Process Costing - Part 1

Introduction: Process costing is a method of operation costing which is used to ascertain the cost of production at each process, operation or stage of manufacture, where processes are carried in having one or more of the following features:

Ø  Where the product of one process becomes the material of another process or operation

Ø  Where there is simultaneous production at one or more process of different products, with or without by product,

Ø  Where, during one or more processes or operations of a series, the products or materials are not distinguishable from one another, as for instance when finished products differ finally only in shape or form’.

Definition: Process costing is defined by Kohler as:  “A method of accounting whereby costs are charged to processes or operations and averaged over units produced; it is employed principally where a finished product is the result of a more or less continuous operation, as in paper mills, refineries, canneries and chemical plants; distinguished from job costing, where costs are assigned to specific orders, lots or units.

Features/Characteristics of Process Costing: The following are the features of Process costing:

a)      Process Costing Method is applicable where the output results from a continuous or repetitive operations or processes.

b)      Products are identical and cannot be segregated.

c)       It enables the ascertainment of cost of the product at each process or stage of manufacture.

d)      The output consists of products, which are homogenous.

e)      Production is carried on in different stages (each of which is called a process) having a continuous flow.

f)       The input will pass through two or more processes before it takes the shape of the output. The output of each process becomes the input for the next process until the final product is obtained, with the last process giving the final product.

g)      The output of a process except the last may also be saleable in which case the process may generate some profit.

h)      The input of a process except the first may be capable of being acquired from the outside sources.

i)        The output of a process is transferred to the next process generally at cost to the process. It may also be transferred at market price to enable checking efficiency of operations in comparison to the market conditions.

j)        Normal and abnormal losses may arise in the processes

Fundamental Principles of Process Costing: The following are the fundamental principles of process costing:

a)      Cost of material, wages and overheads expenses are collected for each process or operation in a period.

b)      Adequate records in respect of output and scrap of each processes or operation during the period are kept.

c)       The cost per unit of each process is obtained by dividing the total cost incurred during a period by the number of units produced during that period after taking into consideration the losses and amount realized from sale of scrap.

d)      The finished product of one process is transferred as a raw material to the next process.

Application of Process Costing: There are number of industries where Process costing system can be used except where job, Batch or Unit Operation Costing is necessary. The following are examples of industries where process costing is applied:

Ø  Where the final product merges only after two or more process such as paper-the raw material, bamboo is made into pulp; pulp is a made into paper and then it is finished, glazed etc. for sale;

Ø  The product of one process becomes the raw material of another process or operation e.g. refined groundnut oil is the material for making vegetable ghee and

Ø  Different products may have a common prior process e.g. brass goods will require melting of brass commonly for all goods. Another example is petroleum products by the same refinery.

Some other industries where Process Costing is applied are:

                Chemical works                                                                Textiles, weaving, spinning etc.

                Soap making                                                                      Food products

                Box making                                                                         Canning factory

                Coke works                                                                        Paint, ink and varnishing etc.

Difference between Job costing and Process Costing:

Job Costing

Process Costing

a)       Job costing is used when the cost object is an individual (or a lot/batch) unit or a distinct product or service. b)      Costs can be accumulated by each individual product or service. c)       Job costing is done against a specific order being produced. d)      Costs are calculated when a job is over. e)      There are usually no transfers of costs from one job to another. f)        There is more paper work. g)       There is little or no inventory.            h)      It is less amenable to mechanization & automation.

a)       Process Costing is generally used for a mass of identical product or service. b)       The Costs are accumulated in a period. The total costs in a period are divided over the number of units to get an average unit cost. c)        Costs are compiled for each process over a period of time. d)       Costs are calculated at the end of a cost period like an accounting year. e)       Transfer of costs from one process to another is made as the product moves from one process to the other. f)        It has lesser paper work. g)       There is regular and significant inventory. h)       It is more amenable to mechanization & automation.

Advantages of Process Costing: The following are the main advantages of Process Costing:

Ø  It is possible to determine process costs periodically at short intervals. Average unit cost can be computed weekly or even daily.

