Managerial Accounting

B11-A681Chapter 23

Process Costing

Learning Objectives

1. Explain process operations and how they differ from job order operations

2. Compare process cost accounting to job order cost accounting systems

3. Record the flow of direct materials in process costing

4. Record the flow of direct labour in process costing

5. Record the flow of factory overhead in process costing

6. Define equivalent units and explain their use in process cost accounting

Learning Objectives

7. Compute equivalent units produced in a period8. Explain the four steps in accounting for

production activity9. Define a process cost summary and describe

its purposes10. Prepare a process cost summary11. Record the transfer of goods between

departments12. Record the transfer of goods from finished

goods to cost of goods sold13. Analyze cost per equivalent unit with and

without spoiled units

Process Costing

• Process costing is the mass production of many homogenous units.

• Examples of process costing include oil refineries, automobile production plants, carpeting, paint, hand tools and even Canada Post.

Process vs Job Order

Process Costing• Repetitive

production• Homogenous

products• High production

volume• Low product

flexibility• High standardization

Job Order Costing• Custom orders• Heterogeneous

products• Low production volume• High product flexibility• Low to medium

standardization

Objective

• The objective of job order costing was to determine the cost per unit of each finished product

• This is the same in process costing but the environment is completely different.

• In job order costing costs could be directly attributed to a batch or job.

• In process costing this is impossible.• Instead the ‘cost object’ is not the product but

the process or more specifically departments or stages in the production process.

Process Costing

• In process costing each process is identified as a separate department, workstation or work centre.

• A manager is usually responsible for at least one of these.

• With the exception of the first department each department receives the output from the prior department.

• As the product moves from one department to the next additional labour, overhead and sometimes material are added.

Cost Objects

• In job order costing the cost object was the product being produced.

• Cost were accumulated to a particular product because material and labour could be traced directly to the product.

• In process costing the cost object is the process itself, or the departments which make up the process.

• Direct materials are materials that can be traced to a particular department

• Direct labour is the labour used in that department

Cost Objects

• What’s the difference?• A supervisor in a department in job

order manufacturing would be indirect labour, as the work done could not be directly attributed to any particular job in production

• In process costing that same supervisor would be direct labour as the work is directly associated with the department.

Materials Costs

• When $3,000 of materials are received in raw materials inventory:

Dr: Raw materials inventory $3,000Cr: Cash or A/P $3,000

• To record the requisition of $1,000 worth of raw materials into production for department A

Dr: Goods in process inventory – department A $1,000Cr: Raw materials inventory $1,000

• As each department will have separate costs, and it is these cost we track, each department has its own goods in process inventory account.

• Notice this is virtually identical to job order costing

Labour Costs

• To record factory payroll of $15,000 for the factory the journal entry is:

Dr: Factory payroll $15,000Cr: Cash $15,000

• Based on time records $10,000 is for department A and $5,000 for department B

Dr: Goods in process – dept A $10,000Dr: Goods in process – dept B $5,000

Cr: Factory payroll $15,000• Notice the similarity to job order costing

Factory Overhead• To record $500 of indirect materials the journal entry is:Dr: Factory Overhead $500

Cr: Raw materials inventory $500• To record $800 of indirect labour the journal entry is:Dr: Factory Overhead $800

Cr: Factory payroll $800• To record $2,500 in amortization, $1,000 in expired

insurance, $3,500 in other miscellaneous overhead costs:

Dr: Factory overhead $7,000Cr: Accumulated amortization $2,500Cr: Prepaid insurance $1,000Cr: Accounts payable $3,500

• Notice the similarity to job order costing

Factory Overhead

• As was the case in job order costing, we also ‘apply’ factory overhead in process costing.

• This can be done with one ‘global’ or factory wide rate

• Some companies prefer to have a rate set by department.

• It is also possible to have separate factory overhead costs for every department to aid in having multiple rates

Factory Overhead

• Assume the predetermined rate is 50% of labour, the journal entry is:

Dr: Goods in process – dept A$5,000

Dr: Goods in process – dept B$2,500Cr: Factory Overhead $7,500

Equivalent Units

• As examined so far the entry of inputs such as materials, labour and overhead is virtually identical to job order costing.

