Cost Accounting

In management accounting, cost accounting establishes

budget and actual cost of operations, processes, departments
or product and the analysis of variances, profitability or social
use of funds. Managers use cost accounting to support
decision making to cut a company's costs and improve
profitability. As a form of management accounting, cost
accounting need not follow standards such as GAAP because
its primary use is for internal managers, rather than outside
users, and what to compute is instead decided pragmatically.
Costs are measured in units of nominal currency by
convention. Cost accounting can be viewed as translating the
supply chain (the series of events in the production process
that, in concert, result in a product) into financial values.
There are various managerial accounting approaches:
▪ standardized or standard cost accounting
▪ lean accounting
▪ activity-based costing
▪ resource consumption accounting
▪ throughput accounting
▪ marginal costing/cost-volume-profit analysis

Classical cost elements are:

1. raw materials
2. labor
3. indirect expenses/overhead

Process Costing 1
Origins

Cost accounting has long been used to help managers

understand the costs of running a business. Modern cost
accounting originated during the industrial revolution, when
the complexities of running a large scale business led to the
development of systems for recording and tracking costs to
help business owners and managers make decisions.
In the early industrial age, most of the costs incurred by a
business were what modern accountants call "variable costs"
because they varied directly with the amount of production.
Money was spent on labor, raw materials, power to run a
factory, etc. in direct proportion to production. Managers could
simply total the variable costs for a product and use this as a
rough guide for decision-making processes.
Some costs tend to remain the same even during busy
periods, unlike variable costs, which rise and fall with volume
of work. Over time, the importance of these "fixed costs" has
become more important to managers. Examples of fixed costs
include the depreciation of plant and equipment, and the cost
of departments such as maintenance, tooling, production
control, purchasing, quality control, storage and handling,
plant supervision and engineering. In the early twentieth
century, these costs were of little importance to most
businesses. However, in the twenty-first century, these costs
are often more important than the variable cost of a product,
and allocating them to a broad range of products can lead to
bad decision making. Managers must understand fixed costs
in order to make decisions about products and pricing.
For example: A company produced railway coaches and had
only one product. To make each coach, the company needed
to purchase $60 of raw materials and components, and pay 6
laborers $40 each. Therefore, total variable cost for each
coach was $300.

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Elements of Cost

▪ 1. Material (Material is a very important part of business)

A. Direct material
B. Indirect material

▪ 2. Labor
A. Direct labor
B. Indirect labor

▪ 3. Overhead
A. Indirect material
B. Indirect labor

(In some companies, machine cost is segregated from

overhead and reported as a separate element)

They are grouped further based on their functions as,

1. Production or works overheads
2. Administration overheads
3. Selling overheads
4. Distribution overheads

Process Costing 3
Classification of Costs
Classification of cost means, the grouping of costs according
to their common characteristics. The important ways of
classification of costs are:
▪ By nature or element: materials, labor, expenses
▪ By functions: production, selling, distribution, administration,
R&D, development,
▪ As direct and indirect
▪ By variability: fixed, variable, semi-variable
▪ By controllability: controllable, uncontrollable
▪ By normality: normal, abnormal

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Standard Cost Accounting
In modern cost accounting, the concept of recording historical
costs was taken further, by allocating the company's fixed
costs over a given period of time to the items produced during
that period, and recording the result as the total cost of
production. This allowed the full cost of products that were not
sold in the period they were produced to be recorded in
inventory using a variety of complex accounting methods,
which was consistent with the principles of GAAP (Generally
Accepted Accounting Principles). It also essentially enabled
managers to ignore the fixed costs, and look at the results of
each period in relation to the "standard cost" for any given
product.
For example: if the railway coach company normally produced
40 coaches per month, and the fixed costs were still
$1000/month, then each coach could be said to incur an
overhead of $25 ($1000 / 40). Adding this to the variable costs
of $300 per coach produced a full cost of $325 per coach.
This method tended to slightly distort the resulting unit cost,
but in mass-production industries that made one product line,
and where the fixed costs were relatively low, the distortion
was very minor.
For example: if the railway coach company made 100 coaches
one month, then the unit cost would become $310 per coach
($300 + ($1000 / 100)). If the next month the company made
50 coaches, then the unit cost = $320 per coach ($300 +
($1000 / 50)), a relatively minor difference.
An important part of standard cost accounting is a variance
analysis, which breaks down the variation between actual cost
and standard costs into various components (volume
variation, material cost variation, labor cost variation, etc.) so
managers can understand why costs were different from what
was planned and take appropriate action to correct the
situation.

