You are on page 1of 43

Process Costing

INTRODUCTION TO STUDY: Process costing is probably the most widely used method of cost ascertainment. It is used in mass production industries producing standard product like Process-costing systems are generally used in industries that produce similar goods in mass production. Examples may include: oil refining, chemical processing, plastics, tile manufacturing, pharmaceuticals, semiconductor chips, or beverages and breakfast cereals etc. In all such industries goods produced are identical and all factory process re standardized goods are produced without waiting for any instructions or orders from customers and are put into warehouse for sale. Raw materials move down the production line through a number of process in a particular sequence and costs are complied for each process or department by a preparing a separate account for each process the products are standardized and homogeneous. Cost per unit produced is the average cost, which is calculated by dividing the total process cost by number of units produced. The sequence of operations or process is specific and pre determined. Some loss of material in process (due to chemical action evaporation etc) is unavoidable. Processing of raw material may give rise to the

production of several products these several products produced from the same raw material may be termed as joint products or by-products.

Theoretical View of Process Costing: Concept of Process Costing:


Process costing is a method of operation costing which is used to ascertain the cost of production at each process, operation or stage of manufacture, where processes are carried in having one or more of the following features: a) or operation b) Where there is simultaneous production at one or more process of different Where the product of one process becomes the material of another process

products, with or without by product, c) Where, during one or more processes or operations of a series, the products

or materials are not distinguishable from one another, as for instance when finished products differ finally only in shape or form.

Definition:
Process costing is defined by Kohler as: A method of accounting whereby costs are charged to processes or operations and averaged over units produced; it is employed principally where a finished product is the result of a more or less continuous operation, as in paper mills, refineries, canneries and chemical plants; distinguished from job costing, where costs are assigned to specific orders, lots or units. Process costing is a type of operation costing which is used to ascertain the cost of a product at each process or stage of manufacture. CIMA defines process costing as "The costing method applicable where goods or services result from a sequence of continuous or repetitive operations or processes. Costs are averaged over the units produced during the period". Process costing is suitable for industries producing homogeneous products
2

and where production is a continuous flow. A process can be referred to as the sub-unit of an organization specifically defined for cost collection purpose.

Features/Characteristics of Process Costing: The following are the features of Process costing:

a)

Process Costing Method is applicable where the output results from a

continuous or repetitive operations or processes. b) c) Products are identical and cannot be segregated. It enables the ascertainment of cost of the product at each process or stage

of manufacture. d) e) The output consists of products, which are homogenous. Production is carried on in different stages (each of which is called a

process) having a continuous flow. f) The input will pass through two or more processes before it takes the shape

of the output. The output of each process becomes the input for the next process until the final product is obtained, with the last process giving the final product. g) The output of a process except the last may also be saleable in which case

the process may generate some profit. h) The input of a process except the first may be capable of being acquired

from the outside sources. i) The output of a process is transferred to the next process generally at cost

to the process. It may also be transferred at market price to enable checking efficiency of operations in comparison to the market conditions. j) Normal and abnormal losses may arise in the processes

Fundamental Principles of Process Costing:

The following are the fundamental principles of process costing: a) Cost of material, wages and overheads expenses are collected for each

process or operation in a period. b) Adequate records in respect of output and scrap of each processes or

operation during the period are kept. c) The cost per unit of each process is obtained by dividing the total cost

incurred during a period by the number of units produced during that period after taking into consideration the losses and amount realized from sale of scrap. d) next process. The finished product of one process is transferred as a raw material to the

Process Costing Types

There are three types of process costing, which are:

Weighted average costs. This version assumes that all costs, whether from a preceding period or the current one, are lumped together and assigned to produced units. It is the simplest version to calculate.

Standard costs. This version is based on standard costs. Its calculation is similar to weighted average costing, but standard costs are assigned to production units, rather than actual costs; after total costs are accumulated based on standard costs, these totals are compared to actual accumulated costs, and the difference is charged to a variance account.

First-in first-out costing (FIFO). FIFO is a more complex calculation that creates layers of costs, one for any units of production that were started in the previous production period but not completed, and another layer for any production that is started in the current period. 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. Why have three different cost calculation methods for process costing, and why use one version instead of another? The different calculations are required for different cost accounting needs. The weighted average method is used in situations where there is no standard costing system, or where the fluctuations in costs from period to period are so slight that the management team has no need for the slight improvement in costing accuracy that can be obtained with the FIFO costing method. Alternatively, process costing that is based on standard costs is required for costing systems that use standard costs. It is also useful in situations where companies manufacture such a broad mix of products that they have difficulty accurately assigning actual costs to each type of product; under the other process costing methodologies, which both use actual costs, there is a strong chance that costs for different products will become mixed together. Finally, FIFO costing is used when there are ongoing and significant changes in product costs from period to period to such an extent that the management team needs to know the new costing levels so that it can re-price products appropriately, determine if there are internal costing problems requiring resolution, or perhaps to change manager performance-based compensation. In general, the simplest costing approach is the weighted average method, with FIFO costing being the most difficult.

A.

Process costing is a method for assigning product costs to units of product when all units of product are virtually the same. Products are completed in a short time, and costs for a single period can be averaged over the number of units produced.

1.

With process costing, costs are not traced to units of product. Instead, all production costs (unit-level and otherwise) are assigned or allocated based on total production costs and total units produced.