• The major problem in process costing is determining the cost of the outputs from each department.

• To approach this problem we must determine the cost per unit and then apply that cost to the number of units transferred.

Equivalent Units

• This problem is simple if there is no inventory.• Costs transferred out = costs transferred in.• However, we often have inventory and must come

to a measure of how complete the inventory is.• If we have 100 units of inventory that are 40%

complete how many units is that?• We have created a ‘theoretical’ measure called

equivalent units.• 100 units 40% complete = 100 x40% = 40

equivalent units• Equivalent units is the theoretical measure of how

many whole units would have been completed.

Equivalent Units• The logic of this is:

– If a department had only worked on 40 units in the same time they would have been 100% complete.

• Equivalent units are often different for – Materials – Labour

• Example– A production department adds all its material at the

beginning of the production process– Labour and overhead take place evenly throughout the

process– In this case if ending inventory is 50% complete the 50%

would apply only to labour and overhead– Materials would be 100% complete, material is added only

at the beginning of the process.– Anytime after that materials are 100% complete.

Equivalent Units

• Critical to the computation of equivalent units is how we assume the department actually processes units.

• We will assume that units are produced on a FIFO (first in first out) basis.

• This is a very common assumption and is used widely in industry.

• There is an alternative called weighted average.

• In this course, and in this text, we will only concern ourselves with FIFO.

Accounting for a Periods Activity

• To account for a periods activity we examine a four step process:

1. Physical flow2. Equivalent units3. Cost per equivalent unit4. Cost reconciliation

Physical Flow of Units

• Step 1 of the 4 step process:• A simple reconciliation of the units started in

the period to the physical units completed.• Units to account for:

– Beginning inventory plus– Units started in the period– Total units to be accounted for

• Units accounted for as:– Units transferred out plus– Ending inventory– Total units to be accounted for

Physical Flow of Units

• The two total must always agree.• Effectively the units to account for are the

units the department is responsible for.• The department is responsible for those

units in opening inventory plus those units transferred in (units started)

• Those units can only be in one of two places:– Either the units are still in the department

(ending inventory) or– The units were transferred out to the next

department

Example

• Consider the following example of Fort Garry Potato Chips

• Fort Garry has a four step process:1. Peeling2. Cutting3. Frying4. Packaging

• Assume the following for the peeling department:– Opening inventory is 5,000 kg.– Units transferred in is 100,000 kg.– Ending inventory is 3,000 kg.– Units transferred out is 102,000 kg.

Example

Units to account for:Beginning inventory 5,000Units started during the month100,000

Total number of units 105,000Units accounted for as:

Units transferred from peeling to cutting 102,000Ending inventory 3,000

Total number of units 105,000

Example

• A key number used in subsequent calculations is the number of units started and completed this month.

• Completed this month is 102,000 units• Under the FIFO assumption, the

‘oldest’ inventory is processed first.• Therefore 102,000 – 5,000 = 97,000

units started and completed this month.

Equivalent Units of Production Overview

• In this step we need to multiply the % by the whole units for:– Beginning inventory– Started and completed– Ending inventory

Equivalent Units of Production Beginning

Inventory• Recall that beginning inventory this month was ending

inventory last month• The % given is always based on the % complete for

ending inventory last month– This oddity is always true

• If beginning inventory was 20% complete – – This means ending inventory last month was 20% complete– Under FIFO costing we assume we work on this inventory

first– If it was 20% complete last month, and if we assume it was

completed this month (a reasonable assumption), that means we completed the rest which is 100% - 20% = 80%.

• This is always true for beginning inventory, the % to be used is always 100% - the percent given.– The reason is that the % given related to ending inventory

complete last month.

Equivalent Units of Production

• Started and Completed– By definition, units that are both started and

completed in the month are 100% complete– This is always true

• Ending Inventory– Ending inventory are those units started but

not yet completed– The % complete is almost always the %

given.

