Process Costing

Whenever we think of cost for making a product the first thing that comes to our mind is Material Cost and undoubtedly it’s the heaviest cost incurred by any manufacturing company due to which we try to minimise it. Inventory is nothing but assets of organisation which requires investment. Every investment has a cost attached to it and if we invest huge in inventory we will have to loose an opportunity of investing these funds elsewhere and earn something but if we are low on investment in inventory we tend to loose on sales. Think of being a trader of any commodity you will definitely feel the above words. So now we not only have to think on how much to invest in inventory (HOW MUCH TO ORDER) but when to invest (WHEN TO ORDER). We hereby only discuss how many units should one order i.e. HOW MUCH TO ORDER.

Process basically means a series of actions that you do for a particular purpose. Process can also be understood as getting into something and continuing it till you don’t get the desired result.

E.g. 1. Process of growing up in Life.

2. Process of a Day.

3. Process of Education

4. Process of Becoming the Best. Your Role Model is a live example of this:

Whatever course you might enroll yourself into you will have to clear 1st 2nd & 3rd level to get the requisite degree may it be CA / CS / CFA or any other professional degree.

Process costing deals with manufacturing companies producing goods where material has to pass through two or more processes for being converted into a final product and costs are charged to processes or operations and averaged over units produced. It is similar to Manufacturing Accounts in Financial Accounts. CIMA, London defines process costing as “that form of operation costing which applies where standardized goods are produced.”

1.The factory is divided in a number of processes and cost is collected process – wise.
2.The production is continuous and processes are standardized.
3.The output of one process becomes the input of another process and finally transferred to finished goods.
4.The products produced are homogenous.
5.It is not possible to trace the identity of any particular lot of output to any lot of input materials.
6.Both direct and indirect costs are accumulated in each process.
7.If there is a stock of semi-finished goods, it is expressed in terms of equivalent units.
8.Cost per unit is calculated at the end of period by dividing the total process cost by the normal output produced.
9.Production of a product may give rise to Joint and/or By-Products.

Process costing is being used by following Industries as under:
1.Identical Products Industries
2.Industries with Multiple Departments

Businesses having multiple departments use process costing to assess the costs accumulated by each department. When the costs of production go up unexpectedly, process costing allows management to quickly pinpoint the department responsible for the increased costs and identify the source of the increased cost.

3. Industries with Interchangeable Parts

Process costing comes into play when a factory manufactures identical parts. For example, a computer manufacturing plant will create numerous components that are interchangeable among computers of the same model. Process costing allows manufacturers to sell individual parts separately to computer repair shops or individual buyers, since the manufacturers know the cost of the separate parts.

4. Industries with Varying Product Features

Products that have multiple extraneous features can benefit from process costing. Manufacturers can release two versions of the product, with one version costing less but having fewer features and another product costing more but having more features.

5. Innovative Industries

Process costs are important in industries that have high innovation. For example, manufacturers cannot determine an appropriate price for a new type of product without knowing how much the product will cost to manufacture overall.

6. General Application

It is generally applied in –
a) Paper Industries
b) Chemical Industries
c) Textiles Industries
d) Sugar Industries
e) Steel Industries
f) Rubber Industries
g) Shoes Industries
h) Crude Oil Refineries

1.Accumulate cost of each and every process and open a separate account in respect of each process.
2.On the debit side of process account we record –
a.Material cost
b.Labour cost
c.Direct expenses
d.Factory overheads are charged on the some suitable basis.
e.Cost of rectification of normal defectives
f.Cost of Abnormal Gain (If any)
But we never record Admin and Selling & Distribution overheads as they are not related to production of goods.
3.On the credit side of process account we record –
a.Scrap value of Normal loss (if any)
b.Units transferred to next process or finished goods
c.Cost of Abnormal loss (if any)
4.Equivalent Production Units
For incomplete physical units in progress at the end of a period, equivalent production units are calculated on the basis of percentage estimate of degree of completion. Foe e.g. If 1000 units are in progress and it is estimated that they are only 40 % completed, then these 1000 units are equivalent to 400 completed units.
5.Average cost / Normal cost per unit is calculated as follows
= Total Cost – Scrap Value of Normal Loss (if any)
Expected Output (Input – Normal loss units)
6.The units transferred to the next process or finished goods as well as the abnormal loss or abnormal gain (as the case may be) are valued at Normal cost per unit.