2.

Job costing and process costing differ in the way costs are assigned, and they differ because of differences in product characteristics. With job costing, many costs are traceable to jobs or can be assigned to specific jobs using cost-driver rates. For products in a process costing environment, all costs must be assigned using a cost-driver approach. The
6

key difference is that the only cost-driver is the actual number of units produced.

B.

A very basic model of process costing assumes there are only two cost categories materials and conversion costs. Materials costs (also called direct materials) are unit-level costs, but they are assigned to units of product based on the cost of materials and the actual number of units produced. Conversion costs include all other costs for resources used besides materials. These other costs may be batch, product, or facility-level costs. Resources are recorded as processes rather than activities. Simplifying assumptions in the basic process costing model presented in Chapter 8 preclude the use of ABC.

C.

The simplest case for assigning costs using a process costing approach assumes all production is started and completed within a single accounting period. This simplifying assumption makes it easier to see how materials and conversion costs are used and applied to units of product. If all units of product are completed in one month, there is no work-on-process inventory. It is the presence of WIP inventory that makes process costing complex.

1.

There are only two cost categories to consider in a simple process costing model. They are direct material and conversion costs. Each of these resources is assigned to units of product separately. That is because, except in the simplest case, these two resources are added and used in production in differing amounts and points in time.

2.

There is only one cost-driver. The cost-driver in process costing is the actual number of units produced. Calculation of a rate for direct materials is calculated as total direct materials cost divided by total number of (equivalent) units = direct materials cost per unit of product. The rate for conversion costs is total conversion cost divided by total (equivalent) units

= conversion cost per unit of product. The process costing system described is an actual costing system.

3.

Calculation of the cost per unit for conversion costs includes higher-level resources. For decision-making purposes, the cost per unit information can be misleading. Managers should separate higher-level costs from unitlevel costs when making cost decisions or when trying to assess profitability.

4.

When making decisions, managers should determine whether the decision should be based on resource spending or resource use. Average costing, as it is used in process costing, measures resource use.

D.

A slightly more complex case for process costing occurs when there is production that is not completed at the end of an accounting period. In other words, there is no beginning work-in-process inventory, but there is ending WIP inventory. This case better illustrates the need to segregate the costs and activities of different resources like materials and conversion activities. It is useful at his point to explain the five steps used to assign costs to units of product.

1.

First, summarize the flow of physical units. What is the total number of units being made when all production is complete?

a.

The basic cost flow model can be used to depict the flow of physical units through WIP inventory. Beginning WIP + units transferred in (or units started) units transferred out (or completed) = ending WIP.

b.

In the simplest case, beginning WIP and ending WIP are zero. In this simple case, the number of units transferred (started) equals the number of units transferred out (completed).
8

c.

In the case where there is no beginning WIP but there is ending WIP, the number of units transferred in (started) does not equal the number of units transferred out (completed). Transferred in units are greater than units transferred out because some units are not completed at the end of an accounting period.

d.

This first step expresses the number of units to account for and then accounts for them. It shows where units of product came from (beginning WIP and units started) and where they went (transferred out and ending WIP).

2.

The second step requires that the number of equivalent units (EUs) be computed. Equivalent units equal the number of whole units that could have been completed given the amount of resources actually used. For instance, if 5,000 toys had 90% of the direct materials needed for the toys to be complete, this would be the equivalent of having 5,000 * 90%, or 4,500 toys being fully completed. Suppose 2,000 physical units were started and 1,500 were fully complete as far as conversion activity goes, and the remaining 500 were 60% complete as far as conversion activity goes. This is the equivalent of 1,500 + (60% * 500) = 1,500 + 300 = 1,800 equivalent units.

a.

The number of equivalent units must be computed separately for each different resource. In the simplest case there are just two resources direct materials and conversion costs.

b.

The equivalent units calculations could be expanded to include as many different categories as the accounting system needed to improve information, but the calculations for each resource would be accomplished the same way.

3.

The third step requires that costs to account for be identified, and classified as direct materials cost or conversion cost. This information comes from the beginning WIP balance and costs transferred in for the period. In the case where there is no beginning WIP, just the costs transferred in are the costs to account for. This cost information can be obtained from the accounting system.

4.

Step 4 requires that cost per equivalent unit be calculated. It is simply the cost obtained in Step 3 divided by the number of equivalent units calculated in Step 2. Separate costs per equivalent unit must be calculated for direct materials costs and for conversion costs.

a.

The total cost per equivalent unit is the sum of direct materials cost per equivalent unit plus conversion cost per equivalent unit. This represents the cost of producing one whole unit.

b.

Managers should compare monthly calculations over time to see whether costs are stable. Costs per equivalent unit should not fluctuate erratically from month to month, because the

corresponding price cannot usually fluctuate the same way. This would result in erratic profits.

5.

The last step shows the assignment of costs to the ending WIP inventory balances and to units transferred out (to FGI, or the next production department).

a.

This step shows how costs to account for in Step 3 are accounted for.

b.

The number of equivalent units transferred out * cost per EU = total dollar amount transferred out. Since the number of equivalent
10

units transferred out is the same for both materials and conversion costs, it is not necessary to calculate costs transferred out separately for materials and conversion costs. This is true when the weighted average method is used but is not true when the FIFO method is used. The number of equivalent units in ending WIP * cost per EU = total dollar value of ending WIP. For ending WIP, calculations must be made separately for materials and conversion costs because the number of equivalent units will probably not be the same for these two resources.

