What is process costing and how does it help? Process costing calculations can provide manufacturers and production companies with information on how much product will be produced and the costs involved. It is important to note, however, that factors such as the ‘number of completed products' and the ‘number still in progress' at the end of an accounting period can affect the overall costs incurred by a company during production. Therefore, many large corporations use process costing in cost accounting to keep track of their total costs and inventories.
Let's dive in to understand what is process costing, the types of process costing, and how it is calculated along with process costing system examples.
What Is Process Costing?
In manufacturing, process costing is an approach used to determine the cost of continuous mass production through one or more processes. Chemicals, erasers, and processed foods are examples of such products.
Process costing is an accounting method to track the costs associated with manufacturing a product. This method is often used in industries where products are produced in large quantities, and the production process is continuous.
Today, process costing software alternatives are available to simplify this activity. Process costing software enables precise allocation of costs to individual processes, allowing businesses to accurately determine the cost of each unit produced. This helps in understanding the profitability of different processes and making informed decisions.
With process costing in cost accounting, the cost of each unit produced is calculated by taking the total cost of production and dividing it by the number of units produced. This total cost is a culmination of all the direct costs of manufacturing the product, such as materials, labor, and overhead.
There is a difference between job costing and process costing, as job costing tracks the costs associated with specific batches or orders of products. In general, industries that use process costing produce products in large quantities, and there is little variety in the products being manufactured. Examples of industries that use process costing include chemical manufacturing, food and beverage production, and textile manufacturing.
By using this method and understanding the advantages and disadvantages of process costing, companies can better understand the total costs associated with production. This allows them to make more informed decisions regarding pricing and production processes. With this information, businesses can also identify areas where they can reduce costs and improve efficiency.
Overall, it is an invaluable tool for businesses in manufacturing industries as it provides them with a comprehensive view of their production costs. By understanding these costs and making adjustments where necessary, companies can increase their profitability and remain competitive in the marketplace. Having understood what is process costing, and the benefits of process costing software let's know the difference between process and job costing in detail.
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Process Costing vs. Job Costing
Process costing and job costing are methods used to determine the cost of each product. Let's briefly understand the core difference between job costing and process costing.
Unlike traditional costing, process costing focuses on the overall costs of the process rather than tracing costs for each individual item. This makes process costing useful for industries that produce identical products in mass quantities but are unable to trace the costs of each item individually.
On the other hand, the job costing method records both direct and indirect costs for each item or project. Custom products and services are usually priced individually by companies using this method. Construction companies that make custom homes, for instance, need to know exactly how much each house costs. They need this data to charge an appropriate amount and gauge the profitability of each project. Read Also - Software Is Recommended For Inventory Management
Importance of Process Costing
Process costing is an important part of managerial accounting that allows organizations to track the costs of their production processes. By understanding the costs associated with each process, managers can make informed decisions about where to allocate resources and how to improve efficiency.
In addition, the importance of process costing in cost accounting cannot be understated as it can help managers identify bottlenecks and other areas of waste in the production process. By reducing these costs, organizations can increase their profits and competitiveness.
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Why Use Process Costing?
Let's consider industries where the output units are uniform and individually not worth a lot. For example, reams of paper or bottles of soda, where the production costs for each unit are impossible or difficult to trace.
In such cases understanding the importance of process costing is the logical choice. Process costing is also essential to calculate the cost of goods manufactured (COGM).
Let's understand the reasons behind its usage:
Inventory control
Your inventory may need to be reported to the tax authorities, depending on your business type. It can be challenging for large companies to track thousands or even millions of products. Process costing software can help simplify this. The value of each item produced is recorded, and each department keeps track of different aspects of the business.
Monitor profit margins
When a company operates in a highly volumetric industry with narrow profit margins, even the slightest change can significantly impact profits. The process costing method enables companies to target specific departments for improvement and focus on the costs associated with their production stages.
Uniformity in reporting
The importance of process costing can be gauged by tracking the costs of each department and adding them up to calculate the cost of producing a specified quantity of items. The exact cost codes should be used to report all expenses since these expenses need to be added together. This makes reports uniform, making it easier to track costs over time.
