1

MANAGEMENT ACCOUNTING AND CONTROL

(MNAC)

Session 10

Process Costing

Chapter 17 of Prescribed Text-Book : Horngren

Learning Objectives (1- 4 of Chapter 17)

LO 1. Identify the situations in which process-costing

systems are appropriate
LO 2. Understand the basic concepts of process-costing and
compute average unit costs
LO 3. Describe the five steps in process-costing and
calculate equivalent units
LO 4. Use the weighted-average method and first-in, first-out
(FIFO) method of process costing
 Job Versus Process-Costing

Job-costing systems Process-costing systems

Distinct, identifiable units Masses of identical or

of a product or service similar units of a product
or service
Examples: Examples:
Custom-made machines, houses Food, chemical processing
Clothes Manufacturing
(both process and job costing)
Process costing – cost per unit of each operation like cutting or sewing is identical
Job costing – different materials are used in different batches of clothing
 Process-Costing

• Many companies use mass-production techniques to produce

identical or similar units of a product or service.
• Examples: Apple (smartphones), Novartis (pharmaceuticals)
• Management accountants at companies like these use process
costing.
• It helps them to :
– Determine how many units of the product the firm has on hand
at the end of the accounting reporting period.
– Evaluate the units’ stages of completion.
– Assign costs to units produced and in inventory; choice of
method results in different operating income and affects taxes a
company pays and the performance evaluation of managers.
 Process-Costing

• Process costing is a system where the unit cost of a product

or service is obtained by assigning total costs to many
identical or similar units of output.

• Unit costs are calculated by dividing total costs incurred by

the number of units of output from the production process.
Unit Cost = Total Costs / No. of units of output

• Each unit receives the same or similar amounts of direct

materials costs (DM), direct manufacturing labor costs (DML),
and indirect manufacturing costs (Manufacturing O/H).
 More on Job Versus Process-Costing

• In a job-costing system, individual jobs use different

quantities of resources, so it would be incorrect to cost
each job at the same average production cost.
• In contrast, when identical or similar units of products
or services are mass-produced, process costing is used
to calculate an average production cost for all units
produced.
• The main difference between process costing and job
costing is the extent of averaging used to compute the unit
costs of products or services.
 Process-Costing (explained with illustration)

• Example - Pacific Electronics manufactures a variety of cell

phone models. These models are assembled in the Assembly
Department. Upon completion, units are transferred to the
Testing Department.
• Assembly Department process for one model, SG-40. All units
of SG-40 are identical and must meet a set of demanding
performance specifications.
• The Process costing for SG-40 in the Assembly department has
a single direct-cost category – Direct materials and
a single indirect cost category- Conversion costs.
Conversion costs – all manufacturing costs (manufacturing labor,
energy, plant depreciation etc.) other than direct material costs.
 Elements of Product Cost

Direct Labor cost + Overhead cost = Conversion cost

Conversion cost + Direct Material cost = Full production

cost

Full production cost + Selling cost + General and

Administration cost = Full Cost
 Process-Costing
• Direct materials – are added at the beginning of the
Assembly process
• Conversion costs- are added evenly during assembly.
• In this case of Pacific Electronics - Only two costs classifications are necessary to
assign costs to products because all direct materials are added to the process at one
time and all conversion costs generally added to the process evenly through time.

Conversion costs added

evenly during process
Transfer
Assembly Department Testing Department

Direct Materials added to

the process at one time
(at beginning )
 Process-Costing Cost Categories

Process-costing systems separate costs into cost categories

according to when costs are introduced into the process.

1. Direct materials are usually added at the beginning of the

production process, or at the start of work in a subsequent
department down the assembly line.
2. Conversion costs are generally added equally along the
production process.
 Process-Costing Cost Categories

Sometimes the situation is different:

a. If two different direct materials were added to the process
at different times with two direct materials categories would
be needed to assign these costs to products.

b. If manufacturing labor costs were added to the process at

a different time from when the other conversion costs were
added – an additional cost category- direct manufacturing
labor costs would be needed to separately assign these
costs to products.

.
 Process-Costing: Three Cases
Process-costing using three cases, of increasing complexity:

Case 1 : No beginning or ending work-in-process (WIP) inventories –

most basic process costing case and illustrates the feature of averaging of
costs (all units are started and fully completed within the accounting period)

Case 2 : No beginning work-in-process inventory (WIP) and some ending

work-in-process (WIP) inventory- introduces the five steps of process costing
and the concept of equivalent units (some units started during the accounting
period are incomplete at the end of the period).