6.

Steps 1 and 2 divide the cost flow model into two pieces for quantities. Beginning WIP and units transferred in (started) are used in Step 1 to identify the number of physical units. These amounts show where the units came from. Units transferred out and units remaining in ending WIP are converted to equivalent units, and in Step 2 these units are identified as either completed and transferred out or as incomplete units in ending WIP.

7.

Steps 3 and 5 divide the cost flow model into two pieces also, but, instead of quantities identified in Steps 1 and 2, Steps 3 and 5 divide costs into two pieces. Step 3 uses the beginning WIP balance and costs transferred in, indicating the costs to account for. Step 5 uses costs transferred out and ending WIP, indicating how the costs were accounted for. When an item is completed in one department, it may be transferred to a second department as an intermediary product for additional work. In such a case the transferred in cost is treated as a separate ingredient to which additional material and processing costs are added. So we would have at least three cost items, transferred in, materials, and processing costs for which we need to calculate costs.

8.

E. The third example of process costing and cost assignment adds another layer of complexity to the process costing approach by including spoilage. Spoilage is the cost of wasted resources and defective products that cannot be recovered by rework or recycling

1.

Spoilage is a normal part of production costs. One way to handle spoilage costs is to view them as a normal part of production. Spoilage, if material
11

in amount, should be identified and reported, at least internally, so that managers can assess spoilage and waste as a cost to be managed and minimized. Calculations for spoiled units are made the same way as for good units, using the five-step approach described earlier. However, the number of physical units must be split between good units and spoiled units. Equivalent units are also split so that costs can be assigned to the spoiled units. The percentage of completion for spoiled units depends on when the spoilage is detected and what portion of the work has been completed for those units. Step 1 of the five-step process is the same as described before determine the total number of physical units. b. Step 2 is different. Now, units must be split three ways instead of two. Before, units were split between those that were completed and transferred out and those remaining in ending WIP. With spoiled units included, there is a third group of units those that are spoiled. The number of equivalent units for each of these three groups must be calculated separately. Step 3 is the same as before it consists of determining what costs are to be accounted for.

a.

c.

d.

Step 4 is the same, except now the number of equivalent units will be calculated and shown for spoiled units, and therefore the cost per EU will be different.

e.

Step 5 is different. Now, costs must be assigned to units completed and transferred out, ending WIP inventory and spoiled units.

12

2.

Spoilage costs can be reported as a period cost and expensed right away (as part of cost of goods sold), or they can be treated as part of production costs and flow through the inventory system until product is sold.

a.

Normal spoilage is waste that is considered to be part of the production process. It is generally counted as a normal cost of good units produced.

b.

Abnormal spoilage is waste in excess of normal spoilage. Abnormal spoilage is usually treated as a period cost, regardless of how normal spoilage is treated.

c.

Spoilage is usually not listed as a separate expense on financial statements. Regardless of how spoilage is reported on financial statements though, the amount and associated cost of spoilage is important information for managers to have.

F. The next layer of complexity in process costing arises when there are units from the prior period included in the assignment of production costs. There are two methods that can be used in process costing. These methods are the weighted average (WA) method and the first-in, first-out (FIFO) method. The only difference between these two methods is the way in which beginning WIP units and costs are treated.

1.

The weighted average method treats the units in beginning WIP as if they are part of the current months production activity. The amount of work completed on these units in prior months is assumed to be zero. The costs in beginning WIP are added to the current months costs, and this total cost is used to compute cost per EU. Steps 1 through 5 of the five-step costing approach are reviewed based on the WA method.

13

a.

Step 1 is exactly the same as before, except now there are some physical units that came from beginning WIP

b.

Step 2 is different. The beginning WIP units are treated as units that were started and completed in the current period. The calculation of equivalent units is based on the assumption that 100% of the work for the beginning WIP units was completed in the current month. Thus, for units completed and transferred out, the number of EUs is 100% of the physical number of units transferred out. Calculation of EUs for ending WIP is the same as described before.

c.

Step 3 is the same as before, except that now there is a dollar amount for beginning WIP.

d.

Step 4 is the same as before also, except that the number of equivalent units now includes some from beginning inventory. The calculation is the same though.

e.

Step 5 is also the same. Costs assigned go to units completed and transferred out, spoiled units, and units in ending WIP.

f.

A disadvantage of the WA method is that it combines current period costs with prior period costs. This makes it difficult to isolate fluctuations in current period costs.

2.

The FIFO method segregates prior period costs and production activity from current period costs and activity. The FIFO method only considers that portion of work needed to complete the beginning WIP units in calculating the number of EUs for beginning WIP units. Spoilage must be segregated in the same fashion. That is, spoilage must be identified as
14

being from beginning WIP or from current months activity. The units in beginning WIP are assumed to be the first units completed and transferred out. Units started in the month are either completed and transferred out or are incomplete and remain in ending WIP.

a.

Step 1 of the five-step process is the same under WA and FIFO.

b.