Process Costing 5
 Process Costing
Process costing is an accounting methodology 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. It assigns average costs to each unit, and is
the opposite extreme of Job costing which attempts to
measure individual costs of production of each unit. Process
costing is usually a significant chapter.
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 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.

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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 7
Advantages of Process Costing
1. Cost of each process and that of finished products can
be determined at short intervals,weekly or daily.

2. Cost control and control over production are more

effective because of uniform output and usage of
predetermined costs as budgeted  or standard costs.

3. Cost ascertainment is simple and less expensive.

4. Average cost per unit can be easily obtainable.

5. Indirect expenses can be apportioned and allocated

more accurately and relaible data can be obtained.

6. Valuation of inventories is easier and accurate.

7. Quotations become easier due to standardised

processes.

Disadvantage of Process Costing

1. Costs obtained at the end of  processes are historical
costs and their utility for cost control and managerial
decision making is not significant.

2. Inefficiencies in process can be concealed.

3. Later processes may be adversely affected due to the

inefficiency of earlier processes.

4. Evaluating the efficiency of individual workers or

supervisors is difficult.

5. Apportionment of Joint Costs to common products may

lead to irrational pricing decisions.

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Basics
Production is continuous in a series of stages called
processes.

Each Process is deemed as a cost centre and costs are

accumulated for each process separately along with finished
output and in progress.

Products and Processes are standardised.

The output of one process becomes the raw material to the

next process,usually till the final product is completed.

The cost of the previous process is transferred to the next

process along with the output.Sometimes, the transfer may be
at a transfer price inclusive of profit.

There may be process losses of the input.They may be normal

or abnormal or both.

Completed  and semi-finished goods must be expressed in

common terms for cost determination.

Since Production is of identical units, the total cost of a

process is to be divided with the unit of output to obtain the
average cost per unit.
Two or more products may be produced unavoidably in the
same process.They may be of equal importance or of
disproportionate values.
It is not possible or necessary to trace or identify specific loss
of material inputs with product or output.

Process Costing 9
Steps In Process Accounting

Step 1: Summarize the flow of physical units of

output.

Step 2: Compute output in terms of equivalent units.

Step 3: Compute equivalent unit costs.

Step 4: Summarize total costs to account for.

Step 5: Assign total costs to units completed and to

units in ending work in process inventory.

Process Costing :Case Study

10
 
Process Costing is a topic which is viewed by many
candidates with trepidation and, quite often, despair as they
plough their way through numerous calculations in the hope
that their final process accounts will balance. Terms such as
“abnormal losses”, “work in progress” and “equivalent units”
frequently bemuse candidates, resulting in panic and a
reluctance to even attempt any question set on this topic.
This article, relevant to paper B2, is designed to show
candidates how to approach a Process Costing question by
working through a detailed example, including such difficulties
as how to treat losses and the calculation of equivalent units.

Definitions
Before looking at the worked example you should refer to the
study manuals to familiarise yourself with the definitions of the
key terms including Opening and Closing Work In Progress
(WIP), Normal and Abnormal Losses, Scrap Value and
Equivalent Units.

A detailed worked example

The following example illustrates how to approach a Process
Costing question, paying particular attention to presentation
and calculation. Candidates should always strive to present
their solutions as neatly and methodically as possible, not only
to help the marker follow the calculations, but also to allow
themselves to check that they have not missed out a vital
step. The data for the question is shown in Figure 1.