Ø  It is simple and less expensive to find out the process costs.

Ø  It is possible to have managerial control by evaluating the performance of each process.

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

Ø  It is easy to quote the prices with standardization of process. Standard costing can be established easily in process type of manufacture.

Disadvantages of Process Costing: The following are the main disadvantages of Process Costing:

Ø  Cost obtained at the end of the accounting period are only of historical value and are not very useful for effective control.

Ø  Valuation of work-in-progress is generally done of estimated basis which introduces further inaccuracies in total cost.

Ø  Where different products arise in the same process, it is not possible to exactly ascertain the total cost of the products.

Ø  If any error occurs while calculating average costs, it will be carried through all the processes to the valuation of work in process and finished goods.

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

Costing Procedure in process costing

The factory or concern is divided into distinct processes or operations and a separate account is opened for each process (cost centre). The account is debited with the value of material, labour and overheads relating to the process. The value of by products and scrap, if any, is credited to the account and the balance of this account, representing the cost of partially worked out product, is passed on to the next process becomes the raw material of the next process.

In some industries, depending upon the plant arrangement, the partially worked out product of a process may be transferred to a process stock account from which it may be issued to the next process as and when required. The finished out of the last process (i.e. finished product) is transferred to the Finished Goods Account.  All expenditure of materials, labour, direct expenses and overheads are charged to the process concerned.

The following are the main elements/components of costs involved in the manufacturing process where process costing is adopted.

a)      Direct Materials There are two types of materials that we come across in process costing:

Ø  Primary Material Materials that are introduced in the initial process, which is passed on to the next process after completion of processing.

Ø  Secondary Material Materials, which are introduced in the first or subsequent processes in addition to, the main material introduced in the initial process. This gets mixed up with the main material and is passed on to the subsequent processes as a part of the output.

b)      Direct Labour the direct labour cost is incurred in every process. Identification of direct Labour cost is also relatively easy in process costing industry.

c)       Direct Expenses in addition to Direct Material and Labor, which can be directly attributable to a particular process. These are costs relevant to specific processes.

d)      Production Overheads The overhead expenses are generally expended over all the processes involved in production. These are to be apportioned over the various processes in an amicable manner.

Treatment of Normal Loss, Abnormal Loss and Abnormal Gain in process account

Normal or uncontrollable loss : Because of the nature of the raw materials, some loss is inherent and is unavoidable. This is known as normal waste or normal loss. And this type of loss is expected in normal condition for example, weight loss, scrap loss, pilferage. Normal loss is calculated at a certain % of input in unit in respective process. It may have scrap value. The cost of such normal loss is included in the total process cost but the scrap value is deducted with total cost by crediting scrap value in process account.

Abnormal or Controllable Loss: It is the part of the process loss caused due to abnormal circumstances in the factory. For Ex, labour strike, break down of machinery. It is avoidable and controllable by mgmt. Abnormal loss occurs in addition to normal loss. Abnormal spoilage or defective work may arise in a process due to unforeseen factors.

The cost of such abnormal loss is not included in the total process cost but the average cost of the lost units is charged to an Abnormal Loss Account which is credited with the scrap and closed to the Profit and Loss Account. Thus, in computing the abnormal loss, scrap value of the abnormal lost units will be ignored but in working out the loss for charging to Profit and Loss Account, this will be taken into consideration.

Valuation of abnormal loss = (Total cost – scrap value of normal loss)/ Normal Output x Units of abnormal loss

Abnormal Gain or Effectiveness: Some times, the actual loss in a process may be smaller than what so expected on the basis of experience. This represents an exceptional or abnormal gain over what is normally anticipated. The value of abnormal gain is calculated in the same manner as that of abnormal loss and is credited to Abnormal Gain Account. The amount of scrap which would otherwise have been realised, had there been normal and no abnormal gain, is debited to the Abnormal Gain Account and the balance is credited to Costing Profit and Loss Account.

Value of abnormal gain is calculated with the following formula: (Total cost – scrap value of normal loss)/ Normal Output x Units of abnormal gain.