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Steps in Process Costing
A process costing model accounts for work-in-progress (WIP) items that have entered the production process but are yet to be completed. This is accounted for at the beginning and end of every period to accurately estimate the cost of producing each unit. In process costing, there are five primary steps:
Analyzing inventory
Analyzing inventory, and evaluating cost flow is the first step in calculating process costing. A company must determine the costs of each process of production to ascertain the inventory accounted for at the beginning of the accounting period and the inventory completed during the period. Additionally, the company needs this information to determine the amount of WIP inventory at the end of the period.
Assess costs associated with inventory conversion
In process costing, the second step involves converting any inventory considered in process at the end of the period into an equal number of units. If at the end of an accounting period, a manufacturing company that manufactures ink cartridges uncovered 6,000 cartridges in-process, and each of these cartridges was 50% complete, that inventory would be considered to be 3,000 cartridges produced by the company.
Estimate the costs applicable
Once you have converted the inventory into finished units, you must calculate the direct and indirect costs incurred during the manufacturing process. Once the amount has been calculated, it is divided between the completed inventory and that which remains in process. During both the initial period and the subsequent period, both indirect and direct production costs are included.
Determine the per-unit cost
To calculate the costs per unit in the manufacturing process, you first need to calculate the costs associated with both complete and in-process inventory. At the end of the accounting period, the costs associated with completed units and equivalents of completed units are included.
For example, if the company that manufactures ink cartridges completes 1,000 cartridges and leaves 4,000 cartridges half-completed, then the company would divide the costs by 3,000 to obtain the final price.
Calculate the cost of both completed and incomplete products
The proper amount is determined by assessing how many products were completed and how much inventory was in progress at the end of the period.
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Types of Process Costing
It is possible to calculate costs in process costing using one of three methods: standard costing, weighted average, or first-in-first-out (FIFO). Choosing the best accounting method for your business should be carefully considered to achieve the best results. It is also essential to gauge the best fit for your company based on the importance of process costing methods in depth:
Standard costing
Instead of using the actual costs for each stage, this method uses an estimated standard cost. It is common for companies to turn to this method when collecting current information about real costs is time-consuming or cumbersome.
Some companies can benefit from it if they manufacture a wide variety of items and need help putting a specific cost on each one of those products due to a lack of exact cost information. After a production run has been completed, the estimated totals are compared to the actual totals, and the difference is added to a variance account, which is a record of the variances.
Weighted average costing
In this method, the cost is calculated in the simplest way possible. A company adds up all the costs for the current period and divides the total by the number of units completed and transferred out, as well as the equivalent number of units still pending at the end of the period. It can be used when there are minor fluctuations in the cost from one period to another.
First-in, First-out (FIFO)
By using FIFO process costing, one of the most popular costing approaches, we can calculate a more accurate product costing. This works well especially if the product's cost varies greatly from period to period. In FIFO, the earliest units to be completed are those that have been started (i.e., the units that were in progress at the beginning of the current period). For those units which are beginning work-in-progress, the cost incurred during the previous period is excluded when calculating the costs for the current period.
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Examples of Process Costing
When the units of product are homogeneous, process cost accounting is used. Below are some fictional process costing system examples showing how it works.
Example of XYZ Ltd.
XYZ Ltd. specializes in bottling soda water drinks with unique flavors. Several departments are involved in the production of sodas. Direct material costs Rs. 25,000 for the filling department, and conversion costs amount to Rs. 50,000 (including direct labor and overhead).
The department processed a total of 50,000 bottles during that period. By dividing direct material costs by unit output for the month, the per unit cost of the filling department in April is (Rs. 25,000/50000)= Rs. 0.50.
For conversion costs, the per unit cost is (Rs. 50,000/50000)= Rs. 1.00 (conversion costs divided by the number of output units). The company performs similar calculations for labeling and packaging departments, which show that one month of production of 50,000 bottles costs Rs. 1,00,000. In this case, the unit price equals Rs. 1,00,000/50,000 = Rs. 2/unit.
Example of ABC Ltd.
ABC Ltd. produces paper products out of wood pulp. As raw materials progress through the production cycle, identical packages of paper are produced. A total of 1,50,000 packages were completed this month.
Rs. 50,000 in raw materials is used, or (Rs. 50000/150000)= Rs. 0.33 per package. The conversion costs are Rs. 1,00,000 (including Rs. 70,000 for direct labor and Rs. 30,000 for overhead expenses such as maintenance, insurance, and electricity), or (Rs. 100000/150000) = Rs. 0.67 per package. With the total cost being Rs. 1,50,000, the cost per unit for 1,50,000 units is Rs. 1. Having seen the above process costing system examples, let's know more about the pros and cons of process costing.
