PROCESS COSTING

LEARNiNG OBJECTiVES After studying this chapter you should be able to:

● explain when process costing systems are appropriate;

● explain the accounting treatment of normal and abnormal losses;

● prepare process, normal loss, abnormal loss and abnormal gain accounts when there is no ending
work in progress;

● explain and calculate equivalent units;

● compute the value of closing work in progress and completed production using the weighted average
and first in, first out, methods of valuing work in progress.

process costing system is used in industries where masses of similar products or services are produced.
Products are produced in the same manner and consume the same amount of direct costs and
overheads. It is therefore unnecessary to assign costs to individual units of output. Instead, the average
cost per unit of output is calculated by dividing the total costs assigned to a product or service for a
period by the number of units of output for that period. Industries in which process costing is widely
used include chemical processing, oil refining, food processing and brewing. For example, one litre of
beer that is produced is identical to another litre so the cost of one litre is identical to another.

In this chapter, we will examine the cost accumulation procedure that is required for inventory valuation
and profit measurement for a process costing system. This chapter can be omitted if you are pursuing a
management accounting course that does not require you to focus on cost accumulation for inventory
valuation and profit measurement (see ‘Guidelines for using this book’ in Chapter 1). We begin with a
description of the flow of production and costs in a process costing environment. We shall then look in
detail at the cost accumulation system. Three different scenarios will be presented. First, all output is
fully complete. Second, ending work in progress exists, but no beginning work in progress, and some of
the units started during the period are incomplete at the end of the period. Our third scenario is the
existence of both beginning and ending work in progress of uncompleted units. One of the most
complex areas in process costing is accounting for losses when units within the process are both fully
and partially complete. Because some courses omit this topic, it will be discussed in Appendix 5.1.

FLOW OF PRODUCTiON AND COSTS iN A PROCESS COSTiNG SYSTEM

The flow of production and costs in a process costing system is illustrated in Exhibit 5.1. The major
differences between process and job costing are also highlighted. You will see that production moves
from one process (or department) to the next until final completion occurs. Each production process
performs some part of the total operation and transfers its completed production to the next process,
where it becomes the input for further processing. The completed production of the last process is
transferred to the finished goods inventory.
The cost accumulation procedure follows this production flow. Control accounts are established for each
process (or department) and direct and indirect costs are assigned to each process. A process costing
system is easier to operate than a job costing system because the detailed work of allocating costs to
many individual cost units is unnecessary. Also, many of the costs that are indirect in a job costing
system may be regarded as direct in a process costing system. For example, supervision and
depreciation that is confined to one process would be treated as part of the direct costs of that process,
since these costs are directly attributable to the cost object (i.e. the department or process). By contrast,
such costs are normally regarded as indirect in a job costing system because they are not directly
attributable to a specific job.

As production moves from process to process, costs are transferred with it. For example, in Exhibit 5.1,
the costs of process A would be transferred to process B; process B costs would then be added to this
cost and the resulting total cost transferred to process C; process C costs would then added to this cost.
Therefore the cost becomes cumulative as production proceeds. The cost per unit of the completed
product thus consists of the total cost accumulated in process C for the period, divided by the output for
that period.

In contrast, job costing relates to a costing system where each unit or batch of output is unique. This
creates the need for the cost of each unit to be calculated separately. In practice, these two costing.

Process costing
Work in progress stock

Finished goods stock

Process A Process B Process C Completed

production
Input Output Input Output Input Output
Consists of stock of like
units valued at average
unit cost of production

No attempt is made to allocate costs to individual units of production.

