Process Costing – Definition
A process costing system accumulates the costs of a production process and assigns them to the products that comprise the organization’s output. Production report has to be made under process costing system.
The method of process costing is applied to ascertain the cost of production in those industries, where a product passes through different processes or stages of production before its completion. Under process costing, there is a finished product at each stage which becomes the raw material of the subsequent stage or next process till the final stage of completion.
Process costing method is generally employed in industries like chemicals, distilled products, canned products, food products, oil refineries, edible oils, soap, paper, textiles, etc.
Process costing refers to a type of costing procedure adopted by such a factory wherein there is continuous or mass production and costs, where, are accumulated on a basis. The following five conditions are favorable for the use of process costing:
(1) Production of a single output in a plant.
(2) Division of a plant into different processes and departments. Each process is responsible for the manufacture of a single product.
(3) Processing a single product for a Scheduled time, followed by successive runs of other products. Here costs are calculated separately for each run.
(4) Production of several products being produced simultaneously from the same process.
(5) Division of a factory into separate operations, each performing standard operation.
(6). Costs are calculated process-wise.
Characteristics of Process Costing
The following are the main characteristics of process costing.
- Continuous production.
- End product comes out after a sequence of process is complete.
- Homogeneous product, Identical and standardized product ensures quality.
- The processing sequence is specific and predetermined.
- The finished product of one process is a raw material for next process till the final process.
- Costs are calculated process wise.
General Principles of Process Costing
The following are the general principles of process costing:
- All expenses—direct and indirect—are accumulated and classified according to the process.
- Process wise records are maintained including that of quantity of production, scrap, wastage, etc.
- To know the average cost per unit for the period, the total cost of each process is divided by the total production.
- The cost of the process is also transferred with the transfer of the product to another process.
- The production and inventories are computed in terms of completed products.
- The cost of normal spoilage, wastage, etc. is included the cost products.
Features or Process Costing
The main features of process costing may be given as follows:
- The production is divided into various stages (known as processes) and each process is carried out by separate cost center or department.
- The production is continuous and the final product or end product is the result of a sequence of processes or operations.
- The finished product of each process is treated as the raw material of the subsequent process.
- The units of the commodity produced are homogeneous and identical in nature.
- The cost of production per unit is the average cost which is obtained by dividing the total process cost by the total number of units manufactured.
- The sequence of processes and operations employed is pre-determined.
- There is indispensable loss in the process of production. It is known as a normal loss. It may be due to the inherent nature of the material used for production i.e., loss may occur due to chemical action, loss in weight and evaporation, etc. The normal loss is absorbed by the cost of good units.
- The processing of raw material may lead to joint products and by-products.
- There may occur abnormal loss and abnormal gain. These are treated separately under process costing.
- Inter-process profits are also kept in mind while transferring the output at market Plice to another process. It will depict the market price and will be helpful in checking the inefficiency and losses taking place in a process.
- The concept of equivalent production is also considered under process costing. It means that when some units are in the semi-finished stage, these are to be expressed in terms of equivalent completed units or effective units.
- Costing profit and loss is calculated after taking into account the opening balance of finished stock and the closing balance of the finished stock. The process accounts are helpful in the proper valuation of the raw material, work-in-progress (semi-finished goods) and finished goods. These stocks are shown in the Balance Sheet.
To sum up these principles, W.W. Big. has nicely remarked, “The fundamental principle involved in process cost accounts is simple. A separate account is opened for each process or distinct operation to which all expenditure incurred thereon is charged. When the process or operation has been completed, the partially worked out product is passed into a process stock account from which it will be requisitioned as and when required by the next process or it may become automatically the raw material of the next process and be charged to the Process Account immediately.”
Application of Process Costing
Industries which may apply process costing may be classified as:
(1) Those producing a single product. These industries are those which are engaged in producing (i) electric power (ii) gas, (iii) water, (iv) steam, (v) cement, (vi) rubber, (vii) paper, etc.
(2) Those producing a variety of products. These industries use the same productive facilities. Such industries are (i) founds aries, (ii) laundries, (iii) flour mills, etc.
(3) Those producing a variety of products bat using separate facilities instead of the same productive facilities. Such industries may be known as extractive i.e. mining.
Process Costing Procedure
Under process costing, the manufacture of a product is divided into well-defined processes. A separate account is opened for each process to which all costs incurred thereon, are charged. The total number of units produced during a given period is calculated and by dividing the total cost of a process by the total number of units produced, the cost per unit shall be obtained. The finished material of one process constitutes the raw material of the next or subsequent process and therefore, the finished material as also the cost of each process is transferred to the next process till it is transferred to the Finished Stock Account.
Computation of unit cost under process costing system
The computation of units costs for the work performed during a period is a key part of the production report. You might think that this is easy — just divide the total cost by the number of units produced. However, the presence of work in process inventories causes problems. You cannot calculate the total output of the period by just taking the sum of completed units and work in process (ending inventory). Because units in the work in the process inventory are not 100% complete. This problem is handled through the concept of equivalent units of production.
The process costing procedure can be explained by means of the following example/illustration:
A product passes through three processes, Process A, Process B and Process C, to completion. The production of the commodity was 1,000 tonnes. The costs were as follows:
Assume that there was no work-in-progress either at the beginning or at the end. Show the process costs for each process and the total cost of the finished product.
Cost per Unit = Cost of input / Output
= $6,000 / 1,000 tonne
= $6 per tonne
Cost per unit = $15,000 / 1,000 tonne = $15 per tonne
Cost per unit = $27,000 / 1,000 tonne = $27 per tonne
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.