Product Costing

• Why would you want to know the cost of

a product?
Reasons include:
• Value inventories on hand
• Determine cost of goods sold
• Make pricing decisions
• Determine product line profitability
• Should we drop a product line?
Should we make or buy? Should
we accept a special order?

Job Costing and Process Costing

Product costing systems

• Accumulate product-related costs and use

procedures to assign them to the final products

• Product costs include production costs

• In some businesses upstream and downstream

costs are also regarded as product related
Job and Process costing

Job costing
Products produced in distinct batches, or jobs.
Costs assigned to each job and the total cost of the job is
averaged over the number of units
e.g. furniture craftsmen, lawyers, electricians

Process costing
Products identical or very similar & produced in large quantities.
Costs assigned to processes and the total cost of each process
is averaged over the number of units passing through it
eg soft drink manufacturers, vehicle registrations
Job Costing & Process 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

and averages these costs over units produced in the job

• Process costing systems accumulate the cost of each

process then averages these costs across all units
passing through each process

• Many businesses use a combination of job and

process costing; ie a hybrid costing system
Process costing

• Used by businesses that mass produce one product or a small

range of almost identical products
• Involves a number of processes that are performed
repetitively
eg oil refineries, food processors and manufacturers of
tobacco, chemicals and paper

Also used by producers of repetitive services eg routine

processing of cheques in banks
Process costing (cont.)

• Two main steps

– Estimate the cost of the production process
– Calculate the average cost per unit by dividing the cost of
the process by the number of units produced

• Process costing can occur where there is no opening or

closing WIP inventory
• More complex process costing takes account of WIP
inventory
– Need to calculate equivalent units to apportion cost
between new production and inventory
Process costing with work in process
inventories

• WIP inventory
– Not all products are complete at the beginning or end of the
period (usually a month)

• Production costs calculated after taking into account

– Units started in the previous period and completed in
current period (beginning WIP)
– Units started and completed in the current period
– Units that are incomplete at the end of the current
period (ending WIP)
Process costing with work in process
inventories (cont.)

• If at the end of a period have partially completed goods need

to convert them to equivalent units

• Equivalent units –relate to the amount of production

inputs that have been applied to the physical units in
production
– Physical units are all units currently in production
whether complete or incomplete
– When WIP exists equivalent units must be used to
calculate unit costs
Process costing with work in process
inventories (cont.)

• Direct Materials are usually placed into production at one

or more distinct points in the process

• Direct labour & Manufacturing Overhead are usually

incurred continually throughout the process

• Units in ending WIP are generally at different stages of

completion with respect to material and conversion
cost
Equivalent units

• Equivalent units are used to calculated unit costs when

there is WIP

• If WIP of Spritz soft drink is 50% complete for 10,000 litres

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, as conversion costs
occur uniformly across the production process 5,000
equivalent units of conversion cost
The effects of beginning and ending
work in process inventories

• 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
Lecture Illustration: Spritz Soft Drinks

Exhibit 1: Summary of Production & Costs for Mixing Dep’t - April

Work in Process, 1 April: 20,000 litres
Direct Material: 100% complete $ 54,600
Conversion: 10% complete
Balance in work in process, 1 April 4,670
$ 59,270
Physical flow of units
Units in work in process inventory, 1 April 20,000 litres
Units started in April 380,000 litres
Units completed during April & transferred out 390,000 litres
Units in work in process inventory, 30 April 10,000 litres
Direct Material 100% complete, conversion 50% complete
Costs incurred during April
Direct Material $505,400
Conversion:
Direct Labour $ 30,880
Manufacturing Overhead 110,600 141,480
Total manufacturing costs $646,880
incurred in April
Process costing using the weighted
average method

• Step 1: Analyse the physical flow of units

Physical
Physical units Physical Physical units units in
in beginning + units - completed and = ending
WIP started transferred out WIP

20,000 + 380,000 - 390,000 = 10,000L

Process costing using the weighted
average method (cont.)

• Step 2: Calculate the equivalent units

Under the weighted average method the equivalent units in

beginning WIP are not identified separately

Equivalent units
completed and Equivalent units Total equivalent
+ transferred = in ending WIP units
out
 Lecture Illustration: Spritz

Steps 1 and 2 can be combined into 1 schedule

% Complete Equivalent Units

Physical with respect Direct
Units to conversion Material
Work in process, 1 April Conversion
+ Units started in April
= Total Units to Account For

Units Completed & Transferred

Out in April
+ Work in Process, 30 April
= Total Units Accounted For

Total Equivalent Units

Process costing - weighted average
method (cont.)