Direct costs and factory overhead costs are allocated to process A, process
B and so on. When units are completed, they are transferred to finished
goods stock at average unit cost
Job costing
Work in progress stock

Job A Job B Job C

Finished goods stock

Consists of stock of
unlike units

Direct costs and factory overheads are allocated to

individual units of production

REAL WORLD ViEWS 5.1

The brewing process at SAB Miller Almost all beer contains four basic ingredients – a grain (typically
barley), water, hops and yeast. While the process of brewing can be complex and some ingredients
varied, the basic process is quite consistent. First the barley (or other grain) is soaked in water and
allowed to begin development into plants. Enzymes are released that break down the grain into simple
sugars. Once this process has begun, the barley is cooked, stopping the growth while the enzymes are at
their peak – this is the process of malting. Next is mashing, where the grain is actually transformed into
sugar by being crushed into a fine powder, or grist, and then soaked in water. The mash is heated and
strained to yield a substance called wort. The wort is then cooled and placed in a fermentation vessel.
Yeast is added and then the fermentation process produces alcohol. After about ten days, the beer is
separated from the yeast, then stored, filtered, pasteurized and finally packed into bottles, cans or kegs.

Questions

1 When does the ‘product’ materialize in the brewing process described above?

2 Would you imagine there is any waste in the brewing process?

systems represent extreme ends of a continuum. The output of many organizations requires a
combination of the elements of both job costing and process costing. We shall examine a costing system
that combines elements of job-order and process costing systems later in the chapter.
PROCESS COSTiNG WHEN ALL OUTPUT iS FULLY COMPLETE

Throughout this section, it is assumed that all output within each process is fully complete. We shall
examine the following six cases:

1 no losses within a process;

2 normal losses with no scrap value;

3 abnormal losses with no scrap value;

4 normal losses with a scrap value;

5 abnormal losses with a scrap value;

6 abnormal gains with a scrap value.

You should now look at Example 5.1. The information it contains will be used to illustrate the accounting
entries. To simplify the presentation, it is assumed that the product is produced within a single process.

No losses within the process

To calculate the cost per unit (i.e. litre) of output for case 1 in Example 5.1, we merely divide the total
cost incurred for the period of £120 000 by the output for the period (12 000 litres). The cost per unit of
output is £10. In practice, the cost per unit is analysed by the different cost categories such as direct
materials and conversion cost which consists of the sum of direct labour and overhead costs.

EXAMPLE 5.1

Dartmouth Company produces a liquid fertilizer within a single production process. During the month of
May the input into the process was 12 000 litres at a cost of £120 000. There were no opening or closing
inventories and all output was fully complete. We shall prepare the process account and calculate the
cost per litre of output for the single process for each of the six cases listed below:

Normal losses in process with no scrap value

Certain losses are inherent to the production process. For example, liquids may evaporate, part of the
cloth required to make a suit may be lost and losses occur in cutting wood to make furniture. These
losses occur under efficient operating conditions and are unavoidable. They are referred to as normal or
uncontrollable losses and are absorbed by the good production. Where normal losses apply the cost per
unit of output is calculated by dividing the costs incurred for a period by the expected output from the
actual input for that period. In case 2 in Example 5.1, the normal loss is one-sixth of the input. Therefore,
for an input of 12 000 litres the expected output is 10 000 litres so that the cost per unit of output is £12
(£12 0000/10 000 litres). When actual output is equal to expected output, there is neither an abnormal
loss nor gain. Compared with case 1, the unit cost has increased by £2 per unit because the cost of the
normal loss has been absorbed by the good production. Our objective is to calculate the cost of normal
production under normal efficient operating conditions.

Abnormal losses in process with no scrap value

There may be some losses that are not expected to occur under efficient operating conditions, caused
for example by the improper mixing of ingredients, the use of inferior materials and the incorrect cutting
of cloth. These losses are not an inherent part of the production process, and are referred to as
abnormal or controllable losses. Because they are not an inherent part of the production process and
arise from inefficiencies, they are not included in the process costs. Instead, they are removed from the
appropriate process account and reported separately as an abnormal loss. The abnormal loss is treated
as a period cost and written off in the profit statement at the end of the accounting period. This ensures
that abnormal losses are not incorporated in any inventory valuations.

