Process Costing System: Definition, Types, and Examples

process costing system

Calculating process costing for goods produced can assist manufacturing or production organizations in determining how much product is produced and how much it costs to manufacture it.
However, factors such as the number of completed items and the number of products remaining in process at the conclusion of an accounting period might change the total costs a company is accountable for during production. This is why many large firms employ process costing methodologies to track overall costs and inventory production.
So, this article will explain what process costing is, the three categories of the process costing system, and how to calculate process costing using examples.

What is a Process Costing System?

The process costing system accumulates costs when a large number of identical units are being produced. In this case, it is more effective to accumulate costs for a large batch of products and then distribute them to individual units produced. The presumption is that the cost of each unit is the same as the cost of any other unit, hence tracking information at the individual unit level is unnecessary.

Who Makes Use of Process Costing?

A process costing system is used by any large-scale firm that produces huge quantities of identical commodities. A petroleum refinery is a perfect example of a process costing system environment since it is hard to trace the cost of a specific unit of oil as it passes through the refinery.

Process Costing Steps

process costing system

Process costing system considers work in progress — things that have entered but have not completed the production process — at the beginning and end of each period to precisely estimate the cost of creating each unit. The following are the five basic steps in process costing.

Step #1. Analyze Inventory

Analyze the flow of items during the period to identify the amount of inventory at the start of the period, how many items were begun during the period, how many were completed and moved out, and how many were incomplete at the end of the period.

Step #2. Calculate equivalent units

The idea of equivalent units is used in process costing to account for items that are unfinished at the conclusion of each period. So, multiply the number of incomplete units at the end of the period by a percentage denoting their progress through the manufacturing process for this stage. For example, if 2,000 pieces of inventory are still in progress and are 75% complete, they are comparable to 1,500 units for process costing reasons (2,000 x.75 = 1,500).

Step #3. Determine the costs that apply:

Total the expenses for all phases of production, including direct materials and conversion costs.

Step #4. Determine the cost per unit:

Subtract the total cost from the number of units. This calculation takes into account both completed and comparable units. So, if a company finished 4,000 items and another 1,000 units were halfway finished, the applicable costs would be divided by 4,000 + (1,000/2) = 4,500 units. If the total cost of production for those units was $16,875, simply divide the total cost by the number of units created to arrive at $3.75 per unit produced.

Step #5. Allocate costs to completed and incomplete products:

Allocate costs to the respective accounts for completed and terminating work-in-progress inventory. This helps assess how much money is currently locked up in work-in-progress inventories. In the preceding example, since the equivalent of 500 units are in production and each unit costs $3.75 to make, the work-in-progress inventory cost is $1,875 (500 x $3.75). And the total cost of the merchandise inventory is 4,000 x $3.75 = $15,000.

Types of Process Costing System

There are three methods for calculating costs in process costing: weighted average, standard costing, and first-in-first-out (FIFO). So, a solid accounting practice is to carefully select the approach that best matches your business’s demands.

#1. Weighted average costs:

This is the most basic form of cost calculation. Companies sum all current-period costs and divide them by the entire number of units finished and transferred out, plus the equivalent units of work-in-progress at the conclusion of the period. It is utilized when the cost changes between periods are small.

#2. Standard costs:

Instead of actual costs, this strategy employs an estimated standard cost for each process stage. Companies generally employ this strategy when gathering current information regarding real expenses is too difficult or time-consuming. It can also be useful for organizations that manufacture a large range of products and find it difficult to assign specific costs to each of the products. After a production run is completed, the estimated totals are compared to the actual totals, and the difference is added to a variance account.

#3. First in, First-out (FIFO):

The most difficult process costing method, FIFO is used to provide more precise product costing, particularly when expenses vary dramatically from one period to the next. The first units (i.e., work in progress at the start of the current period) are assumed to be the first to be completed under FIFO. Costs incurred during the previous period for those initiating work-in-progress units are excluded from determining costs for the current quarter.

Examples of Operations That Utilize Process Costing System

The following are examples of operations likely to prefer the process costing system over another costing method:

  • Bottling plant for Coca-Cola
  • Companies that manufacture bricks
  • Cereal Making Companies.
  • Companies that manufacture computer chips
  • Lumber manufacturing company

For example, it would be impractical and inefficient for a company that bottles cola to separate and record the cost of each bottle of cola in the bottling process. As a result, the corporation would allocate costs to the entire bottling process for a set period of time. Then, to assign production costs to each bottle of cola, they would divide the entire process cost by the number of bottles produced during that time period.

