Lecture note on Process Costing

Date: juli 2005

Author: Prof.dr.A.N.A.M. Boons

Key learning points

• In process industries detailed experienced-based knowledge is available to control the
manufacturing flow. This intimate knowledge can also be used to calculate product costs
and inventory valuation;
• Understand the differences between process costing and alternative costing systems;
• Being able to apply the weighted-average and first-in first out method;

Methods and instruments

Process costing is the name for a group of costing systems which are
especially suited for accumulating costs in an environment where the
production is characterised by a constant repetition of large numbers of
identical or similar products in a continuous flow.

This means that calculating product cost for each identifiable product
(unit) is not efficient or even meaningful, because each product has
practically the same product costs.

In a job order costing system costs are accumulated for each separate job
order throughout the different stages of production. In a process costing
system the opposite is realized: the costs are accumulated for each
production stage (also: department) for each period. In order to be able to
calculate the product cost an additional step is necessary: averaging the
total costs incurred in each production stage over the units produced
during the period. Before entering into a discussion on process costing
methods (calculating product costs and the valuation of inventory) a few
words on process control are called for, because the process costing
methods rest on data that are used to control the manufacturing
processes.

Work in Process (WIP)

Process A Process B Process C Inventory

Through Through Through Finished
Input Output Input Output Input Output
put put put Goods

Process D
Through
Input Output
put
Process control
In the field of Operations management a host of techniques are available
to control manufacturing processes. One of the most popular among them
is Statistical Process Control (SPC). This method is based on the statistical
properties of repetitive processes. When advanced computer-based
production technology is used an impressive amount of data is gathered
during the production flow. In addition to technical information quite a lot
of data are registered on productivity, resource consumption, reject rates
etc. Because the processes are repetitive this control information can be
summarized in a few statistics (for example: average, variance). In the
figure below the resource consumption over the most recent 100
production runs is gathered in a graph.

Statistical Process Control

60,00

50,00
Material consumption

40,00

30,00

20,00

10,00

-
0 20 40 60 80 100 120
Run number

Over the last 100 runs the average consumption of raw material was 40
kilo’s for each product. The dispersion around the mean was 5 kilo’s
(expressed in the standard deviation). Assuming that the distribution is
normal there is a 95% change that material consumption for each unit is
between 30 and 50 kilo. These values are called control limits: each
consumption rate above the lower control limit and below the upper
control limit is supposed to be ‘ in-control’ or normal. Resource
consumption outside the control limits is seen as ‘out-of-control’ or
abnormal (this apparently is caused by factors not included in normal
operations).

The distinction between normal and abnormal is important because in the

absence of absolute process control ‘ normal’ resource consumption and ‘
normal’ spoilage (rejection of substandard products) is treated as part of
the costs of production, where as abnormal resource consumption or
spoilage is taken as a period cost (written off as a loss).

In order to be able to calculate the product cost for the products

manufactured during a certain period in a certain production stage two
problems arise. The first is the treatment of normal costs versus abnormal
gains or losses. The second is the handling of inventory changes. Both
problems will be dealt with in this lecture note.
Scrap
In most manufacturing processes a number of products are rejected in a
quality inspection (these products do not meet the required
specifications; they are sometimes called ‘ off-spec’). In most cases the
rejection rate is an average based on past experiences and is considered
a normal phenomenon inherently bound to the manufacturing process.
For our purposes this is an important feature because the product cost
should cover the cost of expected spoilage and waste. On the other hand:
non-normal spoilage and waste are not included in product costs.

Suppose that in a certain production stage on each unit of input 20% is

lost as waste. If we were to start production with 1.250 units of input only
1.000 units of (approved) output would be produced on average. If each
units of input was acquired for € 20, then the total input cost would be €
25.000. If in the average production run 1.000 units of output are
produced then the product costs would be € 25. If these 1.000 units are
taken into inventory the valuation of these units is: € 25.000 (1.000 * €
25).

