Process Costing System

A process costing system is a method of assigning production costs to products that are made in large volumes of identical or very similar units, passing through a series of continuous processes. Instead of tracking costs for each order or batch, the system accumulates costs for each department or process over a period, then divides them by the number of units produced to arrive at an average cost per unit. It is used in industries such as oil refining, chemicals, food and beverages, paper, cement, textiles and pharmaceuticals.

Process costing contrasts with job order costing, which tracks costs separately for each distinct job or customer order, such as custom furniture, construction projects or audit engagements. Many companies use a hybrid, or operation costing, when they make batches of different products that share standard processes.

• Costs are collected by process or department, for example mixing, cooking and packaging in a food plant. Each department has its own work in process inventory account.
• Direct materials, direct labor and overhead are charged to each department as they are used. Labor and overhead are often combined as conversion costs.
• Partly completed units at the start and end of the period are converted into equivalent units of production, the number of whole units that the work done would represent.
• A cost per equivalent unit is calculated for materials and conversion separately, and costs are assigned to units completed and to ending work in process.
• Completed units' costs are transferred to the next department, and from the last department to finished goods inventory.

A paint manufacturer's mixing department starts the month with 2,000 litres in process, carrying costs of $3,000 for materials and $1,200 for conversion. It starts 18,000 more litres, adding $27,000 of materials and $22,800 of conversion costs. It completes 16,000 litres; the 4,000 litres still in process at month end have all their materials but are only 50 percent complete for conversion.

Equivalent units are 16,000 plus 4,000, or 20,000, for materials, and 16,000 plus 2,000 (half of 4,000), or 18,000, for conversion. The cost per equivalent unit is:

Here the numerator is total cost to account for in each category and the denominator is the equivalent units for that category. Materials cost is $30,000 divided by 20,000, or $1.50 per litre; conversion is $24,000 divided by 18,000, or about $1.333 per litre. Completed units cost 16,000 times $2.833, or about $45,333, and are transferred to the next process. Ending work in process is 4,000 times $1.50 plus 2,000 times $1.333, or $6,000 plus $2,667, which is $8,667. The total, $54,000, equals all costs to account for.

An alternative, the FIFO method, separates the cost of finishing beginning inventory from the cost of units started in the period, giving a purer measure of current-period efficiency.

Process costing is simpler and cheaper to run than job costing when output is uniform, and it produces regular unit cost figures useful for pricing, budgeting and control. However, it relies on estimates of the percentage completion of work in process, which can be subjective, and on averaging, which can hide differences between batches. Losses in production need care: normal losses are absorbed into the cost of good units, while abnormal spoilage is expensed separately. Overhead is applied using predetermined rates, as for factory overhead generally. Costs of finished goods ultimately flow to cost of goods sold when the products are sold.