Lecture 4: Process and Operation Costing

Systems

ACC2706
Managerial Accounting
Semester I, AY 2022/23

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 Learning Objectives & References

Learning Objectives
1. Process costing using the weighted-average method
2. Treatment of spoilage
3. Operation costing system

Reference
Chapter 5 Process and Operation Costing Systems
(*FIFO process costing methodology is out of scope.)

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 Real World Application
– Process Costing at Coca Cola

• Coca-Cola’s strategy focuses on both cost management

and product differentiation.

• It positions itself as a unique and special product. Coca

Cola is the world’s sixth most valuable brand in 2020.

• Coca-Cola uses process costing to track direct materials,

direct labor, and factory overhead costs incurred in its
production processes.

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 Process Costing - Soft Drinks
Recall: Types of product costing
• Job costing and process costing are two extremes of the
continuum of conventional product costing systems.
• Job costing systems accumulate the costs of each job.
• Process costing systems average the accumulated costs across
all units.
• Hybrid costing is a combination of job costing and process
costing.

Watch the video. Let’s examine:

• What are the key processes in a soft drink manufacturing
process?
• What are the key features of such a manufacturing process?
• Why is job-order costing system not suitable for such a
manufacturing process?
• How should the production costs of a bottle of soft drink be
measured? 4
 Why Use Process Costing?

Features of the manufacturing process:

• A single product is produced either on a continuous basis or for long
periods of time
• The activity in the processing department is performed uniformly on all
of the units passing through it
• the output of the processing department is homogeneous

1. It is not efficient to identify materials, labor and overhead costs with

a particular customer order as each order is just one of many that are
filled from a continuous follow of identical units from the production
line.

2. More appropriate to
• Accumulate costs by process or department.
• Assign these costs uniformly to all units that pass through the process
or department during a period by averaging total cost by output
units.
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 1. Steps in Process Costing

• The process costing system involves two main steps:

1. estimating the cost of the production process
2. calculating the average cost per unit.

• Process costing can occur where there is no opening or

closing WIP inventory (see Ch 4).
• More complex process costing takes account of WIP
inventory.

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 Process Costing with Work in Process
Inventories
• Production costs will be calculated after taking into account:
oBeginning WIP (work in process)
oUnits started and completed during the period
oEnding WIP

• Direct materials are input into production at various stages.

• Assume that direct labour and manufacturing overhead

(conversion cost) are used uniformly throughout the
production process. When direct labor is a relatively small
amount, it is often combined with overhead as conversion
cost.
(cont.)

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 Equivalent Units: A Key Concept

• Units in beginning and ending WIP are partially completed,

generally at different stages of completion with respect to
material and conversion cost.

• Partially completed WIP units need to be converted to

equivalent units for product costing purposes.

• Equivalent units concept expresses these partially completed

products as a smaller number of fully completed products.
EU = number of partially completed units * percentage of
completion of those units
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 Equivalent Units: A Key Concept
Two half completed products are equivalent to one
complete product.

So, 10,000 units 70% complete

are equivalent to 7,000 complete units.
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 Quick Check 
For the current period, Jones started 15,000
units and completed 10,000 units, leaving 5,000
units in process 30 percent complete end of
period. How many equivalent units of
production did Jones have end of the period?
a. 10,000
b. 11,500
c. 13,500
d. 15,000

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 Equivalent Units: A Key Concept

For example, the production process has WIP ending of

10,000 units on hand at the end of the month, it is
• 100% complete for direct materials, which are added at
the start of the process  10,000 equivalent units of
material.

• 50% complete for conversion costs, assuming that

conversion costs occur uniformly across the production
process  5,000 equivalent units of conversion

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 Process costing

Four steps in process costing

1. Analyse the physical flow of units
2. Calculate the equivalent units
3. Calculate the unit costs
4. Analyse the total costs

Products are costed using one of two assumptions about

product flow
• Weighted average method
• First-in, first-out (FIFO) method (out of scope)

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Production processes in the Mixing and Finishing
Departments, Spritz

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Weighted average method, Spritz Mixing Department

Step one: Analyse the physical flow of units.

