Process Costing: Definition

A process costing system accumulates the costs of a production process and assigns them to the products that the business outputs. A production report has to be made under the process costing system.

Process costing is applied to determine the cost of production in industries where products pass through different phases of production before completion.

Under process costing, there is a finished product at each stage. This becomes the raw material of the subsequent stage until the final stage of completion.

Process costing is generally used in industries that deal with chemicals, distilled products, canned products, food products, oil refineries, edible oils, soap, paper, textiles, and others.

Process Costing: Explanation

Process costing refers to a type of costing procedure commonly adopted by factories. In process costing, there is continuous or mass production and ongoing costs, which are accumulated regularly.

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 that are produced simultaneously from the same process.
  5. Division of a factory into separate operations, each performing standard protocols and procedures.
  6. Costs are calculated process-wise.

Characteristics of Process Costing

The main characteristics of process costing are:

  1. Continuous production.
  2. The end product is the result of a sequence of processes.
  3. Homogeneous products with identical and standardized features ensure quality.
  4. The processing sequence is specific and predetermined.
  5. The finished products outputted from one process are used as the raw materials for the next process, which happens until completion.
  6. 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 those relating to the quantity of production, scrap, wastage, etc.
  • To determine 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 transferred along with the transfer of the product to another process.
  • Production and inventories are computed in terms of completed products.
  • The cost of normal spoilage, wastage, etc. is included in product cost.

Features of Process Costing

The main features of process costing include:

  1. Production is divided into various stages (known as processes) and each process is carried out by separate cost centers or departments.
  2. Production is continuous and the final product or end product is the result of a sequence of processes or operations.
  3. The finished product of each process is treated as the raw material for the subsequent process.
  4. The units of the commodity produced are homogeneous and identical in nature.
  5. 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.
  6. The sequence of processes and operations employed is pre-determined.
  7. There is an indispensable loss in the production process (“normal loss”). This may be due to the qualities of the material used for production (e.g., losses from evaporation). The normal loss is absorbed by the cost of good units.
  8. The processing of raw material may lead to joint products and by-products.
  9. Abnormal losses and gains may occur. These are treated separately under process costing.
  10. Inter-process profits are also kept in mind when transferring the output at market price to another process. This indicates the market price and can be helpful to identify inefficiencies and losses in a process.
  11. The concept of equivalent production is also considered under process costing. Under this concept, when some units are in the semi-finished stage, they should be expressed in terms of equivalent completed units or effective units.
  12. Profit and loss are calculated after considering the opening and closing balances of finished stock. Process accounts are helpful for the valuation of raw materials, work-in-progress, and finished goods. Stocks are shown in the balance sheet.

To summarize, W. Big offered an informative remark:

The fundamental principle involved in process cost accounts is simple. A separate account is opened for each process … to which all expenditure incurred thereon is charged.

The author continued:

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.

Use of Process Costing

Industries that may benefit from the use of process costing are:

(1) Those producing a single product: These industries are those which are engaged in producing electric power, gas, water, steam, cement, rubber, paper, etc.

(2) Those producing a variety of products: These industries use the same production facilities. Such industries include foundries, laundries, and flour mills.

(3) Those producing a variety of products but using separate facilities: Instead of using the same production facilities, such industries may be known as extractive (e.g., mining).

Process Costing Procedure

Under process costing, the procedure used to manufacture a product is divided into well-defined processes. A separate account is opened for each process to which all incurred costs are charged.

The total number of units produced during a given period is calculated. By dividing the total cost of a process by the total number of units produced, the cost per unit can be obtained.

The finished material of one process constitutes the raw material of the next. Therefore, as the finished material is transferred to the next process, the cost of each process is also transferred, until it ends in the finished stock account.

Calculating Unit Cost Under Process Costing

Calculating the unit cost for any work performed during a period is a key part of a production report.

A student’s first thought is 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-process inventory are not 100% complete.

This problem is handled through the concept of equivalent units of production. The process costing procedure is explained in more detail in the next example.

Example

A product passes through three processes: Process A, Process B, and Process C. 1,000 tons of the commodity were produced at the following costs:

Costs for Processes A, B, and C

Required: Assume that there was no work-in-progress (i.e., not at the beginning or at the end). Show the process costs for each process and the total cost of the finished product.

Solution

Process A Account
Cost per unit = Cost of input / Output
= $6,000 / 1,000 tons
= $6 per ton
Process B Account
Cost per unit = $15,000 / 1,000 tons = $15 per ton
Process C Account
Cost per unit = $27,000 / 1,000 tons = $27 per ton
Finished Stock Account

Frequently Asked Questions

What is process costing?

Process Costing, also called job-order costing, assigns total manufacturing costs to the units being produced. Process Costing is a system of product cost allocation used in merchandising and industry. The main objective is to allocate total manufacturing costs to the various products according to the proportion of resources consumed by each product.

What are the benefits of process costing?

The main benefit of Process Costing is that it provides information that can be used to make critical business decisions. For example, managers using this system can assess profit margin by product and isolate problem products before they become major issues. Process Costing also allows companies to set prices according to production costs.

What is the difference between process costing and job-order costing?

While both systems produce a cost of goods sold for a given period, Process Costing focuses on the product's progression through various stages of production. Job-order costing focuses on a specific product or service produced for a given customer. Process costs are expensed as incurred; job-order costs are capitalized. Process costs represent a higher level of accuracy than job-order costing, but they are also more complex and time consuming to develop.

How is process costing useful?

Process Costing helps companies make critical decisions based on accurate information. It allows companies to track product cost performance by production location or department—information that can be used to help determine which products are most profitable.

Can process costing be applied to service industries?

Yes, many services are produced in a manner similar to manufacturing goods. For example, when an airline provides transportation for passengers the way it would produce any product.

True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, 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.

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