Step 2 is different. Spoilage quantities are exactly the same as before, except they are shown as spoiled units from beginning WIP and spoiled units from those units started. Calculation of EUs for ending WIP is exactly the same as for WA. The total number of equivalent units from the total period are calculated just as they were for the WA method, but the equivalent units from beginning WIP that were completed in the prior month are subtracted from the EUs transferred out.

c.

Step 3 is the same as the WA method, but the beginning WIP costs are not used to calculate cost per EU in Step 4.

d.

Step 4 is different. Cost per EU is based on current costs divided by EUs. The balance in beginning WIP is not used to calculate cost per equivalent unit.

e.

Step 5 is complicated by the fact that costs for spoiled units come from beginning WIP and current period costs. It is further complicated by the fact that, even though beginning WIP costs are not included in the calculation of cost per EU, those costs must be transferred out in order for the costs to account for to equal the costs accounted for. The only straightforward calculation in Step 5 is calculation of the costs in ending WIP.

15

f.

The main differences between the WA and FIFO methods are that the WA method is simple but less accurate, while the FIFO method is more accurate, more complex, and more costly to maintain. If costs change a lot from period to period and beginning WIP balances are relatively large, it is probably better to use the FIFO method. However, if an organization has many products that are process costed, using FIFO may be too messy and complex to justify its use.

16

I.

The WA and FIFO methods are compared below, in terms of how the five steps are completed. STEP 1 WEIGHTED AVERAGE 1. Summarize flow of Use the basic cost flow Same, except keep track of units physical units model: BI + TI = TO + S + EI from beginning WIP separately from units started in the current period 2. Compute EUs for Multiply physical units by Same, except subtract EUs in each cost category degree of completion beginning WIP to obtain current EUs 3. Summarize total Add costs in beginning Same as WA costing WIP to costs of the FIFO

costs to account for

current period 4. Compute costs per Divide EU total costs in Divide current costs in process

process by total EUs in by current EUs in each cost each cost category to get category to get current cost/EU average cost/EU

5.

Assign

costs

to Multiply EUs by cost Beginning WIP units started in category for units the period are always transferred

products and spoilage

completed, units spoiled, out or assigned to spoiled units. units in ending WIP by Costs of units completed or cost/EU category in each cost spoiled include costs of beginning WIP, costs to finish beginning WIP, and costs from the current period. Ending WIP units include costs from the current period.

17

J. Many companies that use process costing have more than one production process. Instead of completing production and transferring finished goods to finishedgoods inventory, some portion of production may be completed, and then partially completed goods are passed on to the next production department. In this case, there are three types of costs to be assigned to units of product in a subsequent production department. These costs are direct materials and conversion cost, as well as transferred-in costs. All units transferred in are 100% complete in terms of the prior departments process costs, so cost computations are simple since the number of EUs equals the number of physical units for this resource called transferred-in costs.

K. Operation costing is a hybrid of job-order and process costing and is used

when companies produce batches of similar products with significantly different types of material. An operation is a standardized method of making a product that is repeatedly performed. Hybrid costing also occurs when the same product is produced in a process costing environment, and then additional custom features are added to it. Like a computer made to

specifications for its software and operating system or a car that has many custom features.

18

Elements/Components of Cost
For the purpose of cost accounting, the process industry is divided into separate departments with each department representing a specific process. The Direct Material and Direct Labour Costs are collected for each department separately and the overheads, which are collected over all the departments/processes, are apportioned over the various departments/processes on some rational basis The following are the main elements/components of costs involved in the manufacturing process where process costing is adopted. a) Direct Materials There are two types of materials that we come across in

process costing. Primary Material Materials that are introduced in the initial process, which is passed on to the next process after completion of processing. Secondary Material Materials, which are introduced in the first or subsequent processes in addition to, the main material introduced in the initial process. This gets mixed up with the main material and is passed on to the subsequent processes as a part of the output. b) Direct Labour the direct labour cost is incurred in every process.

Identification of direct Labour cost is also relatively easy in process costing industry. c) Direct Expenses in addition to Direct Material and Labor, which can be

directly attributable to a particular process. These are costs relevant to specific processes. d) Production Overheads The overhead expenses are generally expended over

all the processes involved in production. These are to be apportioned over the various processes in an amicable manner.

19

General Characteristics of Joint Production


Joint products are two or more products produced simultaneously by the same process. Joint products become separate and identifiable at the split-off point.

A.

Cost Separability and the Need for Allocation 1. Joint costs are the total of the raw material, labor, and overhead costs incurred up to the initial split-off point. a. Joint costs can be allocated to the final product only in some arbitrary manner because such costs cannot be traced directly to the products they benefit. b. Joint cost allocation is performed to meet the requirements of financial reporting (GAAP) and federal income tax law for income measurement and inventory valuation. In addition, joint cost allocation is useful in costing for government cost-type contracts and in justifying prices for legislative or administrative regulations. c. Joint cost allocation is much less useful for cost control and managerial decision making. 2. Separable costs are those costs incurred after the split-off point; they can be easily traced to individual products.

B.

Distinction and Similarity Between Joint Products and By-Products 1. The distinction between joint products and by-products rests solely on the relative importance of their sales value. 2. A by-product is a secondary product whose total sales value is relatively minor in comparison with the sales value of the main product (joint product). 3. Relationships between joint products and by-products change over time as technology and markets change.