Step two: Calculate the equivalent units. Step 2

same

Step 1

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(cont.)
Weighted average method, Spritz Mixing Department
Step three: Calculate the cost per equivalent unit.

Given

(cont.)
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 Weighted average method, Spritz Mixing Department
Step four: Analyse the total costs. Compute costs of Goods completed and transferred
out and Ending WIP

(cont.)
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Weighted average method, Spritz Mixing Department
Departmental Production Report

match

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 Comparison of weighted average and FIFO
methods
• WAM is more widely used than FIFO.

• FIFO differs from WAM on its treatment of the beginning

WIP, and the costs per EU are based only on the costs
incurred during the current month divided by the EUs of the
work done in the current month.

• If there is no beginning WIP, there is no difference between

the two methods.

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 Transferred-in costs (Appendix)

• Transferred-in costs occur in sequential production

processes.

• Transferred-in costs are the costs assigned to the units

transferred from the first process/department to the
subsequent process/department.

• Transferred in costs are conceptually similar to direct

material costs.

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Transferred in
from Mixing
department.
Refer to the
Departmental
Production
Report on
slide 18.
390,000 litres
= 1,220,000
bottles.

Additional
column to
account for
the
transferred-
in EU from
the mixing
department

This is the cost

of the
completed and
transferred out
units from
Mixing
Department
(slide 17) to
Finishing
Department.

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 Quick Check 
Hamilton, which uses a process-costing system, had a balance in its
Work-in-Process account of $68,000 on January 1. The account was
charged with direct materials, direct labor, and manufacturing
overhead of $450,000 throughout the year. If a review of the
accounting records determined that $86,000 of goods were still in
production at year-end, Hamilton should make a journal entry on
December 31 that includes:

A. a debit to Cost of Goods Sold for $432,000.

B. a credit to Finished-Goods Inventory for $432,000.

C. a credit to Work-in-Process Inventory for $432,000.

D. a debit to Finished-Goods Inventory for $86,000.

E. a credit to Work-in-Process Inventory for $86,000.

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 Quick Check 
Barrett Corporation had 6,500 units of work in process on
April 1. During April, 19,100 units were completed and as of
April 30, 5,100 units remained in production. How many
units were started during April?
A. 11,600.
B. 17,700.
C. 20,500.
D. 30,700.
E. None of the other answers are correct

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 Quick Check
Willingham uses a process-costing system for its single product, which is
manufactured from Material X and Material Y. X and Y are introduced to the
product as follows:

Material X: Added at the beginning of manufacturing

Material Y: Added at the 75% stage of completion

The company started and completed 40,000 units during the period
and had an ending work-in-process inventory amounting to 8,000 units, 20%
complete. Which of the following choices correctly expresses the total
equivalent units of production for Material X and Material Y?

X Y
0% 75%
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 2. Process costing and spoilage

• For almost all businesses, defective outputs are produced

and have to be scrapped or disposed off.

• Spoilage cost is the cost of defective products and wasted

resources that cannot be recovered by rework or recycling.

• Spoiled units are costed along with the other two outputs –
units completed and work in process, depending on the
stage of completion when the inspection happens that
detects the spoilage.

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 Process costing (weighted average method)
and spoilage Spritz Mixing Department
Step one: Analyse the physical flow of units, including spoiled units
Step two: Calculate the equivalent units, including spoiled units

(cont.)
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 Process costing (weighted average method)
and spoilage Spritz Mixing Department
Step three: Calculate the cost per equivalent unit, including spoiled units

(cont.)

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Step four:
Analyse the total
costs, including
spoilage.
Compute
• Cost of goods
completed and
transferred out
• Cost of spoiled
units
• Cost of ending
WIP

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 Understand the treatment of
Spoilage – Normal Spoilage
• It is unavoidable, necessary, inherent in the production
process and that occurs even when under efficient operating
conditions. E.g., in packaged/canned manufacturing – parts
of vegetables purchased are not suitable for consumption.