• Step 3: Calculate the unit costs

– The cost per equivalent unit for direct material is the total
direct material costs divided by the total equivalent units
for direct material

– The cost per equivalent unit for conversion cost is the

total conversion cost divided by the total equivalent
units for conversion

– Under the weighted average method the cost per

equivalent unit is based on the total costs incurred
including the cost of beginning WIP
Lecture Illustration cont.

Step 3: Calculate the Unit Costs

Direct
Material Conversion Total

Work in Process, 1 April (Exh 1)

+ Costs incurred in April (Exh 1)
= Total Costs to Account For

 Equivalent Units (Exh 2)

= Cost per Equivalent Unit
Process costing - weighted average
method (cont.)

• Step 4: Analyse the total costs

– The production cost of units are transferred to the

next production process or to finished goods

– Cost of incomplete units remains in WIP

Lecture Illustration cont.

Step 4 : Analyse the total costs

Total
Cost of goods completed & transferred out in April
= (No. of units transferred out X total cost per eq. unit)

Costs remaining in WIP inventory - April 30

• Direct Material (DM)
= (No. of eq units of DM X DM cost per eq unit)
• Conversion (Conv)
= (No. of eq units of Conv X Conv. cost per eq unit)

Total cost of WIP inventory -- April 30

Process costing - the FIFO method

• Assumes that the WIP inventory is completed before the

production of new units commences

• Step 1: Analyse the physical flow of units

• Identical to the weighted average method

• Step 2: Calculate the equivalent units

• Under FIFO the equivalent units in opening WIP are
subtracted from total equivalent units to give
equivalent units of new production for the month

(cont.)
Process costing - FIFO method (cont.)

• Step 3: Calculate the unit costs

• Costs of opening inventory are not used in this
calculation

• Step 4: Analyse the total costs

• Assumes that the units in beginning WIP are
completed and transferred out first
• Costs of the beginning WIP are not mixed with those
new costs incurred during the current month
Comparison of weighted average and
FIFO methods

• Key difference is the treatment of beginning WIP

• Under the weighted average method the cost of
beginning WIP and equivalent units of work done on it
are included in the calculation of the average cost per
equivalent unit

• Under FIFO the cost per equivalent unit is based only

on costs incurred in the current month

Weighted average is more commonly used than FIFO

Process costing and spoilage

• Spoilage: the cost of defective products and wasted

resources that cannot be recovered by rework or
recycling

• When spoilage occurs there are 3 forms of output

• Units completed and transferred out
• Spoiled units
• Unfinished units remaining in WIP

• Spoiled units are costed using cost per equivalent unit

along with the other two outputs
(cont.)
Process costing and spoilage (cont.)

Normal spoilage: inherent in the production process and

occurs even under efficient operating conditions
• Included as part of the cost of good units
completed

Abnormal spoilage: spoilage that would not occur under

efficient operating conditions
eg contamination due to lapse in sterilisation
procedures
• Costs of abnormal spoilage are expensed as
incurred
Operation Costing

Operation Costing is a hybrid costing system that

• assigns direct material costs to individual batches (job
costing)
• Accumulates conversion costs by department and allocates
these costs to units passing through the department (process
costing)

Suits businesses that use repetitive production processes

to produce a range of products
Other points to consider in process
costing

• Standard costs are more likely to be used than actual costs

• Process costing and operation costing are consistent with concepts

of responsibility accounting
– Costs accumulated by processes or operations that are
usually performed in separate departments
– Department manager may be held responsible for the
department’s costs and for output produced

• A predetermined overhead rate may be used to apply mfg o/head eg

process costing; & a predetermined conversion cost rate may be
used to apply labour & overhead (conversion costs) eg operation
costing
– Underapplied or overapplied costs to be accounted for
Other points to consider (cont.)

• Production units are usually used as the cost driver in

process costing and operation costing
– Inputs such as machine hours or labour hours may be used
as cost drivers in operation costing
• The percentage of completion is difficult to determine and is
often only a rough estimate
– Some businesses will ignore WIP inventories for simplicity
• In service firms some routine, repetitive or similar services
can be costed using process or operation costing
procedures e.g. processing cheques at a bank
Summary

• Job Costing suits firms that produce a range of dissimilar

products
• Process costing suits firms that mass produce identical or very
similar products
• In process costing, the presence of WIP inventory requires
calculation of equivalent units
• Equivalent units reflect the amount of production inputs
applied to the physical units in production
• Weighted average or FIFO methods may be used to assign
costs to products and inventory
• Operation costing is a hybrid of job costing and process costing