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Introduction to Process Costing Managerial Accounting

Process costing is the optimal costing system when a standardized process is used to manufacture identical products and the direct material, direct labor, and manufacturing overhead cannot be easily or economically traced to a specific unit. The cost flows in a process costing systemare similar to the cost flows in a job costing system. The primarydifference between the two costing methods is that a processcosting system assigns product costs—direct materials, directlabor, and manufacturing overhead—to each production department (orprocess) rather than to each job. Each production department hasits own work-in-process inventory account when using processcosting. Often, process costing makes sense if the individual costs or values of each unit are not significant. For example, it would not be cost effective for a restaurant to make each cup of iced tea separately or to track the direct material and direct labor used to make each eight-ounce glass of iced tea served to a customer.

For example, General Mills uses process costing for its cereal, pasta, baking products, and pet foods. Job order systems are custom orders because the cost of the direct material and direct labor are traced directly to the job being produced. For example, General Mills uses process costing for its cereal, pasta, baking products, and pet foods.

  1. The following journal entries relate to the production activity for the Packaging Department in May.
  2. For example, some items that are classified as overhead, such as plant insurance, are period costs but are classified as overhead and are attached to the items produced as product costs.
  3. This becomes the raw material of the subsequent stage until the final stage of completion.
  4. Understanding the full manufacturing process for a product helps with tracking costs.

Process costing is the optimal costing system when a standardized process is used to manufacture identical products and the direct material, direct labor, and manufacturing overhead cannot be easily or economically traced to a specific unit. Process costing is used most often when manufacturing a product in batches. Each department or production process or batch process tracks its direct material and direct labor costs as well as the number of units in production. The actual cost to produce each unit through a process costing system varies, but the average result is an adequate determination of the cost for each manufactured unit.

The equivalent unit is determined separately for direct materials and for conversion costs as part of the computation of the per-unit cost for both material and conversion costs. When the units are completed, they are transferred to finished goods inventory and become costs of goods sold when the product is sold. The sticks are dried, and then sent to the packaging department, where the sticks are embossed with the Rock City Percussion logo, inspected, paired, packaged, and shipped to retail outlets such as Guitar Center.

When the goods are eventually sold, the cost is shifted to the cost of goods sold account, where it appears on the income statement. In addition to setting the sales price, managers need to know the cost of their products in order to determine the value of inventory, plan production, determine labor needs, and make long- and short-term plans. They also need to know the costs to determine when a new product should be added or an old product removed from production. Notice that two different work-in-process inventory accounts areused to track production costs—one for each department. Process costing refers to a type of costing procedure commonly adopted by factories. In process costing, there is continuous or mass production and ongoing costs, which are accumulated regularly.

The assumption is that the cost of each unit is the same as that of any other unit, so there is no need to track information at an individual unit level. The next picture shows the cost flows in a process cost system that processes the products in a specified sequential order. That is, the production and processing of products begin in Department A. From Department A, products go to Department B. Department B inputs direct materials and further processes the products. The diagram above shows the cost flows in a process cost system that processes the products in a specified sequential order.

Using either a periodic or perpetual inventory system, we determine the amount of direct materials used during the period. We then calculate the number of units begun and completed during the period, as well as the number of units begun but not completed (work-in-process units). We generally assume that materials are added at the beginning of the production process, which means that a work-in-process unit is the same as a completed unit from the perspective of assigning material costs. We then assign the amount of direct materials used based on the total of fully and partially produced units. Manufacturing overhead includes indirect material, indirect labor, and other types of manufacturing overhead. It is difficult, if not impossible, to trace manufacturing overhead to a specific product, and yet, the total cost per unit needs to include overhead in order to make management decisions.

The second and third groups were started in May, so all of the whole units had materials added in May. (3) Group 3 has 7,300 (given) units started this month to be completed next month. (1) Group 1 consists of 5,900 (given) units started the previous month and completed this month. Calculating the unit cost for any work performed during a period is a key part of a production report. The following journal entries relate to the production activity for the Packaging Department in May.

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Process Costing, also called job-order costing, assigns total manufacturing costs to the units being produced. Process Costing is a system of product cost allocation used in merchandising and industry. The main objective is to allocate total manufacturing costs to the various products according to the proportion of resources consumed by each product. This becomes the raw material of the subsequent stage until the final stage of completion. There is no last in, first out (LIFO) costing method used in process costing, since the underlying assumption of process costing is that the first unit produced is, in fact, the first unit used, which is the FIFO concept. A process costing system accumulates costs and assigns them at the end of an accounting period.

Basic Managerial Accounting Terms Used in Job Order Costing and Process Costing

For example, assume a not-for-profit pet adoption organization has an annual budget of \(\$180,000\) and typically matches 900 shelter animals with new owners each year. Materials, labor, and factory overhead costs are added in each department. The sum of the departmental work in process costs is the total cost of the batch that is transferred to Finished Goods. For example, assume a not-for-profit pet adoption organization has an annual budget of $180,000 and typically matches 900 shelter animals with new owners each year. For example, some items that are classified as overhead, such as plant insurance, are period costs but are classified as overhead and are attached to the items produced as product costs.

Choosing Between Process Costing and Job Order Costing

One type of costing system that is used in certain industries is process costing that varies from other types of costing (such as job costing) in some ways. In process costing unit costs are more like averages, the process-costing system requires less bookkeeping than does a job-order costing system. Process costing is the only reasonable approach to determining product costs in many industries. It uses most of the same journal entries found in a job costing environment, so there is no need to restructure the chart of accounts to any significant degree. This makes it easy to switch over to a job costing system from a process costing one if the need arises, or to adopt a hybrid approach that uses portions of both systems. Overhead is assigned in a manner similar to what was just described for direct labor, where we estimate the average level of completion of all work-in-process units, and assign a standard amount of overhead based on that percentage.

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Also, when one order does not affect the production process and a standardization of the process and product exists. However, if there are significant differences among the costs of various products, a process costing system would not provide adequate product-cost information. Costing is generally used in such industries such as petroleum, coal mining, chemicals, textiles, paper, plastic, glass, food, banks, courier, cement, and soap. Understanding the full manufacturing process for a product helps with tracking costs. This video on how drumsticks are made shows the production process for drumsticks at one company, starting with the raw wood and ending with packaging. While both systems produce a cost of goods sold for a given period, Process Costing focuses on the product’s progression through various stages of production.

Manufacturing departments are often organized by the various stages of the production process. Each department, or process, will have its own work in process inventory account, but there will only be one finished goods inventory account. Process costing is an accounting methodology 7 4 prepare flexible budgets that traces and accumulates direct costs, and allocates indirect costs of a manufacturing process. Costs are assigned to products, usually in a large batch, which might include an entire month’s production. Eventually, costs have to be allocated to individual units of product.

Process costing can also accommodate increasingly complex business scenarios. While making drumsticks may sound simple, an immense amount of technology is involved. Rock City Percussion makes \(8,000\) hickory sticks per day, four days each week. The sticks made of maple and birch are manufactured on the fifth day of the week. It is difficult to tell the first drumstick made on Monday from the \(32,000\)th one made on Thursday, so a computer matches the sticks in pairs based on the tone produced. Rock City Percussion makes 8,000 hickory sticks per day, four days each week.

The computation of inventory for the packaging department is shown in Figure 5.7. We follow strict ethical journalism practices, which includes presenting unbiased information and citing reliable, attributed resources. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly.