Process Costing

Introduction

Process costing is a form of operations costing which is used where standardized homogeneous goods are produced. This costing method is used in industries like chemicals, textiles, steel, rubber, sugar, shoes, petrol etc. Process costing is also used in the assembly type of industries also. In process costing, it is assumed that the average cost presents the cost per unit. Cost of production during a particular period is divided by the number of units produced during that period to arrive at the cost per unit.

Meaning of Process Costing

Process costing is a method of costing under which all costs are accumulated for each stage of production or process, and the cost per unit of product is ascertained at each stage of production by dividing the cost of each process by the normal output of that process.

Definition

CIMA London defines process costing as “that form of operation costing which applies where standardize goods are produced”

General Principles of Process Costing

• The majority of items of cost can ordinarily be identified with specific processes and collected and accumulated separately for each period.
• Production records of each process are so designed as would show the quantum of production for each period.
• The total cost of each process is divided by the total production by the process for arriving at the unit cost of the article processed.
• The cost of any normal spoilage or wastage is included in the cost of the total units produced. Thereby the average cost per unit is increased.
• As the product travels from one process to another, the cumulative cost thereof in respect of the processes it has already undergone is transferred to the account of the process it has yet to undergo.

Features of Process Costing

• The production is continuous
• The product is homogeneous
• The process is standardized
• Output of one process become raw material of another process
• The output of the last process is transferred to finished stock
• Costs are collected process-wise
• Both direct and indirect costs are accumulated in each process
• If there is a stock of semi-finished goods, it is expressed in terms of equivalent units
• The total cost of each process is divided by the normal output of that process to find out cost per unit of that process.

A common example of an industry where process costing may be applied is “Sugar Manufacturing Industry.

Applications of Process Costing

Process costing is being used by following Industries as under:

• Identical Products Industries: Process costing is most often used when manufacturers release identical products. If mass produced televisions have the same parts, manufacturers can assign consistent prices to the products based on how much the products cost to manufacture overall.
• Industries with Multiple Departments: Businesses that have multiple departments usually use process costing so that management can assess the costs accumulated by each department. For example, one department can take the raw resources and refine them before turning them into finished parts, another department can assemble the parts and a third department can test the finished product to assess both quality and safety. Materials might need to be shipped from one department to another, which may incur additional costs. When the costs of production go up unexpectedly, process costing can allow management to quickly pinpoint the department responsible for the increased costs and identify the source of the increased cost.
• Industries with Interchangeable Parts: Process costing comes into play when a factory manufactures identical parts. For example, a computer manufacturing plant will create numerous components that are interchangeable among computers of the same model. Process costing allows manufacturers to sell individual parts separately to computer repair shops or individual buyers, since the manufacturers know the cost of the separate parts.
• Industries with Varying Product Features: Products that have multiple extraneous features can benefit from process costing. Manufacturers can release two versions of the product, with one version costing less but having fewer features and another product costing more but having more features. For example, a manufacturer might release two coffee pots, one with a timer and one without. Process costing lets the manufacturer know how much the timer costs to add to the coffee pot, which enables the manufacturer to gauge how much it must raise the price on the coffee pot with the timer.
• Innovative Industries: Process costs are important in industries that have high innovation. For example, manufacturers cannot determine an appropriate price for a new type of product without knowing how much the product will cost to manufacture overall. In addition, businesses cannot determine if a product will be profitable until they know the overall cost so they can estimate the maximum price that customers will pay for the product.

Advantages of Process Costing

• Costs are be computed periodically at the end of a particular period
• It is simple and involves less clerical work that job costing
• It is easy to allocate the expenses to processes in order to have accurate costs.
• Use of standard costing systems in very effective in process costing situations.
• Process costing helps in preparation of tender, quotations
• Since cost data is available for each process, operation and department, good managerial control is possible.

Limitations of Process Costing

• Cost obtained at each process is only historical cost and are not very useful for effective control.
• Process costing is based on average cost method, which is not that suitable for performance analysis, evaluation and managerial control.
• Work-in-progress is generally done on estimated basis which leads to inaccuracy in total cost calculations.
• The computation of average cost is more difficult in those cases where more than one type of products is manufactured and a division of the cost element is necessary.
• Where different products arise in the same process and common costs are prorated to various costs units. Such individual products costs may be taken as only approximation and hence not reliable.

Cost of Process

The cost of the output of the process (Total Cost less Sales value of scrap) is transferred to the next process. The cost of each process is thus made up to cost brought forward from the previous process and net cost of material, labour and overhead added in that process after reducing the sales value of scrap. The net cost of the finished process is transferred to the finished goods account. The net cost is divided by the number of units produced to determine the average cost per unit in that process.

Process Account Specimen

Particular	Units	Amount in Rs.	Particulars	Unit	Amount in Rs.
To Basic material			By Normal Loss
To Direct Material			By Abnormal Loss
To Direct labour			By Process II (Output transferred to next processes)
To Direct Expenses			By Finished stock
To Production overhead
To Cost of rectification of defective material
To Abnormal gains
	XX	XXX		XX	XXX

Process Losses

In manufacturing processes, entire input is not getting converted into output. A certain part of input is lost while processing which is inevitable. Certain production techniques are of such a nature that some loss is inherent to the production. Wastages of material, evaporation of material are un- avoidable in some process. But sometimes the Losses are also occurring due to negligence of Labourer, poor quality raw material, poor technology etc. These are normally called as avoidable losses. Basically process losses are classified into two categories

• Normal Loss
• Abnormal Loss

Normal Loss

Normal loss is an unavoidable loss which occurs due to the inherent nature of the materials and production process under normal conditions. It is normally estimated on the basis of past experience of the industry. It may be in the form of normal wastage, normal scrap, normal spoilage, and normal defectiveness. If the normal loss units can be sold as a scrap then the sale value is credited with process account. If some rectification is required before the sale of the normal loss, then the cost of rectification is debited in the process account. The cost per unit of a process is calculated after adjusting the normal loss. In case of Normal Loss the cost per unit is calculated by the under given formulae.

Cost of Goods unit = Total Cost – Sale value of scrap

Input – Normal Loss units

Abnormal Loss:

Any loss caused by unexpected abnormal conditions such as plant breakdown, substandard material, carelessness, accident etc. such losses are in excess of pre-determined normal losses. This loss is basically avoidable. Thus abnormal losses arrive when actual losses are more than expected losses. Abnormal losses in calculated as per under given formulae:

Value of Abnormal Loss = Total Cost – Scrap Value of Normal Loss

Input – Normal Loss Units

Abnormal Process loss should not be allowed to affect the cost of production as it is caused by abnormal (or) unexpected conditions. Such loss representing the cost of materials, labour and overhead charges called abnormal loss account. The sales value of the abnormal loss is credited to Abnormal Loss Account and the balance is written off to costing P & L A/c.

Abnormal Loss Account

Particulars	Units	Amount in	Particular	Units	Amount in
To Process A/c	XX	XXX	By Bank Account	XX	XXX
			By Closing P & L A/c	XX	XXX
					XXX

Abnormal Gains:

The margin allowed for normal loss is an estimate (i.e. on the basis of expectation in process industries in normal conditions) and slight differences are bound to occur between the actual output of a process and that anticipates. This difference may be positive or negative. If it is negative it is called ad abnormal Loss and if it is positive it is Abnormal gain i.e. if the actual loss is less than the normal loss then it is called as abnormal gain. The value of the abnormal gain calculated in the similar manner of abnormal loss. The formula used for abnormal gain is:

The sales values of abnormal gain units are transferred to Normal Loss Account since it arrive out of the savings of Normal Loss. The difference is transferred to Costing P & L A/c. as a Real gain

Abnormal Gain Account

Particular	Units	Amount in Rs.	Particular	Units	Amount in Rs.
To Normal loss A/c	XX	XXX	By Process A/C	XX	XXX
To Closing P & L A/C
	XX	XXX		XX	XXX

Valuation of Work-In-Progress

Meaning of Work-in-Progress

Since in process industries, production is continuous, there may be some incomplete production at the end of an accounting period. Incomplete units mean those units on which percentage of completion with regular to all elements of cost (i.e. material, labour and overhead) is not 100%. Such incomplete production units are known as Work-in-Progress. Such Work-in-Progress is valued in terms of equivalent or effective production units.

Meaning of Equivalent Production Units

This represents the production of a process in terms of complete units. In other words, it means converting the incomplete production into its equivalent of complete units. The term equivalent unit means a notional quantity of completed units substituted for an actual quantity of incomplete physical units in progress, when the aggregate work content of the incomplete units is deemed to be equivalent to that of the substituted quantity. The principle applies when operation costs are apportioned between work in progress and completed units.

Equivalent units of work in progress = Actual no. of units in progress x Percentage of work completed

Equivalent unit should be calculated separately for each element of cost (viz. material, labour and overheads) because the percentage of completion of the different cost component may be different.

Accounting Procedure

The following procedure is followed when there is Work-in- Progress

• Find out equivalent production after taking into account of the process losses, degree of completion of opening and / or closing stock.
• Find out net process cost according to elements of costs i.e. material, labour and overheads.
• Ascertain cost per unit of equivalent production of each element of cost separately by dividing each element of costs by respective equivalent production units.
• Evaluate the cost of output finished and transferred work in progress

The total cost per unit of equivalent units will be equal to the total cost divided by effective units and cost of work-in progress will be equal to the equivalent units of work-in progress multiply by the cost per unit of effective production.

In short the following from steps an involved.

• Step 1 – prepare statement of Equivalent production
• Step 2 – Prepare statement of cost per Equivalent unit
• Step 3 – Prepare of Evaluation
• Step 4 – Prepare process account

The problem on equivalent production may be divided into four groups.

• When there is only closing work-in-progress but without process losses
• When there is only closing work-in-progress but with process losses
• When there is only opening as well as closing work-in progress without process losses
• When there is opening as well as closing work-in progress with process losses

Situation I: Only closing work-in-progress without process losses:

In this case, the existence of process loss is ignored. Closing work-in-progress is converted into equivalent units on the basis of estimates on degree of completion of materials, labour and production overhead. Afterwards, the cost pr equivalent unit is calculated and the same is used to value the finished output transferred and the closing work-in-progress

Situation II: When there is closing work-in-progress with process loss or gain.

If there are process losses the treatment is same as already discussed in this chapter. In case of normal loss nothing should be added to equivalent production. If abnormal loss is there, it should be considered as good units completed during the period. If unit’s scrapped (normal loss) have any reliable value, the amount should be deducted from the cost of materials in the cost statement before dividing by equivalent production units. Abnormal gain will be deducted to obtain equivalent production.

Situation III: Opening and closing work-in-progress without process losses.

Since the production is a continuous activity there is possibility of opening as well as closing work-in-progress. The procedure of conversion of opening work-in-progress will vary depending on the method of apportionment of cost followed viz, FIFO, Average cost Method and LIFO. Let us discuss the methods of valuation of work-in-progress one by one.

• FIFO Method: The FIFO method of costing is based on the assumption of that the opening work-in-progress units are the first to be completed. Equivalent production of opening work-in-progress can be calculated as follows:

Equivalent Production = Units of Opening WIP x Percentage of work needed to finish the units

• Average Cost Method: This method is useful when price fluctuate from period to period. The closing valuation of work-in-progress in the old period is added to the cost of new period and an average rate obtained. In calculating the equivalent production opening units will not be shown separately as units of work-in-progress but included in the units completed and transferred.

• Weighted Average Cost Method: In this method no distinction is made between completed units from opening inventory and completed units from new production. All units finished during the current accounting period are treated as if they were started and finished during that period. The weighted average cost per unit is determined by dividing the total cost (opening work-in-progress cost + current cost) by equivalent production.
• LIFO Method: In LIFO method the assumption is that the units entering into the process is the last one first to be completed. The cost of opening work-in-progress is charged to the closing work-in-progress and thus the closing work-in progress appears cost of opening work-in-progress. The completed units are at their current cost.