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Pros and Cons of Process Costing
A process costing method is the most effective way to determine product costs for some manufacturers. However, there are some advantages and disadvantages of process costing. For example, the cost of work in progress can be challenging to assign accurately.
Here are some pros and cons to consider:
Pros:
Flexibility
The use of process costing can help companies provide products at competitive prices. In this way, companies can identify obsolete, inefficient, and redundant processes.
Ease of use
In companies producing similar products, process costing is more practical and more accessible to use than job costing. Since job costing involves tracking items, parts, payroll, and other overhead while tracking costs, it's not favorable for producing identical products.
Standardized
By understanding what is process costing, companies can compare changes in costs over time by using the same standardized costing method each period. Identifying areas for investigation and ensuring that costs align with budgeted expenses helps companies reduce costs.
Cons:
Errors
Each unit's cost is determined based on the overall cost of each department or stage involved in the manufacturing process. Errors can occur when non-production costs are also included in the calculation.
Time-consuming
Equivalent units are difficult to calculate. Unfinished goods must be assigned costs according to their position in production, which the management accountant determines.
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Cash Flow in Process Costing
Process costing typically involves adding direct material costs at the beginning of the process and adding indirect costs (both direct labor and overhead) gradually during the production process.
Food processing operations, for example, begin with the direct material, such as a potato, and gradually transform the direct material into finished products (such as wafers) by various rendering operations.
Streamline Process Costing Activities With TranZact
Maintaining inventory levels is a challenging task for business owners. Due to the large amount of data they have to track, maintaining spreadsheets and manual calculations consumes a lot of time. This may hinder growth when the business plans to scale.
TranZact helps to combat this scenario as it is more than an ordinary ERP solution. The software monitors your entire sales cycle from start to finish and controls your inventory. This tool allows businesses to automate their process costing estimations by streamlining diverse functions and reducing their costs.
FAQs on Process Costing
1. What is a process costing system?
The process costing system is an organized method to calculate the average cost per unit by considering the total costs spread across all the units produced. In this way, the costs accrued in each department or process are allocated to each product accurately, within a specific manufacturing sector.
2. What is process costing in cost accounting?
Process costing in cost accounting is a methodology used to allocate production costs across multiple stages or processes involved in manufacturing a product or offering a service. It is a useful method of assigning costs for mass-produced goods and processes as it provides valuable insights into the cost structure of the process with limited effort.
3. What are the costing methods for manufacturing?
The costing methods commonly used in manufacturing include process costing and job costing. Process costing allocates costs across different stages or processes of production, while job costing assigns costs to specific individual jobs or projects.
4. What are the steps in process costing?
The following steps are critical in process costing:
- Identifying the cost flow
- Determining the total units of production
- Calculating the cost per equivalent unit
- Allocating costs to units completed and in progress
- Reconciling the costs
5. What are the 3 components of process cost?
The three components of process cost are direct materials, direct labor, and manufacturing overhead. Accurately assessing these components helps to track and allocate production costs across different stages or processes.
6. What are the types of process costing?
The three primary types of process costing methods are standard costing, weighted average costing, and FIFO (First-In, First-Out) costing. Based on the complexities and requirements of the business, it must adopt the right method.
7. What are the essential factors of process costing?
The most important factors of process costing include the type of industry where the business is operating, and the type of product being manufactured. Following this, factors such as the volume of goods demanded, quantity and cost of raw material and equipment required and other overhead expenses should be considered.
8. Who uses process costing?
Oil refiners, food manufacturers, chemical producers, textile manufacturers, glass manufacturers, cement manufacturers, and paint manufacturers generally use process costing.
9. How is process costing calculated?
The costs associated with each item are allocated to the departments or processes through which the item passes over a given period rather than being traced to each item's production. Each item's average cost is determined by dividing the total process cost by the total number of items.
10. How to calculate cost per unit in process costing?
To calculate the cost per unit in process costing, divide the total costs incurred in a particular process by the total equivalent units of production for that process. The resulting value represents the average cost per unit, which helps in assessing the cost efficiency of the production process.
