Process costing is a type of cost accounting method that is used to determine the cost of a product at each production stage or process. Hence, knowing when to use process costing for manufactured goods allows manufacturing companies to evaluate the amount of product that is being produced and how much is spent producing them.
The total costs a company is responsible for during production can be affected by factors such as the number of products completed and the number of products left in process at the end of an accounting period. This is one of the major reasons why a lot of large companies make use of the process costing method so that they can track the total costs and total inventory being produced. In this article, we will discuss when to use process costing and what this accounting method is about.
What is process costing?
Process costing is a cost accounting method that is used in industries to determine the cost of production of products that have passed through different processes of production before completion. That is, this accounting system accumulates the costs of a production process and allocates them to the products that the business produces. Hence, process costing is used when assigning production costs to mass-produced goods.
A large manufacturing firm that mass-produces inventory can use process costing to calculate the total amount of indirect and direct costs for products that are completed and left in process at the end of an accounting period. The main advantage of using this cost accounting method is that it provides information that the firm can use to make evaluative business decisions. For instance, by using this system, the firm can set prices according to the costs of production, and also management can assess profit margin by product and isolate problem products before they become serious issues.
There are four main steps involved in process costing which are the identification of the costs of each process, calculation of the equivalent unit, determination of the price per equivalent unit, and allocation of the costs to the units produced. This accounting method allows a company to accurately calculate the cost of goods sold and inventory value.
When using process costing, the procedure that is used to manufacture a product is divided into well-defined processes. For each process, a separate account is opened to which all incurred costs are charged. The finished material of one process makes up the raw material of the next process. Hence, the cost of each process is transferred alongside the finished material to the next process until it ends in the finished stock account.
In order to understand how this works, let’s look at an example. Assume ABC Company manufactures gadgets that require processing through multiple production departments. The casting department is the first department in the production process wherein the gadgets are initially created. Let’s say during the month of January, the casting department incurs direct material costs of $50,000 and $120,000 of conversion costs (comprised of direct labor and factory overhead).
In order to obtain the cost per unit, the total cost of a process is divided by the total number of units produced during a given period. This means that if the casting department processes 10,000 gadgets during January, the per unit cost of the gadgets passing through the department during this time period is $5 for direct materials ($50,000 / 10,000) and $12 for conversion costs ($120,000 / 10,000). Now, when these gadgets are moved to the trimming department for further work, these calculated per-unit costs will be carried along with the gadgets into this department, where similar calculations will be done and the additional costs will be added.
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When to use process costing
Process costing is used when the costs associated with individual units of production cannot be differentiated from each other due to the mass production of similar products. That is, when you use process costing, you calculate the costs accumulated over a fixed period of time and then allocate them to all of the units that are produced during that period of time. Hence, the cost of each unit produced is assumed to be the same as the cost of every other unit.
Therefore, process costing is used when there is a production of a large number of identical products; it is used by manufacturing companies that are involved in chemical processing, textiles, oil refining, cement, food production, glass, and paint. For instance, a typical example of when to use process costing is when determining the precise cost required to create one gallon of aviation fuel. Since there are thousands of gallons of aviation fuel produced out of a refinery every hour, process costing is an ideal accounting methodology that can be used to determine the precise cost of a gallon of aviation fuel.
Favorable conditions for when to use process costing
- Process costing can be used when there is a production of a single output in a plant
- It is used when there is a division of a plant into different processes and departments whereby each process is responsible for the production of a single product.
- Process costing is used when processing a single product for a scheduled time, followed by successive runs of other products (in this case, costs are calculated separately for each run).
- One of the favorable conditions for when to use process costing is the production of several products that are produced simultaneously from the same process.
- Process costing is used when there is a division of a factory into separate operations, whereby each operation performs standard protocols and procedures.
- It is used when costs are calculated process-wise.
Types of process costing and when to use them
There are basically three types of process costing calculation which are weighted average costs, standard costs, and first-in-first-out costing (FIFO). Cases, where there are minor cost fluctuations from period to period, are a typical scenario of when to use process costing (the weighted average costs method). When using the weighted average costs, all costs from a preceding accounting period or the current one, are added together and allocated to produced units. That is, the cost of goods available for sale is divided by the number of units available for sale to give us the cost per unit. This type of process costing is the simplest version to calculate.
The standard costs method, on the other hand, is based on standard costs. This type of process costing is used when companies find it too difficult or time-consuming to collect current information about the actual costs. It can also be used when a company produces a large number of products but finds it challenging to attribute precise costs to each of the products. When using this method, standard costs are assigned to production units, instead of actual costs. After the total costs are accumulated based on standard costs, they are compared to the actual accumulated costs, and the difference is charged to a variance account.
There are cases whereby costs change significantly from one period to the next; this is a typical scenario of when to use process costing (the FIFO method) in order to obtain more precise product costing. For the first-in first-out costing (FIFO) calculation, different layers of costs are created; one layer is created for any units of production that were started in the previous production period but not completed, and another is created for any production that is started in the current period. This type of process costing is, therefore, a more complex calculation compared to the weighted average costs and standard costs.
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