20

a. By-products may become more and more important, eventually becoming joint products. b. When the relative importance of individual products changes, the products need to be reclassified and the costing procedures need to be changed. II. Accounting for Joint Product Costs A. Introduction 1. Joint cost allocations must be done for financial reporting purposes: to value inventory and to determine income. An allocation method must be found, though arbitrary, to allocate the joint costs as reasonably as possible. 2. The joint cost allocation approaches include the following: a. Benefits-received approaches, which include the following methods: Physical units method Weighted average method b. Allocation based on the relative market value, using the following methods: Sales-value-at-split-off method Net realizable value method Constant gross margin percentage method Sales-to-production-ratio method B. Benefits-Received Approaches 1. Physical Units Method a. Under the physical units method, units of physical output, such as heat content, volume, or weight, that measure the benefits received are used to distribute joint costs. This method allocates to each joint product the same proportion of joint costs as the underlying proportion of units.

21

Example: Manufacturers of forest products use the physical units method to apply the average conversion cost to all finished products, regardless of their type, grade, or market value. b. Disadvantages of the physical units method include the following: It ignores the fact that not all costs are directly related to physical quantities. It may result in incorrect managerial decisions because high profit may be reflected from the sale of high-grade products, with low profit or losses reflected from the sale of low-grade products. 2. Weighted Average Method The weighted average method uses the weight factors to include such diverse elements as amount of material used, difficulty to manufacture, time consumed, difference in type of labor used, and size of unit. Weighted physical units = Number of units Weight factor Example: The canning industry uses weight factors to distinguish between can sizes or quality of product. The weighted average method allocates relatively more of the joint cost to the high-grade products because they represent more desirable and profitable products. C. Allocation Based on Relative Market Value The methods in this approach try to assign costs based on the products ability to absorb joint costs. They are based on the assumption that the joint costs would not be incurred unless the products yield enough revenues to cover all costs plus a reasonable profit. The relative market value approach of allocation is better than the physical units approach if (1) the physical mix of output can be altered by incurring more (or less) total joint costs, and (2) this alteration produces more (or less) total market value. 1. Sales-Value-at-Split-Off Method

22

a. The sales-value-at-split-off method allocates joint cost based on each products proportionate share of market or sales value at the split-off point. b. In this method, the higher the market value, the greater the joint cost assigned to the product. 2. Net Realizable Value Method a. The net realizable value method allocates joint costs based on hypothetical sales values because there may not be a ready market for the product at the split-off point. b. This method is particularly useful when one or more products cannot be sold at the split-off point but must be processed further. Hypothetical sales value =

Market price Further processing costs after splitoff point 3. Constant Gross Margin Percentage Method a. The constant gross margin percentage method allocates joint costs such that the gross margin percentage is the same for each product. b. This method assumes that the further processing yields an identical profit percentage across all products. c. Using the constant gross margin percentage method, the joint cost allocation steps include the following calculations: Grand gross margin percentage =
(Total revenue Total costs) Total revenue

Joint product gross margin = Market price Grand gross margin Joint cost allocated to product = Market value Gross margin Separable costs

23

4. Sales-to-Production Ratio a. The sales-to-production-ratio method allocates joint costs in accordance with a weighting factor that compares the percentage of sales with the percentage of production. b. In this method, the products that sell the most are allocated a larger share of the joint cost of current production. c. Using the sales-to-production-ratio method, the joint cost allocation steps include: (1) Compute the percentage of total sales based on the joint product units sold. (2) Compute the percentage of total production based on the joint product units produced. (3) Compute the sales-to-production ratio of the joint product. Sales-to-production ratio =
Percentage of total sales Percentage of production

(4) Use the sales-to-production ratio to allocate joint cost. 5. The limitations of allocation based on relative market value include the following: All methods are based on price. If price is used to determine cost, then those costs cannot be used to determine price. The decision would be circular. Changes in relative market prices will cause changes in the costs allocated to the product, even when there has been no change in total costs or the method of production. Using allocation based on relative market value produces the same margin per dollar of allocated cost. This could be misleading to management if the impression is created that all products are equally profitable.

24

By-product
A by-product is a secondary product derived from a manufacturing process or chemical reaction. It is not the primary product or service being produced. In the context of production, a by-product can be defined as the 'output from a joint production process that is minor in quantity and/or NRV when compared to the main products'. Because they are deemed to have no influence on reported financial results, by-products do not receive allocations of joint costs. By-products also by convention are not inventoried, but the NRV from by-products is typically recognized as 'other income' or as a reduction of joint production processing costs when the by-product is produced. A by-product can be useful and marketable or it can be considered waste
.

Accounting for By-Products A. Introduction 1. The main objective of by-product accounting is to determine income and inventory for financial reporting purposes. By-products are of less significance than the main products and may not require precise cost allocation.

