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What Is Process Costing?

With process costing, companies determine item cost by tracking the cost of each
stage in the production process, instead of tracking costs for each individual item. After
adding up the cost of all the steps in the process, they divide the total cost by the
number of items. This is called the cost per unit. For example, a paper company might
track the cost of each stage in the process of turning wood pulp into reams of paper,
then divide the total cost by the number of reams to get the cost per ream.

Process Costing Explained

Homogeneous items are products that cannot be distinguished from one another —
for example, a bin of screws of the same size and type. These similar products all
generally flow through a number of stages during the production process. To use the
process costing approach to accounting, companies determine the direct costs and
manufacturing overhead for each of those stages.

These stages include direct and indirect costs. Direct costs are those directly incurred
for production, such as raw materials and machine operators’ wages. Overhead often
includes indirect costs such as equipment maintenance and facility rent, as well as the
wages of administrative staff who aren’t directly involved in making the products.

Companies often break down these costs into direct materials and conversion costs.
Direct materials are the materials consumed at each stage; conversion costs are
process-related costs such as payrolland manufacturing overhead.

At many companies, a different department handles each stage in the production

process. Each department prepares a report that details its direct materials, direct
labor and manufacturing overhead costs. The company then aggregates these reports
to analyze total product cost.

Why Use Process Costing?

Process costing is the logical choice for keeping tabs on product costs in industries
where the individual units of output are uniform and individually not worth a great deal
— such as reams of paper or bottles of soda — and where it’s impossible or difficult
to trace production costs for each individual unit. Instead, the cost of goods
manufactured (COGM) is produced using process costing. This usually appears on
your income statement.
 ▪ Monitor profit margins: For industries that sell in high volume and operate
with narrow profit margins, even a slight change in process costs can make a
big difference to a company’s profit. Process costing enables companies to
home in on the cost of each production stage and target specific departments
for improvement.

▪ Inventory control: Depending on the type of business, you may be required to

report inventory to the IRS for tax purposes. For large companies producing
thousands or even millions of products, this can be a difficult task. However,
process costing can help simplify it. Each item produced is valued and each
department tracks things like materials purchased.

▪ Uniformity in reporting: With process costing, each department will track their
own costs and all those will be rolled up to arrive at an overall cost to produce
a specific number of items. Because all expenses have to be added together,
they all need to be reported in the same manner and with the same cost codes.
This helps bring uniformity to reports and makes it easier to track costs over
time.

Using the Process Costing Method

Process costing involves tracking the number of units passing through the production
process during a given period, collecting cost information for each stage and then
using the collected information to calculate per-unit cost. Having accurate per-unit-
costing helps with pricing products appropriately, which can lead to
improved revenue and better profit margins.

5 Steps in Process Costing

To accurately estimate the cost of producing each unit, process costing takes into
account work in progress — items that have entered but not completed the production
process — at the start and end of each period. Here are five primary steps in process
costing.

1. Analyze inventory: Analyze the flow of items during the period to determine
the amount of inventory at the beginning of the period, how many items were
started during the period, how many were completed and transferred out and
how many were incomplete at the end of the period.

2. Calculate equivalent units: Process costing uses the concept of equivalent

units to account for items that are unfinished at the end of each period. For this
step, multiply the number of incomplete units at the end of the period by a
percentage representing their progress through the production process. For
example, if there are 2,000 units of inventory still in progress and they’re 75%
 complete, they are equivalent to 1,500 units for process costing purposes
(2,000 x .75 = 1,500).

3. Calculate applicable costs: Total the costs for all production stages, including
both direct materials and conversion costs.

4. Calculate cost per unit: Divide the total cost by the number of units. This
calculation includes both completed units and equivalent units. So, if a business
completed 4,000 products and another 1,000 units got halfway through
production, the applicable costs would be divided by 4,000 + (1,000/2) = 4,500
units. If all the costs added up across all departments to produce those units
was $16,875, simply divide the cost by the number of units to arrive at $3.75
per unit produced.

5. Allocate costs to complete and incomplete products: Allocate costs for the
completed and ending work-in-progress inventory to the corresponding
accounts. This helps determine how much money is tied up in current work-in-
progress inventory. In the above example, since the equivalent of 500 units are
in progress and it cost $3.75 to produce each unit, the work-in-progress
inventory cost is $1,875 (500 x $3.75). And the complete product inventory cost
is 4,000 x $3.75 = $15,000.

Types of Process Costing

In process costing there are three different ways to calculate costs: weighted average,
standard costing and first-in first-out (FIFO). Carefully selecting the method that best
meets your business needs is a best accounting practice.

▪ Weighted average costs: This is the simplest method of calculating cost.

Companies add all costs for the current period and divide by the total number
of units completed and transferred out, plus the equivalent units of work-in-
progress at the end of the period. It’s used for cases where cost fluctuations
from period to period are minor.

▪ Standard costs: This method uses an estimated standard cost for each
process stage instead of actual costs. Companies typically use this method
when it’s too difficult or time-consuming to collect current information about the
real costs. It can also be beneficial for businesses that make a wide range of
items and find it challenging to attribute precise costs to each of the products.
The estimated totals are compared to actual totals after a production run is
finished, and the difference is added to a variance account.

▪ First in, first out (FIFO): The most complicated process costing approach,
FIFO is used to obtain more precise product costing, especially in situations
 where costs change significantly from one period to the next. FIFO assumes
that the first units in (i.e., work in progress at the beginning of the current period)
are the first to be completed. When calculating costs for the current period, it
excludes costs incurred during the previous period for those beginning work-in-
progress units.

Examples of Process Cost Accounting

Process cost accounting is used in circumstances where the units of product are
homogenous. Take a look at a few examples of how it works in these fictional
companies. (The companies are not real.)

▪ Bubblez’n’More is a seltzer bottling company specializing in unique flavors. The

sodas pass through several production departments. During the current month,
the filling department accumulates $25,000 of direct material costs and $50,000
of conversion costs (consisting of direct labor and factory overhead). For that
period, the department processes 50,000 bottles. The per unit cost for the filling
department in April is $.50 for direct materials (direct material costs divided by
unit output for the month) and $1.00 for conversion costs (conversion costs
divided by unit output). The company performs similar calculations for the
labelling and packaging departments and finds that overall it spent $100,000 to
produce 50,000 bottles in one month. The unit price = $100,000/50,000 = $2
per unit.

▪ Reams-a-Plenty makes paper products from wood pulp. Raw materials move
through the production cycle in a continuous flow, ending with the production of
identical packages of paper. This month, it completes 150,000 packages. Raw
materials total $50,000, or $.33 per package. Conversion costs are $100,000,
or $.67 per package, comprising $70,000 in direct labor and $30,000 for
overhead, including maintenance expenses, insurance costs and electricity.
The total cost is $150,000, and with 150,000 units produced, its cost-per-unit is
$1.

SOURCE-Process Costing: What It Is & Why It’s Important

Joseph Clancey | Product Marketing Specialist
https://www.netsuite.com/portal/resource/articles/accounting/process-costing.shtml