If in this process only 800 units of output are produced then 200 units of
rejected products are considered an abnormal loss (total number of
rejected units is 450 (1250-800), of which 250 (20% of 1250) are ‘ normal’
or expected and 200 units are an abnormal loss). If these 800 units are
added to inventory the inventory account is debited for € 20.000 (800 * €
25) and an amount of € 5.000 is taken to the Profit & Loss account (200
rejected units * € 25).

Normal loss 20%

Value of scrap € 5,00
Cost per unit of input € 20,00

Cost per
Normal Expected unit of Actual
Actual input Actual input loss Value of scrap output output output
Period (units) (euro) (units) (euro) (units) (euro) (units)
1 1.250 € 25.000 250 € 1.250 1000 €23,75 800
2 1.250 € 25.000 250 € 1.250 1000 €23,75 1.000
3 1.250 € 25.000 250 € 1.250 1000 €23,75 1.250

Total cost Total cost

Actual of Total Total cost incurred
scrap Abnormal loss Abnormal completed Total abnormal abnormal accounted less total
(units) (units) gain (units) production loss gain for scrap value
450 200 0 €19.000 € 3.750 €- € 22.750 € 22.750
250 0 0 €23.750 €- €- € 23.750 € 23.750
- 0 250 €29.688 €- €4.688- € 25.000 € 25.000

In some cases the rejected products can be sold. This revenue is called
scrap value. Suppose that in our example the rejected units can be sold
 for € 5 each. Then the scrap value of the normal or expected number of
rejected products must be deducted from the product cost. If 250 units
are rejected then € 1.250 of scrap value is earned for each production
run. Total cost of production accumulates to € 23.750, or € 23,75 per
accepted unit.
The value of the abnormal loss (or gain) is € 18,75 (€ 23,75 - € 5,00) per
unit.
In spreadsheet ‘ scrap’ this exercise is elaborated.

Process costing in a single stage process

The second problem in process costing is the matching of costs to units
for the calculation of product costs and the valuation of inventory. Two
methods are commonly used for this purpose: the weighted average
method and the first-in-first-out method. Both methods are explained in
this paragraph.

At regular intervals, usually a week or a month, the controller ‘stops’

production and accumulates the costs incurred during the interval and
determines the cost per product in order to evaluate the efficiency. In
continuous flow production (chemicals, paper, food) the flow of production
is not really interrupted at the time the controller finds it necessary to
calculate the product costs for the period that has passed. Stopping (in a
virtual sense) a continuous flow of production at regular, predetermined
points in time can be seen as freezing every motion as in a photograph. In
this picture only the products worked on during this second are visible.
The accumulated costs during the passed period are administratively
captured as the costs incurred between the previous ‘snapshot’ and the
most recent one. This means that the costs accumulated in the cost
records are related to the products which were semi-finished in the
previous photograph, the products finished during the period and the
semi-finished products in the most recent picture. If we want to calculate
the cost per product accurately we need to determine the exact number
of products the costs can be related to. That is what we call the
equivalent number of units (in short: the equivalent units).
In order to be able to work out accurate product costs we need to relate
the costs incurred during the period to the exact number of products
which caused these costs. In other words: taking into account not only the
units which were started and finished during the period but also the
percentage of completion of the units which were semi-finished when the
period started and the percentage of completion of the units semi-
finished at the end of the period.
 Weighted average method
The table shown below is taken from the excel-model ‘ process costing’
which is enclosed in the course materials.

Percentage of completion
Unit flow
during Direct
Conversion
period materials
Units in Work in process beginning of period 2.000
Units started during the period 12.000
Total units to account for 14.000

Units completed during the period 10.000 100% 100%

Units in Work in process end of period 4.000 100% 50%
Total units accounted for 14.000
Equivalent units
Direct
Conversion
materials
Units completed during the period 10.000 10.000
Units in Work in process end of period 4.000 2.000
14.000 12.000
Costing
Direct
Conversion Total
materials
Costs in Work in process beginning of period €6.000 € 4.000 € 10.000
Costs incurred during period €50.000 € 20.000 € 70.000
Total cost to account for €56.000 € 24.000 € 80.000

Cost per equivalent unit € 4,00 € 2,00 € 6,00

Cost of Goods completed €40.000 € 20.000 € 60.000

Cost of Work in process end of period €16.000 € 4.000 € 20.000
Total cost to account for €56.000 € 24.000 € 80.000

The 4.000 products in Work in Process (WIP) inventory at the end of the
period contain all direct materials and 50% of the conversion costs (=
costs of direct labour and variable manufacturing overhead). As for the
direct materials the products in WIP represent 4.000 equivalent units. The
conversion costs of the 4.000 products in WIP are related to 50% of 4.000
units = 2.000 equivalent units.