Process Costing Accounting System Examples

When the units of product are homogeneous, process cost accounting is utilized. Take a look at some examples of how the process costing system works in these fictitious businesses. (The companies are fictitious.)

#1. Bubblez’n’More

Bubblez’n’More is a seltzer bottling firm that specializes in one-of-a-kind tastes. The sodas go through numerous stages of manufacture. The filling department incurs $25,000 in direct material costs and $50,000 in conversion costs for the current month (consisting of direct labor and factory overhead). 50,000 bottles are processed by the department over the time period. In April, the billing department’s per-unit cost is $.50 for direct materials (direct material prices divided by monthly unit output) and $1.00 for conversion costs (conversion costs divided by unit output). Similar calculations are performed for the labeling and packing divisions, and the corporation discovers that it cost $100,000 to make 50,000 bottles in one month. $100,000 divided by 50,000 is $2 per unit.

#2. Reams-a-plenty

Reams-a-plenty manufactures paper using wood pulp. Raw ingredients flow continuously through the production cycle, culminating in the production of identical paper packets. It has completed 150,000 packages this month. The cost of raw ingredients is $50,000, or $.33 per package. Conversion costs $100,000, or $.67 per package, including $70,000 in direct work and $30,000 in overhead, which includes maintenance, insurance, and power. The overall cost is $150,000, with 150,000 units produced at a cost of $1 each unit.

The Importance of Process Costing System

Process costing is a critical technique businesses and production managers use to track product prices in industries that deal with large quantities of manufactured items and are prone to regular price variations owing to processes and various production lines. It yields a cost of goods manufactured (COGM) figure, which is frequently displayed on your company’s income statement.

Process costing is particularly important since it enables businesses to:

  • Control inventory numbers and distribute them correctly.
  • Profits should be tracked to see how much they are spending and gaining.
  • Report numbers from each department in a consistent and accurate manner.

The Benefits and Drawbacks of Process Costing

Process costing is the most practical and efficient accounting method for determining product costs for specific types of firms. Nonetheless, this strategy has both benefits and drawbacks. It can be difficult, for example, to appropriately attribute expenses to work in progress. Consider the following advantages and disadvantages.

Advantages of Process Costing System

Process costing has the process of being easier to use than other costing methods, and it can assist businesses in costing areas for possible cost savings.

#1. Easy to Use

Process costing is more practical and simpler to use than other cost accounting systems, such as job costing, which requires recording the cost of each item and component part, as well as managing salary, other materials, and overhead.

#2. Flexibility:

It can assist businesses in improving their processes in order to cut costs and offer products at more competitive pricing. It exposes the cost of each step in the production process, assisting businesses in identifying duplicate, obsolete, or inefficient processes.

#3. Standard

Process costing uses the same standardized costing approach each period, allowing businesses to compare cost variations over time. This assists businesses in ensuring that costs are in accordance with budgeted expenses and identifying areas for further study.

Disadvantages of Process Cost System

Process costing has some drawbacks, including the possibility of inaccuracy.

#1. Errors:

Process costing determines the cost of each unit based on the overall costs of manufacturing departments or stages. The inclusion of non-production costs in the computation can lead to errors.

#2. Calculation issues (equivalent units):

Process costing also relies on equivalent unit calculations, which are derived by allocating costs to unfinished goods at the beginning and end of an accounting period. On balance sheets, companies include the value of this work in the process. The true cost of these unfinished goods may vary, for example, if raw material prices fluctuate from month to month. Companies will wind up with inaccurate product pricing if they do not accurately estimate the cost of work-in-progress components.

#3. Time-consuming:

Calculating comparable units takes time. Management accountants must evaluate where these unfinished goods are in the manufacturing process and assign expenses accordingly.

Process Costing System Alternatives

If a process costing system does not work well with a company’s cost accounting systems, there are two more systems to consider. The job costing system is intended to gather costs for single units or small manufacturing batches. A hybrid costing system, in which process costing is utilized part of the time and job costing is used the rest of the time, works well in production situations where some manufacturing is done in big batches and other work steps demand labor that is unique to individual units.

Process Costing System FAQs

What types of industries are more likely to use process costing?

Process costing is widely used in many industries, including oil refining, food manufacturing, chemical processing, textiles, glass, cement, and paint manufacturing.

How are costs accumulated in a process cost system?

A process cost system (process costing) collects costs incurred in the production of a product based on the processes or departments that the product passes through on its path to completion.

What are the three cost components?

Direct materials, direct labor, and overhead are the three broad kinds of costs in manufacturing operations.

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