Figure 1
Jammy Ltd is a manufacturing organisation with two
processes. Information for the period ended 31 July 1999 is as
follows:

  Process 1 Process 2
Process Costing 1
1
 Opening WIP Nil 200kg
Costs for the period:  
Material 1000kg costing £25,650 Nil
Labour £12,750 £6950
Overheads £5,950 £3475
Transferred to Process 2 700kg —
Transferred to Finished Goods — 800kg
Closing WIP 200kg 150kg

Normal losses are expected to be 5% of input for each

process. Losses in Process 1 have no scrap value, whilst
losses in Process 2 can be sold for £10 per kg. Losses are
deemed to arise at the end of the process.
Opening WIP is 60% complete with regard to Labour and
Overheads. Closing WIP in Process 1 is 100% complete with
regard to Material and 50% complete for Labour and
Overheads. Closing WIP in Process 2 is 50% complete with
regard to Labour and Overheads.
Prepare the Process Accounts for each process.

Step 1
The best way to approach this question is to concentrate on
Process 1 first, as Process 2 cannot be completed until we
know the value of the items transferred into this process from
Process 1. The first step is to draw up a process account in
typical ‘T’ account fashion. Each side of the account should
have a column for ‘Units’ and a column for ‘£’. You should
then enter all the information given in the question. This will
make it clear as to which items have to be calculated — these
items are numbered in this example for illustrative purposes.

Process 1 Account
  Units £  Units £

12
 Current costs:  
  Transferred to Process 2 700 (1)
Material 1,000 25,650 Normal Loss 50 NIL
Labour — 12,750 Closing WIP 200 (2)
Overheads — 5,950 Abnormal Loss 50 (3)

  1,000 44,350   1,000 (4)

 The Normal Loss figure is 5% of the 1000kg input. No cost is

assigned to Normal Loss as the cost is absorbed into the
"good" units. Abnormal Loss is the difference between the
total units on the debit side and the total units on the credit
side.

Step 2
The next step is to draw up an Equivalent Units Statement to
determine the cost per unit of the equivalent “whole” units
produced.
Equivalent Units Statement
  Material Labour Overhead
Units
  transferred to 700 700 700
Process 2
Abnormal Loss 50 50 50
200 100 100
Closing WIP
950 850 850
Period Costs (b) £25,650 £12,750 £5,950

Closing WIP is 50% complete for Labour and Overheads,

which is equivalent to 200 x 50% = 100 “complete” units.

Step 3
Process Costing 1
3
The information calculated in the Equivalent Units Statement
is then used to construct a Cost Allocation Statement. The
layout of this statement is exactly the same as the Equivalent
Units Statement.

 
  Material Labour Overhead Total  
Units transferred to Process 2 18,900 10,500 4,900 34,300 (1)
Abnormal Loss 1,350 750 750 2,450 (3)
Closing WIP 5,400 1,500 700 7,600 (2)

  25,650 12,750 5,950 44,350  

Each entry in the above statement is calculated using the cost

per unit calculated in the Equivalent Units Statement and the
relevant equivalent units. For example, the Material Cost of
Units transferred to Process 2 (£18,900) is calculated by
multiplying the Material Unit Cost (£27) by the equivalent units
transferred to Process 2 in respect of Material (700). This
gives us £18,900. The Labour Cost of Abnormal Loss is
calculated by multiplying the Labour Unit Cost (£15) by the
equivalent units of Abnormal Loss in respect of Labour (50).
This gives us £750, and so on.
You will notice that the total of each column (Material, Labour
and Overhead) is the same as the figures appearing in the
Process Account for each of these costs.