If the weighted average method is applied the total costs for each
category of costs is related to the total number of equivalent units of the
period. For instance: The total costs of direct material, € 56.000, is a
combination of € 6.000 costs of direct material all ready included in the
products in beginning WIP-inventory and the costs for direct material
incurred during this period, € 50.000. The cost per equivalent unit is
determined by dividing € 56.000 by 14.000 equivalent units. The cost per
equivalent unit is, in fact, a weighted average of direct material cost of
the products in beginning WIP and the products started during this period.
 This can easily be shown. The direct material costs of the products in
beginning WIP are € 3,00 (€ 6.000 / 2.000 units). The direct material costs
of the products started during this period (excluding the products in
beginning WIP) is € 4,17 (€ 50.000 /(14.000-2.000)). The weighted
average is:

3,00 * 2.000 + 4,17 * (14.000 − 2.000 )

= 4,00
(2.000 + 14.000 − 2.000 )

First In First Out method

A more accurate way of calculating the product cost in process costing is
the first-in first-out method (FIFO). By using FIFO the controller is able to
avoid the averaging of costs over the periods. Let’s continue our
example:

Percentage of
completion

Unit flow during Direct Conversio

period materials n
Units in Work in process beginning of
period 2,000 100% 10%
Units started during the period 12,000
Total units to account for 14,000

Units completed from beginning WIP 2,000

Units completed during the period 8,000 100% 100%
Units in Work in process end of period 4,000 100% 50%
Total units accounted for 14,000
Equivalent units
Direct Conversio
materials n
Units completed from beginning WIP 0 1800
Units completed during the period 8,000 8,000
Units in Work in process end of period 4,000 2,000
12,000 11,800
Costing
Direct Conversio
Total
materials n
Costs in Work in process beginning of € € €
period 6,000 4,000 10,000
€ € €
Costs incurred during period 50,000 20,000 70,000
€ € €
Total cost to account for 56,000 24,000 80,000

Cost per equivalent unit € 4.17 € 1.69 € 5.86

€ € €
WIP beginning 6,000 4,000 10,000
€ € €
Cost to complete WIP beginning - 3,051 3,051
Cost of goods completed from beginning € € €
WIP 6,000 7,051 13,051
€ € €
Started and completed this period 33,333 13,559 46,893
€ € €
Cost of Work in process end of period 16,667 3,390 20,056
 € € €
Total cost to account for 56,000 24,000 80,000

In this case we account for the percentage of completion of the products

in beginning WIP. In this example we assume that 2.000 units of products
are semi-finished on the first day of the period. The direct materials have
all ready been consumed, but the conversion costs have only been
applied for 10%. In terms of equivalent units the 2.000 units present on
the first day represent 2.000 equivalent units as for direct materials and
only 200 equivalent units for conversion costs.

If we look at the cost per equivalent unit on the first day of the period the
direct material costs amount to € 3,00 (€ 6.000 / 2.000 units) and the
conversion costs come to € 20 (€ 4.000 / (2.000 * 10%)).

The cost per equivalent unit during the period is calculated by dividing
the costs incurred during the period (cost in WIP is excluded) by the
number of equivalent units actually worked on during the period.

The conversion costs of finishing the products in beginning WIP is € 1,69

per equivalent unit. If we look at the conversion costs for the 2.000 semi-
finished units in beginning WIP than the total amount is:

2.000 * 10% * € 20 + 2.000 * 90% * € 1,69 = € 7.051

By distinguishing between periods it is possible to determine the profit

margin more accurately.