the entries in the process account.
- On the debit side are the values for the opening work in progress, materials, labour and overheads used in that stage of the process. There will be a value for units as well as cost, and a number of units must be entered for the opening work in progress.
- On the credit side, there will be values for the normal and abnormal loss, for work in progress and for the finished product that will be either transferred to the next process or sold. If there is an abnormal gain rather than a loss, this will be on the debit side.
The closing work in progress is carried forward to become the opening work in progress for the next period for the same stage of production, while the completed product becomes an input cost for the next stage of the process or is taken out of the process and sold.
If there are different processes within the enterprise, there may be a series of process accounts and outputs could, of course, be transferred between different production processes as well as continuing to the next stage of the same process. The process costing at each stage arrives at a cost for the inputs of the next stage and the end products for sale.
Which Costing Method Should You Use?
As with all costing processes, there is no single way to approach process costing. The accounting process, like the end product, may seem to be a bit of a fudge. Remember that costing is a means to an end rather than an end in itself. Costing is done to help management make good decisions about the business. The costing method that produces the most useful results is the method to use.
The precise costing method may depend on the nature of the product, the type of business and on what is done with the results of the costing when they are delivered to management. Once you know how the results are to be used, you can have some idea of how to go about producing a costing report.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.