• It is treated as part of the normal production cost for the WIP

inventory or finished items (i.e., is absorbed into all products
and is included in inventory valuation).

*Being the cost of good units completed and transferred out ($630,900) + spoiled units ($59,250)

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 Understand the treatment of
Spoilage – Abnormal Spoilage
• Should not occur under efficient operating conditions.
E.g., in packaged/canned manufacturing – the refrigerator
broke down without notice and food stored inside cannot be
used – abnormal spoilage.

• They are not part of the normal production cost, and therefore
are expensed off separately in the P&L as “loss on abnormal
spoilage” from the production costs (i.e., cannot be used for
inventory valuation).

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 3. Operation costing systems

• Some businesses have repetitive production processes but

produce a range of products that differ in some significant
aspects. For example, Levi Strauss Company (manufactures
jeans).

• Batch manufacturing processes

−Produce products in large batches for the different
product lines.
−Require specific combinations of direct materials and a
specific sequence of production processes.

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Continuum of costing systems

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 Operation Costing

• Used in a hybrid / batch manufacturing environment.

• Contains features of both job costing and process

costing:
• Direct material traced to individual batches, as in job
costing approach.
• Accumulates conversion costs by department (or
process), which are allocated to all units passing through
the department (process), as in process costing.

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Operation Costing

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 Example of Operation Costing
The March production of a basketball manufacturer consisted of
batch 1 (2,000 professional basketballs) and batch 2 (4,000
normal basketballs). Each batch was started and finished during
March, and there was no beginning or ending work in process.
Costs incurred were as follows:
Direct Material:
Batch 1: $42,000 ($21 per ball)
Batch 2: $48,000 ($12 per ball)
Conversion Costs:
- Department A: predetermined rate of $8 per ball
(all basketballs are worked on in department A)
- Department B, predetermined rate of $6 per ball
(only professional basketballs are worked on in department B)

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 Example of Operation Costing
Cost per basketball Batch 1 Batch 2
(prof) (normal)
Direct Material:

- Batch 1 (professional basketballs) $ 21

- Batch 2 (normal basketballs) $ 12

Conversion:

- Department A $8 $8

- Department B (only for professional $6

basketballs)
Total cost per basketball $ 35 $ 20
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 Quick Check 
Glowery Corporation, which uses an operation-costing system, has three
processing departments. All units pass through Department 1. Upon completion of
Department 1’s process, 80% of the goods are sent to Department 2 and 20% are
sent to Department 3. Additional data follow.

Fifty-six thousand units were manufactured during the year.

Conversion cost in each department was: No. 1, $396,000; no. 2, $204,000; and
no. 3, $166,000.

The conversion cost per unit in Department 1 is:

A. $7.45.

B. $7.07.

C. $5.15.

D. $2.55. 36
 Quick Check 
The conversion cost per unit in Department 2 is:

A. $4.45.

B. $4.55.

C. $5.15.

D. $3.55.

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 Quick Check 
Owl's Hours produces herbal tea and prides itself in having one of the largest
ranges of herbal teas in Australia. It sells more than 50 varieties of tea leaves with
a wide range of prices (depending on where the tea leaves are grown). The
production processes of its products is simple, but vary depending on whether
the tea is sold as loose leaves (which requires packing tea leaves in various sized
boxes) or tea bags (which requires additional process in packaging tea in specially
designed tea bags). Owl's Hours decides to use an operation costing system. This
decision is
A. correct, because the company uses a large variety of tea leaves as direct
materials and yet has simple production processes.
B. correct, because the company uses a large variety of tea leaves as direct
materials and the different products require different sequences of
processes.
C. incorrect, because the different production lines require the tea leaves to be
packaged in very distinctive methods.
D. incorrect, because the company has a very homogenous product – it
produces and sells only tea.
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 Other issues in process costing

• The percentage of completion is difficult to determine

and is often only a rough estimate.