2. Relevant factors that influence by-product valuation and accounting include: The uncertainty of by-product value at the time of production. The use of the by-product in other production. The use of the by-product as an alternative to main products. The need for separate profit calculations for sales incentives or for control. 3. By-products can be accounted for using the following: a. Noncost methods
25

Other income By-product revenue deducted from main product cost b. Cost methods Replacement cost method Total costs less by-products valued at standard price method Joint cost proration method B. Noncost Methods of Accounting for By-Products Noncost methods make no attempt to allocate joint cost to the by-product or its inventory but instead make some credit either to income or to the main product. 1. Other Income Method a. The net sales of by-products for the current period is recognized as Other Income or Miscellaneous Income and is reported in the income statement. The market value of by-product inventory, if material, should be reported in a footnote to the balance sheet. b. The other income method is used by those firms where: The value of the by-product is small, Any other allocation would be more expensive than the benefits received, or Carrying by-products with the main products would not appreciably affect the cost of the main product. c. Disadvantages of this method include the following: Inventories on the balance sheet are misstated since no value is placed on the by-products. Matching of revenues with expenses is improper if production of by-products occurs in one accounting period and sales occur in another. No entry for by-products is made at the time of production, only at the time of sale.

26

No attempt is made to control the inventory of by-products and to prevent them from losses due to fraud or errors. 2. By-Product Revenue Deducted from Main Product Cost a. The net sales of by-products will be treated as a deduction from the cost of the main product. Example: The beef-packing industry uses this method because of the great variety of products resulting from operations and the complexity of the processing. b. Disadvantages of this method include the following: The method tends to understate the value of the main product. The cost of the main product can vary from month to month because of the varying quantities of by-products sold. C. Cost Methods of Accounting for By-Products Cost methods attempt to allocate some joint costs to by-products and to carry inventories at the allocated cost levels. 1. Replacement Cost Method The replacement cost method values the by-product inventory at its opportunity cost of purchasing or replacing the by-products. Example: In the oil refining industry, increasing output of one product will cause a reduction in the output and the profit of the other product. 2. Total Costs Less By-Products Valued at Standard Price Method a. By-products are valued at a standard price to avoid fluctuations in by-product value. b. The standard price approach shelters the main product cost from any fluctuations in the by-product price. c. The standard price may be set arbitrarily, or it may reflect an average price over time. d. A variance account is used to account for the difference between actual and standard prices.
27

3. Joint Cost Proration Method The by-product is allocated some portion of the joint costs using any one of the joint cost allocation methods mentioned in Section II. This method is rarely used in practice. IV. Effect of Joint Product Costs on

Cost Control and Decision Making Joint product costing may affect cost control and decision making in the following areas: output decisions, further processing of joint products, and pricing jointly produced products. A. Output Decisions 1. Output decisions are normally based on the comparison of total cost of the joint products and the combined sales revenues for measuring profitability at any given point. 2. If management cannot change the product mix or the product mix is determined by customer demand, cost allocation is useless for output decisions because the entire package has to be produced. B. Further Processing Decisions 1. In making decisions on whether to sell a joint product at split-off or to process it further, only the costs and revenues incurred after the split-off point are pertinent. 2. Joint costs include those costs incurred prior to the split-off point and, thus, are considered sunk costs with respect to further processing decisions (that is, the joint cost is not a relevant cost). C. Pricing Joint Products Methods used to set joint product prices include: 1. Sales or market price method

28

a. This method maintains a constant relationship of cost to market prices, but it cannot be used to set prices since price has to be known in order to determine cost. b. The method is circular but useful in limited situations. Example: The meat-packing industry uses the market value of byproducts as an important determinant of the main products price. Example: The natural gas industry uses it to justify prices and existing price relationships to regulatory bodies. Joint cost allocation is used to determine inventory values, not as a basis to determine a cost to be used in price regulation. 2. Historical market differentials between products method When market differentials are stable over time, this method provides a guide to pricing individual products by giving figures comparable to those of competitors. D. Pricing Based on Cost of Further Production This method differs from the benefits-received approaches because it does not assign average cost based on physical or weighted units. It is different from the relative market value because the joint product itself does not have a market value. Example: The practice of organ transplant sets the costs of the jointly available organs based on the eventual cost of the subsequent transplant operation.

29

V.

Joint Production of Services Normally services do not yield a true joint output because a service can be directed to one effect rather than to two effects simultaneously. Joint cost allocation issues with services usually relate to pricing problems. Example: An insurance company may allow only a portion of a massage therapy charge to be allocated to the therapeutic aspect. Example: The IRS might allow the cost of a two-day seminar as a deductible business expense. But if the seminar were offered on a cruise ship and spread out over a five-day period, the IRS would look closely if claimed as a deduction and not separated from the overall cost of the cruise.

30

ADVANTAGES AND DISADVANTAGES OF PROCESS COSTING:

Process costing is a method used for determining unit product cost. Unlike job costing (traditional costing) method, process costing determines the cost of a product or service by assigning costs to masses of similar units. Unit costs are then computed on average basis. Process costing is appropriate to be used in industries that convert raw materials into homogeneous products, for example: chemical industries, oil refining,

pharmaceuticals industries, cement industries, beverages industries, etc. Process costing provides companies with advantages and disadvantages as follow.

Advantages

Process costing is relatively easier to use compared to job costing or activity based costing, especially in deal with bulk homogenous product. Costs allocated according to the number of processes each good travels through in the production system. It collects the overall costs from each department and ignores costs related to specific jobs within a department. This reduces the volume of data, and makes data collection easy and quick. The analysis is likewise simple and straightforward, does not require any specialized skills other than normal accounting skills, inexpensive, and does not drain the companies time and resources.