For case 3 in Example 5.1, the expected output is 10 000 litres but the actual output was 9000 litres,
resulting in an abnormal loss of 1000 litres. Our objective is the same as that for normal losses. We need
to calculate the cost per litre of the expected output (i.e. normal production), which is:

input cost (£120 000)

= £12
expected output (10 000 litres)

Note that the unit cost is the same for an output of 10 000 or 9000 litres since our objective is to
calculate the cost per unit of normal output. The distribution of the input costs is as follows:

Completed production transferred

to the next process (or finished

goods inventory) 9000 litres at £12

Abnormal loss: 1000 litres at £12 108 000

12 000

120 000

The abnormal loss is valued at the cost per unit of normal production. Abnormal losses can only be
controlled in the future by establishing the cause of the abnormal loss and taking appropriate remedial
action. The entries in the process account will look like this:
 Process account

Unit cost Unit cost

Litres (£) (£) Litres (£) (£)

Input cost 12 000 10 120 000 Normal loss 2 000

Output to

finished goods

inventory 9 000 12 108 000

Abnormal loss 1 000 12 12 000

120 000 120 000

Process accounts represent work in progress accounts. Input costs are debited to the process account
and the output from the process is entered on the credit side. You will see from the process account
that no entry is made in the account for the normal loss (except for an entry made in the units column).
The transfer to the finished goods inventory (or the next process) is at the cost of normal production.
The abnormal loss is removed from the process costs and reported separately as a loss in the abnormal
loss account. This draws the attention of management to those losses that may be controllable. At the
end of the accounting period the abnormal loss account is written off in the profit statement as a period
cost. The inventory valuation will not therefore include any abnormal expenses. The overall effect is that
the abnormal losses are correctly allocated to the period in which they arise and are not carried forward
as a future expense in the closing inventory valuation.

Normal losses in process with a scrap value

In case 4, actual output is equal to the expected output of 10 000 litres so there is neither an abnormal
gain nor loss. All of the units lost represent a normal loss in process. However, the units lost now have a
scrap value of £5 per litre. The sales value of the spoiled units should be offset against the costs of the
appropriate process where the loss occurred. Therefore the sales value of the normal loss is credited to
the process account and a corresponding debit entry will be made in the cash or accounts receivable
(debtors) account. The calculation of the cost per unit of output is as follows:
 Input cost less scrap value of normal loss £120 000 2 (2000 3 £5)
= = £1
Expected output
10 000 litres

Compared with cases 2 and 3, the cost per unit has declined from £12 per litre to £11 per litre to reflect
the fact that the normal spoilage has a scrap value which has been offset against the process costs.

REAL WORLD ViEWS 5.2

Producing a world-famous whiskey Bushmills Irish Whiskey, a world-renowned brand of Diageo plc, is
distilled in County Antrim in Northern Ireland. The Old Bushmills distillery has been in operation since
1608 and currently markets five dis tinct whiskeys under the Bushmills brand. Whiskey production is
essentially a five-part process. The basic raw materials are barley and natural water. The first process,
malting, allows barley corns to germinate for four days. An enzyme called diastase is formed inside each
grain, which converts the starch in the grain to sugar. The corns are then dried in an oven. The second
process, mashing, takes the dried barley and grinds it into a flour called ‘grist’. Hot water is added to the
grist to produce a sugary liquid called ‘wort’. The wort is now ready to be transformed into alcohol by
fermentation. The third process, fermentation, is a simple natural process which occurs when yeast and
sugar are mixed. The wort is pumped into a large vessel, where yeast is added. Fermentation is allowed
to proceed for two days. The resultant liquid, called the ‘wash’ is now ready for transfer to the still
house for distillation, the fourth process.

Distillation involves heating the wash gradually in a large copper kettle called the pot still. As alcohol has
a lower boiling point than water, the a lcohol vapours condense first, run off and cool down to a liquid.
Two further distillations are performed to ensure purity. The resulting liquid, called spirit, is a clear liquid
with a high alcohol content. The final step, maturation, sees the spirit placed in seasoned oak casks for a
number of years – ranging from three to 21 years. The casks tend to be former American bourbon or
Spanish sherry casks. The spirit acquires its colour and flavour from the casks. Once matured for the
required period, the whiskies are bottled in the bottling plant at Bushmills, typically in 750ml bottles.

Questions

1 Why is job costing not appropriate to a process such as whiskey production?

2 Do you think losses of spirit might occur during the maturation process?