Case 3 : Both beginning and ending work-in-process (WIP) inventories

are present- adds more complexity and illustrates the feature the effect of
weighted-average and FIFO methods have on cost of units completed and
cost of WIP inventory.
 Process-Costing: Case #1
No Beginning or Ending Work-in-Process Inventory

When using process costing without any beginning or ending

WIP inventory, all costs that were introduced to the process during
the period will be assigned to the finished units leaving no work-in-
process inventory at the end of the period.

Case 1 applies whenever a company produces homogeneous

product or service but has no incomplete units when each accounting
period ends (common situation in a service-sector organizations).

Example – Bank can adopt this process-costing approach to

compute the unit cost of processing 1,00,000 customer deposits,
made in a month because each deposit is processed in the same way
regardless of the amount of deposit.
 Process-Costing: Case #1
No Beginning or Ending Work-in-Process Inventory

Jan 1, 2017: There is no beginning inventory of SG-40 units in the

Assembly department. During the month of Jan, Pacific Electronics
started, completely assembled and transferred 400 units to the
Testing department.

Physical units refer to the number of output units, whether

complete or incomplete.
In Jan 2017, all 400 units started were completed.
 Process-Costing: Case #1
No Beginning or Ending Work-in-Process Inventory

. Pacific Electronics records these costs incurred in the Assembly department :

Cost per unit is calculated by dividing the total costs incurred in a given
accounting period by the total units produced in that period.

So, the Assembly department costs for SG-40 is Rs. 1400 per unit.
 Process-Costing: Case #2
No Beginning, Some Ending WIP

In Feb 2017 – Pacific Electronics places another 400 units of

SG-40 into production.
Note : All units placed into production in Jan were completely
assembled, there is no beginning inventory of partially
completed units in Assembly Department on Feb1(Case 1).
Some customers order late, so not all units started in Feb
are completed by the end of the month.
Only 175 units are completed and transferred to the Testing
Department.
 Process-Costing: Case #2
No Beginning, Some Ending WIP
Feb 28, 2017
225 partially assembled units are fully processed wrt. Direct materials – all direct
materials are added to the Assembly dept. at the beginning of the assembly process.
Conversion costs are added evenly during assembly – Assembly dept. supervisor
estimates that the partially assembled 225 units are on average 60 % complete wrt.
Conversion costs.
Accuracy of the completion estimate of conversion costs depends on the skill and
experience of the estimator and nature of the conversion process.
Estimating the degree of conversion is usually easier for direct materials costs than
conversion costs – Quantity of direct materials needed for a completed unit and Quantity of
direct materials needed in a partially completed unit can be measured more accurately.
Degree of completion of conversion costs depends on the production of the total
conversion costs needed to complete one unit that has already been incurred on the units
still in process.
Some units are fully assembled, and some are only partially assembled, common metric is
needed to compare the work that’s been done on them and obtain a total measure of the
work done – Equivalent units.
 Process-Costing: Case #2
No Beginning, Some Ending WIP

Feb 1- 28, 2017

400 units *Rs 800 (225 units *Rs 600)*60%

(81000)+(175*Rs 600)*100%
(105000)
 Process-Costing: Case #2
No Beginning, Some Ending WIP

FIVE-STEP PROCESS-COSTING ALLOCATION - to calculate

the a) the cost of fully assembled units in Feb 2017 and b) the
cost of partially assembled units still in process at the end of Feb
for Pacific Electronics :

1. Summarize the flow of physical units of output.

2. Compute output in terms of equivalent units.
 Process-Costing: Case #2
No Beginning, Some Ending WIP Steps 1 and 2
Flow of Physical Units and Compute Output in Equivalent Units for the Assembly Department for
February 2017

Step 1 : Managers track the physical units of output, whether complete or incomplete. (400 units
started – 175 units completed and transferred out and 225 units in ending inventory. There is no
beginning inventory and no. of units started must equal the sum of units transferred out and ending
inventory).

Step 2: Not all 400 units are fully completed. Compute the Equivalent units

EQUIVALENT UNITS:
• A derived amount of output units that:
– Takes the quantity of each input in units completed and in unfinished units of work in
process and
– Converts the quantity of input into the amount of completed output units that could be
produced with that quantity of input.
• Are calculated separately for each input. (direct materials and conversion cost).