Process costing also relatively more flexible because it allows companies to add or remove a process as necessary. This flexibility then allows companies to operate at the most competitive cost by eliminating redundant process or improve product quality by adding processes. The use of process costing may help companies control their production process effectively. Process costing allows budgeting of uniform output and usage costs as standard costs, making it possible to track deviations from such standard costs with ease. It becomes possible to track the inefficiency or discrepancy to a specific process or department without checking each department or process

31

Main Advantages of Process Costing: The following are the main advantages of Process Costing: a) It is possible to determine process costs periodically at short intervals.

Average unit cost can be computed weekly or even daily. b) c) each process. d) costs. e) It is easy to quote the prices with standardization of process. Standard It is easy to allocate the expenses to processes in order to have accurate It is simple and less expensive to find out the process costs. It is possible to have managerial control by evaluating the performance of

costing can be established easily in process type of manufacture.

Other Advantages

Saves Time Process costing saves management accountants copious amounts of time. Many types of cost allocation systems require accountants should to identify specific costs or cost drivers when allocating production costs. Process costing avoids these actions because it allocates costs based on the number of production processes a good travels through. Management accountants focus on the production costs for each manufacturing process. The number of goods leaving a production process will usually have the total process costs applied to each product. Process costing allows management accounts to apply an average per-unit cost for the direct materials, production labor and manufacturing overhead to each product.

Flexible Manufacturing and production companies can have a few or several production processes based on the type good. Production processes can include selling, refining, training, filtering, bottling, labeling and shipping. The type of production process

32

depends on the goods being produced and how much time must be spent on converting raw materials to valuable consumer goods. Companies who use process costing often have a flexible production environment. New production processes may be added to the production system and costs will be allocated for the new process. This concept also works in reverse. Companies can eliminate extemporaneous production processes and decrease product costs by reducing the total production system.

Easier Than Other Costing Systems Process costing is usually an easier costing system for manufacturing and production companies. Using a basic process cost allocation system allows companies to hire and train new accounting employees in less time than other companies. Process costing may also require less paperwork and other information for management decisions. Management and cost accounting is usually responsible for providing business owners and managers with financial information for business decisions. Process costing usually provides information on current work-in-process (unfinished products) and the number of 100 percent complete goods produced. Additional information is often easy to include this process costing includes products in large batches rather than individual units.

Main Disadvantages of Process Costing: The following are the main disadvantages of Process Costing: a) Cost obtained at the end of the accounting period are only of historical value and

are not very useful for effective control. b) Valuation of work-in-progress is generally done of estimated basis which

introduces further inaccuracies in total cost. c) Where different products arise in the same process, it is not possible to exactly

ascertain the total cost of the products. d) If any error occurs while calculating average costs, it will be carried through all the

processes to the valuation of work in process and finished goods.


33

e)

The computation of average cost is more difficult in those cases where more than

one type of product is manufactured and a division of the cost element is necessary.

Other Disadvantages One disadvantage of process costing is the accuracy of the method in determining the production cost. Process costing can cause cost error because it does not directly applies a specific amount of raw materials, production labor, and manufacturing overhead to each individual goods or service. This method may cause over-cost or under-cost and may let to the product cannot compete in the market or let to lower business profits. Process costing also only suitable for homogenous products. It cannot provide an accurate estimate of product when a single process produces many different good or for customized orders.

Process costing is not very useful for managerial control and decision making. The costs obtained by this method are historical costs instead of current cost. It makes the use of this method for managerial decision making remains limited. Moreover, process costing is based on average cost method, which is not suitable for performance analysis and evaluation. Evaluation of the efficiency of individual process or worker also becomes more difficult because individual product costs may be taken as only approximation and not reliable.

In conclusion, despite of those advantages and disadvantages, process costing remains useful for certain companies, especially for companies producing homogenous bulk product continuously

Business owners use process costing because it offers several advantages in the manufacturing and production environment.

34

APPLICATION OF PROCESS COSTING


Process costing is used in situations where job costing cannot be used; that is, for the mass production of similar products, where the costs associated with individual units of output cannot be differentiated from each other. In other words, the cost of each product produced is assumed to be the same as the cost of every other product. Examples of the industries where this type of production occurs include oil refining, food production, and chemical processing. For example, how would you determine the precise cost required to create one gallon of aviation fuel, when thousands of gallons of the same fuel are gushing out of a refinery every hour? The cost accounting methodology used for this scenario is process costing. 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.

Example of areas where Process Costing is applied


INDUSTRY Automobile Beverages Chemicals Food Forest and paper products Metals Petroleum refining Pharmaceuticals Soap and cosmetics EXAMPLE CO. General Motors Coca-Cola Dow Chemical Campbell Soup Georgia Pacific Alcoa ExxonMobil Merck Procter & Gamble

35

Eg 1 ) A common example of an industry where process costing may be applied is "Sugar Manufacturing Industry".

The processes in this industry are

Cane Shredding
The cane is broken/cut into small pieces to enable easier movement through the milling machine.

Milling
The shredded cane is passed through rollers which crush them to extract cane juice. [Similar to the cane juice extracted by the vendors who sell you sugar cane juice.]

Heating and Adding lime


The extracted juice is then heated to make it a concentrate and lime is added to the heated juice.

Clarification
36

Muddy substance is removed from the concentrate through this process

Evaporation
Water is removed from the juice by evaporation.