In manufacturing processes, entire input is not getting converted into output. A certain part of input is lost while processing which is inevitable. Wastages of material, evaporation of material, changes in moisture content are unavoidable in some process. But sometimes losses occur due to negligence of labour, poor quality raw material, poor technology etc. These are normally called as avoidable losses. Basically process losses are classified into two categories (a) Normal Loss (b) Abnormal Loss

NORMAL LOSS

Normal loss is an unavoidable loss which occurs due to the inherent nature of the materials and production process under normal conditions. It is normally estimated on the basis of past experience of the industry. It may be in the form of normal wastage, normal scrap, normal spoilage, and normal defectiveness.

Calculation: Normal Loss = Input x Expected % of Normal loss

Valuation: Units of Normal Loss x Scrap value per unit.

Treatment: The cost of normal process loss is absorbed by good units produced under the process. The amount realised by the sale of normal process loss units should be credited to the process account.

Sometimes we may have to incur cost to pick up scrap in such case it is our cost and we will still write it on the credit side and put the amount in brackets.

ABNORMAL LOSS

Any loss caused by unexpected abnormal conditions such as plant breakdown, substandard material, carelessness of workers, accident, unplanned operations etc. such losses are over and above normal losses and cannot be estimated in advance. This loss is basically avoidable. Thus abnormal losses arrive when actual losses are more than expected losses.

Calculation: Expected Output (Input – Normal loss) – Actual Output

Valuation: Normal Cost x Units in abnormal loss

Treatment: The cost of abnormal loss is not treated as part of cost of production and therefore not absorbed by good units produced and hence charged to Costing Profit & Loss Account.

ABNORMAL GAIN

Abnormal Gain arises when actual output is more than the expected output or when actual losses are less than the expected normal losses.

Calculation: Actual output – Expected Output (Input – Normal loss)

Valuation: Normal Cost x Units in abnormal gain

Treatment: The cost of abnormal loss is not treated as recovery of cost of production and therefore cost of good units is not reduced by the cost of abnormal gains and hence credited to Costing Profit & Loss Account.

• Normally the output of one process is transferred to another process at cost but sometimes at a price showing a profit to the transfer process.
• The transfer price may be made at a price corresponding to current wholesale market price or at cost plus an agreed percentage.
• The advantage of the method is to find out whether the particular process is making profit (or) loss.
• This will help the management whether to process the product or to buy the product from the market.(MAKE OR BUY EVALUATION)
• If the transfer price is higher than the cost price then the process account will show a profit.
• The complexity brought into the accounting arises from the fact that the inter process profits introduced remain a part of the prices of process stocks, finished stocks and work-in-progress. The balance cannot show the stock with profit.
• To avoid the complication a provision must be created to reduce the stock at actual cost prices. This problem arises only in respect of stock on hand at the end of the period because goods sold must have realized the internal profits.
• The unrealized profit in the closing stock is eliminated by creating a stock reserve.

1. Costs are be computed periodically at the end of a particular period.

2. It is simple and involves less clerical work than job costing.

3. It is easy to allocate the expenses to processes in order to have accurate costs.

4. Use of standard costing systems in very effective in process costing situations.

5. Process costing helps in preparation of tender and quotations.

6. Since cost data is available for each process, operation and department, good managerial control is possible.

. Cost obtained at each process is only historical cost and are not very useful for effective control.

2. Process costing is based on average cost method, which is not that suitable for performance analysis, evaluation and managerial control.

3. Work-in-progress is generally done on estimated basis which leads to inaccuracy in total cost calculations.

4. The computation of average cost is more difficult in those cases where more than one type of products is manufactured and a division of the cost element is necessary.

5. Where different products arise in the same process and common costs are prorated to various costs units. Such individual products costs may be taken as only approximation and hence not reliable.

1. This product costing system is used when an entity produces
   • More than one variant of final product
   • Using different materials but
   • With similar conversion activities.
2. It means that conversion activities are similar for all the product variants but materials differ significantly
3. Operation Costing method is also known as Hybrid Product Costing System as materials costs are accumulated by job order or batch wise but conversion costs i.e. labour and overheads costs are accumulated by department, and process costing methods are used to assign these costs to products.
4. Moreover, under operation costing, conversion costs are applied to products using a predetermined application rate. This predetermined rate is based on budgeted conversion costs.
5. For example, a company is manufacturing two grades of products, Product- Deluxe and Product- Regular. Both the products pass through a similar production process but require different quality and quantities of raw materials. The cost of raw material is accumulated on the basis of job or batches or units of two variants of products. But the costs for the conversion activities need not to be identified with the product variants as both the Products require similar activities for conversion. Hence, conversion activity costs are accumulated on the basis of departments or processes only.
6. Examples of industries are ready made garments, Shoe making, jewelry etc.