• When calculating equivalent units in step 2, focus on quantities and disregard rupee amounts
until after the equivalent units are computed.
 Process-Costing: Case #2
No Beginning, Some Ending WIP Steps 1 and 2
Flow of Physical Units and Compute Output in Equivalent Units for the Assembly
Department for February 2017

Step 1 : 175 fully assembled units and 225 units partially assembled are 100%
complete wrt. Direct materials because all direct materials are added in the
Assembly department at the start of the process.

Step 2:

Output is 400 Equivalent units for direct materials : 175 equivalent units for the
175 physical units assembled and transferred out, and 225 equivalent units for the 225
physical units is ending WIP inventory.

Output is 310 equivalent units for the conversion costs :175 fully assembled units
have also incurred conversion costs . 225 partially assembled units ending WIP is 60
% complete on average- their conversion costs are equivalent to conversion costs
incurred by 135 fully assembled units (225 * 60% = 135 units).
 Process-Costing: Case #2
No Beginning, Some Ending WIP Steps 1 and 2
 Process-Costing: Case #2
No Beginning, Some Ending WIP

FIVE-STEP PROCESS-COSTING ALLOCATION –

3. Summarize total costs to account for.

4. Compute cost per equivalent unit.
5. Assign total costs to units completed and to units in
ending work-in-process.
 Process-Costing: Case #2
No Beginning, Some Ending WIP Steps 3, 4 & 5
Total Costs to Account For, Compute the Cost per Equivalent Unit, and Assign Costs to the Units
Completed and Units in Ending Work-in-Process Inventory for the Assembly Department for
February 2017
 General Ledger Cost Flows, Illustrated
Flow of Costs in a Process-Costing System for the Assembly Department for February
2017
 Process-Costing: Case #3
Some Beginning and Some Ending WIP

Flow of Physical Units and Compute Output in Equivalent Units Using the Weighted-
Average Method for the Assembly Department for March 2017.

Pacific Electronics had 225 partially assembled Sg-40 units in Assembly dept. It
started production of another 275 units in March.

Data given in the next slide now has both beginning and ending WIP .

Use the 5 steps used earlier for process costing “

First choose an inventory valuation method- Weighted-average method and

FIFO method.

Process costing can be accomplished using the weighted-average method or the

FIFO method
 Process-Costing: Case #3
Some Beginning and Some Ending WIP
First choose an inventory valuation method- Weighted-average method and FIFO method.

Process costing can be accomplished using the weighted-average method or the FIFO method
Weighted-Average Process-Costing Method

• Process costing using the weighted-average method

• Calculates cost per equivalent unit of all work done to date
(regardless of the accounting period in which it was done).
• Assigns this cost to equivalent units completed and
transferred out of the process, and to equivalent units in
ending work-in-process inventory.
• The Weighted-average cost is the total of all costs
entering the work-in-process account divided by the total
equivalent units of work done to date.
• The beginning balance of the work-in-process account (work
done in a prior period) is blended in with current period costs.
 Process-Costing: Case #3
Some Beginning and Some Ending WIP Steps 1 and 2
Flow of Physical Units and Compute Output in Equivalent Units Using the Weighted-Average
Method for the Assembly Department for March 2017
 Process-Costing: Case #3
Some Beginning and Some Ending WIP Steps 3, 4 and 5
Total Costs to Account For, Compute the Cost per Equivalent Unit, and Assign Costs to the Units
Completed and Units in Ending Work-in-Process Inventory Using the Weighted-Average Method for
the Assembly Department for March 2017
 Result of the Process – Weighted Average

• Two critical figures arise out of step 5 of the cost allocation process:

1. The amount of the journal entry transferring the allocated cost of

units completed and sent from work-in-process inventory to
finished goods inventory – Rs. 5,20,000

2. The ending balance of the work-in-process inventory account

that will appear on the balance sheet - Rs. 102,800
 Process-Costing: Case #3
Some Beginning and Some Ending WIP Steps 1 and 2
Flow of Physical Units and Compute Output in Equivalent Units Using the FIFO Method for the
Assembly Department for March 2017
 Process-Costing: Case #3
Some Beginning and Some Ending WIP Steps 3, 4 and 5
Total Costs to Account For, Compute the Cost per Equivalent Unit, and Assign Costs to the Units
Completed and Units in Ending Work-in-Process Inventory Using the FIFO Method for the Assembly
Department for March 2017
 First-In, First-Out (FIFO)
Process-Costing Method
• Assigns the cost of the previous accounting period’s equivalent units in
beginning work-in-process inventory to the first units completed and
transferred out of the process.
• Assigns the cost of equivalent units worked on during the current period
first to complete beginning inventory, next to started and completed new
units, and finally to units in ending work-in-process inventory.
• A distinctive feature of FIFO process-costing method is that work
done on the beginning inventory before the current period is kept
separate from work done in the current period.
• The costs incurred and units produced in the current period are used to
calculate the cost per equivalent unit of work done in the current period.
• In contrast, the equivalent-unit and cost per equivalent unit calculations
under the weighted-average method MERGE the units and costs in
beginning inventory with the units and costs of work done in the current
period.
Comparing Weighted-Average and FIFO Methods