Crystallisation and Separation


Sugar crystals are grown from the dry juice concentrate in this process.

Spinning
Molasses are separated from sugar using Centrifugals in this process.

Drying
Sugar is obtained by drying the wet raw sugar obtained in the spinning process.

Eg2

) New coke making process:

37

About 500 kg of coke is consumed to produce one ton of hot metal. As mentioned earlier, coke plays a necessary role in the BF ironmaking process in the chemical reaction. However, maintaining good permeability of gases is also an important role of coke in the conventional BF process. Good quality coke is indispensable to the BF-BOF process route, and hence coke ovens comprise an important part of the integrated steel mill.

The construction of Japan's integrated steel mills was completed in the 1970s. Most Japanese coke ovens will reach the end of their service lives in the early 21st century, after about 40 years of operation, which is the expected life of coke ovens. The case for North American and European mills is similar.

Since the BF cannot be operated without coke, efforts have been made to prolong coke oven life and to decrease coke consumption. Significant improvement can be seen in repair technologies for coke oven refractories, pulverized coal injection into the BF, and development of the formed coke process, supported by a national fund during 1978 1986 in Japan.

However, pulverized coal injection and the formed coke process cannot replace all the coke consumed in the BF. New production capacity will soon be needed to replace aging coke ovens. The present coke-making process has drawbacks such as emissions of particulates and harmful gases, low productivity, entailing high equipment cost, and high energy consumption due to high temperature processing, which discourage the construction of new capacity.

After two years of conceptual and fundamental studies, The Japan Iron and Steel Federation (JISF), sponsored by the government, began the development of a new coke-making process in 1996. The project is called SCOPE 21, or Super Coke Oven for Productivity and Environment for the 21st Century, and consists of three years of bench-scale tests followed by three years of pilot plant tests.

38

The concept of the new coke-making process, as shown in the figure, consists of three sub- processes of coal pretreatment and coking, followed by heat treatment and quenching:

(i) The coking properties of coal are improved in the pretreatment process, where coal particles are rapidly heated to 573-673K (300-400 ).

(ii) In the coking process, the pretreated coal is agglomerated and heated to approximately 1,000K (727 ). This temperature is substantially lower than in the conventional coke oven, where the temperature rises to 1,273K (1,000 ).

Uniform heating of the agglomerate makes low temperature coking possible. (iii) The coke thus produced undergoes heat treatment and quenching, in which the coke is stabilized to obtain necessary quality for the BF.

In comparison with conventional coke ovens, the project aims at: increasing the use of non-coking coal from 20% to 50%, virtual elimination of particle and fume emissions and a 30% reduction of NOx, fully automated unmanned operation, energy conservation by 20%, and improved productivity by 300%.

There are number of industries where Process costing system can be used except where job, Batch or Unit Operation Costing is necessary. The following are examples of industries where process costing is applied: a) Where the final product merges only after two or more process such as paper-the raw material, bamboo is made into pulp; pulp is a made into paper and then it is finished, glazed etc. for sale; b) The product of one process becomes the raw material of another process or operation e.g. refined groundnut oil is the material for making vegetable ghee and c) Different products may have a common prior process e.g. brass goods will

require melting of brass commonly for all goods. Another example is petroleum products by the same refinery.
39

Some other industries where Process Costing is applied are: Chemical works Soap making Box making Coke works Textiles, weaving, spinning etc. Food products Canning factory Paint, ink and varnishing etc.

The typical manner in which costs flow in process costing is that direct material costs are added at the beginning of the process, while all other costs (both direct labor and overhead) are gradually added over the course of the production process. For example, in a food processing operation, the direct material (such as a cow) is added at the beginning of the operation, and then various rendering operations gradually convert the direct material into finished products (such as steaks).

40

Industry Food Textiles Primary Metals

Process 96% 91% 92%

Chemicals Oil refining Furniture Machinery Electronics

75% 100% 38% 43% 55%

41

Conclusion
Reasons for use Companies need to allocate total product costs to units of product for the following reasons: A company may manufacture thousands or millions of units of product in a given period of time. Products are manufactured in large quantities, but products may be sold in small quantities, sometimes one at a time (automobiles, loaves of bread), a dozen or two at a time (eggs, cookies), etc. Product costs must be transferred from Finished Goods to Cost of Goods Sold as sales are made. This requires a correct and accurate accounting of product costs per unit, to have a proper matching of product costs against related sales revenue. Managers need to maintain cost control over the manufacturing process. Process costing provides managers with feedback that can be used to compare similar product costs from one month to the next, keeping costs in line with projected manufacturing budgets. A fraction-of-a-cent cost change can represent a large dollar change in overall profitability, when selling millions of units of product a month. Managers must carefully watch per unit costs on a daily basis through the production process, while at the same time dealing with materials and output in huge quantities. Materials part way through a process (e.g. chemicals) might need to be given a value, process costing allows for this. By determining what cost the part processed material has incurred such as labor or overhead an "equivalent unit" relative to the value of a finished process can be calculated.

"Process costing is used to ascertain the cost of each stage of manufacture where material is passed through various operation to obtain a final product to result, with by - products in many cases at different stages"

42

BIBLOGRAPHY

Moneycontrol.com Wikepedia Google Advanced cost accounting text book Ainapure Economicstimes.com

43