Discussion

Chapter 4: Process Costing

Managers need to assign costs to products to facilitate external financial reporting and internal decision making. This chapter illustrates an absorption costing approach to calculating product costs known as process costing.

Job-order and process costing are similar in that they both deal with assigning materials, labor, and overhead to products as a way to calculate the unit product cost.

Both systems use Raw Materials Inventory, Work in Process Inventory, and Finished Goods Inventory.

The flow of costs is similar, but not exactly the same, in the two systems.

Process costing is best suited for the production of a single product that is continuously produced for a long period of time. Recall the mixing and bottling of Coca-Cola from Chapter Three. Job-order costing is best suited when jobs are produced as discrete projects. For example, building a house.

Process costing accumulates costs by department, while job-order costing accumulates costs by individual jobs.

Process costing uses a fundamental document called a department production report, while job-order costing uses the job cost sheet.

In process costing unit cost is computed by department, while in job-order systems unit cost is computed by job.

While there are similarities between the two systems, there are also significant differences.

A processing department is any unit in an organization where materials, labor, or overhead are added to the product. The output from a processing department is homogeneous, that is, they all appear the same. Products in a process costing environment typically flow in a sequence from one department to another.

The flow of costs through the manufacturing accounts is basically the same for process and job-order costing.

Direct materials, direct labor, and manufacturing overhead are added to Work in Process. When work in process is completed, the costs are transferred to Finished Goods. When finished goods are sold, the costs are transferred to Cost of Goods Sold.

There is a key fundamental difference between process and job-order costing systems. Job-order costing systems trace and apply manufacturing costs to jobs. One Work in Process account is often used to accumulate costs for all jobs. The individual job cost sheets serve as a subsidiary ledger.

In a process costing systems, costs are traced to departments that process the goods. In some companies there may be several processing departments that goods must pass through to become finished goods. A separate Work in Process account is maintained for each processing department. Material, labor, and overhead costs transferred from one department’s Work in Process account to another department’s Work in Process account are called transferred-in costs.

Direct materials can be requisitioned for use in both Department A and Department B. These direct materials are likely to be different in nature. Direct material costs are debited to the appropriate departmental Work in Process account depending upon where the materials were added to the production process. The Raw Materials Inventory account is credited for the corresponding amounts.

Direct labor is transferred from the Salaries and Wages Payable account into the work in process account of Departments A and B depending upon where the individual employee worked. Direct labor costs are debited to the appropriate departmental Work in Process account depending upon where the labor was added to the production process. Salaries and Wages Payable is credited for the corresponding amounts.

Manufacturing overhead is applied to each processing department based on a predetermined rate for each department. The predetermined rate does not have to be based on the same cost driver for each processing department. Manufacturing overhead costs are debited to the respective departmental Work in Process accounts. Manufacturing overhead is credited by the corresponding amounts.

The cost of units complete as to processing in Department A are transferred into Department B for additional work. Department B has incurred additional costs to work on units that were in process at the beginning of the period. The transferred-in costs from Department A are added to the manufacturing costs incurred in Department B.

Here we see the transfer of completed goods from Work in Process – Department B into Finished Goods Inventory. The costs transferred represent the cost of good manufactured.

Once we sell finished goods, we debit Cost of Goods Sold and credit Finished Goods Inventory.

The basic idea behind equivalent units is quite easy to understand, but the computation of equivalent can become complex. Here we can say the two half- completed units of production are equal to one complete unit. Using this logic, we can say that 10,000 units that are 70% complete are equivalent, or the same as, 7,000 complete units.

In today’s economy, direct labor costs are becoming small when compared to materials and overhead costs. Automation is one of the causes for this shift.

As a consequence of the change in volume of direct labor costs, many companies combine labor and overhead costs and refer to the total as conversion costs. That is, these are the costs incurred to convert the direct materials into a finished good. We will make extensive use of the notion of direct materials and conversion costs in the remainder of this chapter.

End of Chapter 4.