• FIFO assumes that all the units from the previous period (higher-cost units in
our example) in beginning WIP are the first to be completed and transferred out and
that ending WIP consists of only the lower-cost current-period units.
• The weighted-average method smooths out the cost per equivalent unit by
assuming that more lower-cost units are transferred out and some higher-cost
remain in ending WIP.
• Managers use information from process-costing systems to make pricing and
product-mix decisions and understand how well a firm’s processes are performing.
• FIFO provides managers with information about changes in the costs per unit from
one period to the next.
• In a period of rising prices, the weighted-average method will decrease taxes
because cost of goods sold will be higher and operating income lower.
 Assignment Problems

17.16, 17.18,17.19, 17.20,

17.21,17.29,17.30,17.31,17.34,17.36

Case – Allied Chemicals (page 948)

 Basic Definitions

• Spoilage—units of production, whether fully or partially completed,

that do not meet the specifications required by customers for
good units and that are discarded or sold for reduced prices.
• Rework—units of production that do not meet the specifications
required by customers but that are subsequently repaired and
sold as finished goods.
• Scrap—residual material that results from manufacturing a product.
Scrap has low total sales value compared with the total sales
value of the product.
• Scrap is similar to byproducts but scrap arises as a residual from
the manufacturing process and is not a product targeted for
manufacture or sale by the firm.
 Accounting for Spoilage

• A certain amount of spoilage, rework, or scrap is inherent in many production

processes.
• Accounting for spoilage aims to determine the magnitude of spoilage costs and to
distinguish between costs of normal and abnormal spoilage .
• To manage, control, and reduce spoilage costs, they should be highlighted, not simply
folded into production costs.
• Normal spoilage is spoilage inherent in a particular production process that
arises even under efficient operating conditions.
– Normal spoilage rates are computed by dividing the units of normal spoilage by
total good units completed, not total actual units started in production.
– Management makes a conscious decision about the production rate per hour
which generates a certain level of normal spoilage.
• Abnormal spoilage is spoilage that is not inherent in a particular production
process and would not arise under efficient operating conditions.
– Abnormal spoilage is usually regarded as avoidable and controllable.
– To highlight the effect of abnormal spoilage costs, companies calculate the units
of abnormal spoilage and record the cost in the Loss from Abnormal Spoilage
account, which appears as a separate line on the income statement.
 Spoilage in Process-Costing Using Weighted Average and FIFO

• Units of normal spoilage can be counted or not counted when

computing output units (physical or equivalent) in a process-costing
system.
• Counting all spoilage is considered preferable and will be used in
our examples here.
• Inspection point—the stage of the production process at which
products are examined to determine whether they are acceptable or
unacceptable units.
• Spoilage is typically assumed to occur at the stage of
completion where inspection takes place.
• As a result, the spoiled units in our example are assumed to be
100% complete for direct materials.
The Five-step Procedure for Process Costing with Spoilage
(Slight Modifications to Accommodate Spoilage)

• Step 1: Summarize the flow of physical units of output—identify

both normal and abnormal spoilage.
• Step 2: Compute output in terms of equivalent units. Spoiled units
are included in the computation of output units.
• Step 3: Summarize total costs to account for.
• Step 4: Compute cost per equivalent unit.
• Step 5: Assign total costs to:
1. Units completed
2. Spoiled units
3. Units in ending work-in-process
 Steps 1 And 2, Example (with Spoilage Using Weighted
Average)
Weighted-Average Method of Process Costing with Spoilage for the Forming
Department for July 2017
 Steps 3, 4, and 5, Example (with Spoilage Using Weighted
Average)
Weighted-Average Method of Process Costing with Spoilage for the Forming
Department for July 2017
 Steps 1 And 2, Example (with Spoilage Using FIFO)
FIFO Method of Process Costing with Spoilage for the Forming Department
for July 2017
 Steps 3, 4, and 5, Example (with Spoilage Using FIFO)
FIFO Method of Process Costing with Spoilage for the Forming Department
for July 2017