Step 4
The final step is to complete the Process Account by using the
figures calculated in the ‘Total’ column of the Cost Allocation
Statement. Those figures labelled (1) – (3) are the figures to
be slotted into the spaces similarly numbered in the Process
Account in Step 1. Your final Process Account should now
look thus:

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Process 1 Account
 
  Units £  Units £
Current costs:  
  Transferred to Process 2 700 34,300
Material 1,000 25,650 Normal Loss 50 NIL
Labour — 12,750 Closing WIP 200 7,600
Overheads — 5,950 Abnormal Loss 50 2,450

  1,000 44,350   1,000 44,350

Step 5
We are now in the position to go through the whole “process”
again for Process 2. The main differences between the two
processes are the existence of Opening WIP and scrap value
of losses in Process 2. Explanations for the figures in Process
2 are only given where the concepts have not been explained
already in Process 1.
Construct Process Account:

Process 2 Account

  Units £  Units £
Opening WIP 300 13,000 Transferred to    
Transferred from     Finished Goods 800 (4)
Process 1 700 34,300 Normal Loss 50 500
Labour — 6,950      
Overheads — 3,475 Closing WIP 150 (5)
   
1,000 57,725 1,000 (6)
Process Costing 1
5
 Losses can be sold at £10 per kg, therefore Normal Loss is
assigned a monetary value of 50 x £10 = £500.

Step 6
Construct Equivalent Units Statement:
Equivalent Units Statement
 
  Transferred Costs from Process 1 Labour Overhead
Opening WIP NIL 120 120
Units started and Completed 500 500 500
150 75 75
Closing WIP
Total Equiv Units 650 695 695
Period Costs £33,800 £6,950 £3,475
Cost per unit £52 £10 £5

Opening WIP is already 60% complete with regard to Labour

and Overheads, therefore only 40% remains to be completed
in this period. Equivalent units completed in this period are
therefore 300 x 40% = 120kg.
Opening WIP in respect of “Transferred Costs from Process 1”
are always NIL as they were transferred in a previous period
and therefore do not form part of the cost of the units
transferred from Process 1 in this period.
Units started and completed during the period is the difference
between the units transferred to finished goods (shown in the
Process Account as 800) and the units already started at the
beginning of the period (Opening WIP of 300).
The period cost given for “Transferred Costs from Process 1”
has been calculated by deducting the scrap value of Normal
Loss (£500) from the total transferred cost (£34,300).

Step 7
Construct Cost Allocation Statement:

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 Cost Allocation Statement
Transferred Costs from
  Labour Overhead Total  
Process 1
Opening WIP NIL 1,200 600 1,800 (*)
Units started and
26,000 5,000 2,500 33,500 (*)
Completed
Closing WIP 7,800 750 375 8,925 (5)

  33,800 6,950 3,475 44,225  

   
(*) The calculation of the cost of units transferred to Finished
Goods is slightly different when there is Opening WIP. The
cost of units transferred includes 3 elements: the cost of
Opening WIP brought forward from the previous period
(£13,000), the cost to complete the Opening WIP in this period
(£1,800) and the cost of the units started and completed in this
period (£33,500). This gives us a total of £48300 to be slotted
into the Process Account.

Step 8
Complete the Process Account:
Process 2 Account
 
  Units £  Units £
Opening WIP 300 13,000 Transferred to    
Transferred from     Finished Goods 800 48,300
Process 1 700 34,300 Normal Loss 50 500
Labour — 6,950      
Overheads — 3,475 Closing WIP 150 8,925

  1,000 57,725   1,000 57,725

Process Costing 1
7
Summary
Process Costing is best tackled with a methodical approach.
Given the number of calculations involved, it will help if
workings are presented neatly. Try to get into the habit of
following a particular approach and layout, rather than trying to
confuse yourself with different methods of presentation and
calculation. The approach given above is by no means the
only way of tackling process costing, but is very useful in the
respect that it tackles all the calculations in a logical order.
Work through the example again without looking at the
solution — it is the best way of testing whether you
understand the concepts. Good luck!

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