• A predetermined conversion rate (budgeted conversion

costs/budgeted cost driver level) may be used in
process and operation costing.

• Standard costs are more likely to be used than actual

costs for process costing environment (discussed in
future lecture).

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 Service Industry

• In service firms some routine, repetitive or similar

services can be costed using process or operation
costing.

• Cost of a service is obtained by assigning costs to

masses of similar unit and then computing unit cost on
an average basis. For example, ATM banking, postal
delivery and credit card processing.

• More would be covered in Lecture 5.

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 Summary

• Process costing suits businesses that mass-produce a small

range of products.
• Weighted average or FIFO methods may be used to assign
costs to finished products and work in process inventory.
• The presence of work in process inventory requires
calculation of equivalent units.
• Simple forms of process costing do not entail the costing of
work in process inventory.
• Operation costing is a hybrid of job and process costing

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 Lecture Suppl. Question 1

Auger Inc. uses the weighted-average method in its process costing system. The
following data concern the operations of the company's first processing department
for a recent month.

Required:
a. Determine the equivalent units of production.
b. Determine the costs per equivalent unit.
c. Determine the cost of ending work in process inventory.
d. Determine the cost of the units transferred to the next department. 42
 Lecture Suppl. Question 2
Brani Safe Detectors Ltd makes building safety sensors (SS) for the construction
industry. The company uses a process costing system and has only a single processing
department. The following information pertains to operations for the month of May:

The beginning work in process inventory was 60% complete with respect to materials
and 20% complete with respect to conversion costs. The ending work in process
inventory was 90% complete with respect to materials and 40% complete with
respect to conversion costs. The costs were as follows:

Using the weighted-average method:

(2a) the cost per equivalent unit of materials for May is closest to:
A. $4.12 B. $4.50 C. $4.60 D. $5.03
(2b) the cost per equivalent unit of conversion cost for May is closest to:
A. $5.65 B. $5.83 C. $6.00 D. $6.41
(2c) the total cost of the units in ending work in process inventory is closest to:
A. $156,960 B. $86,400 C. $153,960 D. $154,800
 Lecture Suppl. Question 3 - Challenge
ABC Private Limited (ABC) manufactures a Chicken-based soup. The product goes through three processes:
extraction (P1), cooking (P2) and canning (P3).
In the cooking phase (P2), a specially formulated chicken essence (DM1) is added in its entirety to the transferred-
in solution from P1 in a specially constructed boiler. One-quarter-way (¼) through this process, a concoction (DM2)
is then added, again in its entirety to the mixture. At the end of the process in P2, a secret ingredient (DM3) is then
added to the mixture. DM3 is seen as free of charge because only the owner has the details and no costing
document is available to support the costing details. The output from P2 is then sent to P3 for the canning
process.
The following information is available for P2 for the month of October 20x9.
Litres Costs
Work-in-process (WIP), beginning inventory Oct.1 20x9 20,000
Transferred in costs (TIC) from P1 $ 80,000
Direct material $100,000
Conversion costs (CC) (10% completion) $ 21,760
TOTAL WIP Oct.1 20x9 $ 201,760

Litres Costs
Transferred in costs (from P1) during October 500,000 $830,000
Costs incurred in P2 during October 20x9
DM1 $ 394,000
DM2 $ 980,000
Conversion costs $ 474,240
TOTAL COSTS $1,848,240
WIP, ending inventory (20% completion) Oct. 31 20x9 30,000 litres
Required (Using the weighted-average method)
a) What is the TOTAL cost per equivalent unit (EU) for P2?
b) What is the cost of the finished (completed) product transferred to the Canning Process, P3 (Canning
Department)?
c) What is the cost of the ending work-in-process inventory (WIP) in the Cooking Process P2 (Cooking 44
Department) at the end of October 20x9?