Equivalent Units of Production

Step 2 of 4 step process• In the peeling process all (materials) are added at the

beginning of the process• As far as direct materials is concerned an item is 100%

complete the instant it enters the department• Beginning inventory had to have entered production last

month, therefore no additional costs were added this month.

• % complete is therefore 0% (100% - 100% = 0%)• Items added in the month are 100% complete as they

were added this month• Ending inventory, because of the FIFO assumption, must

have been added this month.• Therefore they are 100% complete with respect to

materials

Equivalent Units of Production

• For labour and overhead they behave similarly since overhead is applied based on labour

• Assume opening inventory is 40% complete.• Following our rule 100% - 40% = 60% is added

this month.• For items started and completed this month,

by definition are 100% complete• If ending inventory is 70% complete, under the

FIFO assumption those costs were added this month, therefore ending inventory is 70% complete.

Equivalent units

MaterialBeginning inventory 5,000 x 0%= 0Started and completed 97,000 x 100% =

97,000Ending inventory 3,000 x 100% = 3,000Labour & OverheadBeginning inventory 5,000 x 60%= 3,000Started and completed 97,000 x 100% =

97,000Ending inventory 3,000 x 70% = 2,100

Cost Per Equivalent Unit

Step 3 of 4Material – equivalent unitsBeginning inventory 0Started and completed 97,000Ending inventory 3,000Total equivalent units 100,000Labour & OverheadBeginning inventory 3,000Started and completed 97,000Ending inventory 2,100Total equivalent units 102,100

Cost Per Equivalent Unit

• Assume the following data:Direct materials costsDr: Goods in process – peeling $100,000

Cr: Raw materials inventory $100,000 Direct Labour costsDr: Goods in process – peeling $306,300

Cr: Factory payroll $306,300Factory overhead applied (50% of direct labour) Dr: Goods in process – peeling $153,150

Cr: Factory payroll $153,150

Cost Per Equivalent Unit

• Materials$100,000 / equivalent units 100,000 = $1.00• Labour$306,300 / equivalent units 102,100 = $3.00• Overhead$153,150 / 102,100 equivalent units = $1.50

Cost Reconciliation

Step 4 of 4• Reconcile costs to account for with the

costs accounted for in the period.• Cost to account for are similar

conceptually to units to account for in step 1:

Beginning inventory plusCosts assigned in the monthTotal Costs to account for

Cost ReconciliationCosts accounted for:Beginning inventory plusCosts assigned during the current period

– (equivalent units beginning inventory x cost per equivalent unit)

– For each of Direct Material, Labour and OverheadPlus Cost of units started and completed in the month

– (equivalent units started and completed x cost per equivalent unit)

– For each of Direct Material, Labour and OverheadPlus Ending inventory

– (equivalent units ending inventory x cost per equivalent unit)– For each of Direct Material, Labour and Overhead

Total costs to be accounted for.• Total costs to be accounted for must equal total costs to

be accounted for.

Cost Reconciliation

• To pull everything together a process cost summary report is produced.

• Different companies will use different forms of the report but they all serve the same function– Helps managers control departments– Helps managers evaluate performance– Provide cost information for financial

statements

Process Cost Summary

• The Process Cost Summary is too large and cumbersome to show using PowerPoint.

• Please refer to the demonstration excel spreadsheet.

• Assume that opening inventory is $10,000

Transferring Goods Between Departments

• As per the report $557,000 is to be transferred to the cutting department (the next department in processing order)

• The journal entry to record this is:Dr: Goods in process-cutting$557,000 Cr: Goods in process-peeling

$557,000

Cutting Department Data

• Beginning inventory– Units of product 12,000– Percent complete 25%

• Units received from peeling department 102,000

• Units transferred to frying 98,000• Ending inventory

– Units of product 16,000– Percentage complete 65%

Spoiled Units

• In our example we assume no spoiled units.• This is of course unrealistic • There is considerable discussion on whether

the cost of the spoiled units should be included in the cost per equivalent units– Some argue that it should be included so that

proper pricing to cover all costs is achieved– Others argue including it will make the product to

expensive and uncompetitive