Process Costing in Cost Accounting

Process costing is a method of costing which allocates production costs to individual production stages (processes) used in the manufacture of a product.

The costing method is particularly useful in mass production manufacturing when the product goes through a number of sequential processes on a continuous basis.

What is Process Costing

Process costing has a number of unique characteristics.

1. Production is continuous and separated into a number of processes.
2. The production units from one process are used as the inputs for the next process.
3. Costs are allocated to processes. e.g the manufacture of a chemical might involve processes such as purification, cooling, etc.
4. Inputs such as raw materials and labor cannot be matched to individual finished units.
5. The finished product units are identical.
6. The manufacturing process might result in joint products (multiple products) or byproducts.
7. Process costing can be applied to manufacturing and non-manufacturing operations.

Job Costing vs Process Costing

It should be noted that process costing and job costing are different methods of costing. The main difference between process costing and job costing is that job costing is used when the costs can be allocated to a specific job, often identified with a particular customer.

For example, a customer might place an order for an item of furniture to be manufactured to their specifications. All the costs relating to the manufacture are identified and allocated to the job and later used to invoice the customer.

Terms Used in Process Costing

There are a number of terms which need to be understood when discussing process accounting. The most significant are explained below.

Normal Losses

Normal losses of production units are losses which are expected from the inherent nature of the process. The costs relating to normal losses remain on the process account and result in an increased cost per unit for the remaining units.

Abnormal Losses

If the product unit losses are greater than the normal expected unit losses they are referred to as abnormal losses. Abnormal losses are not expected (e.g. arising from machine failure) and the costs relating to abnormal losses are removed from the process account.

Abnormal Gains

If the product unit losses are less than the normal expected losses they are referred to as an abnormal gain. The costs attributed to abnormal gains are added back to the process account.

Scrap Value

Normal and abnormal losses result in damaged or partially complete product units. These units can have a scrap value when sold. The scrap value attributed to normal losses is credited to the process account and used to reduce the process cost. Scrap value attributed to abnormal losses is used to reduce the abnormal loss.

The use of these terms will become clearer in example shown below.

How are Manufacturing Costs Treated in Process Costing

A process costing system will normally include the following features.

• Manufacturing costs such as materials, labor, and overheads are accumulated for an accounting period by process.
• Each process has a separate process account which is debited with the costs incurred.
• At the end of an accounting period each process account is adjusted for normal losses and abnormal losses and gains.
• If the process results in work in process at the end of an accounting period adjustment is made using the equivalent units of production technique.
• The unit cost is calculated for each process by dividing the total costs allocated to the process for the period by the number of units produced.
• When one process is completed the units and costs relating to them are transferred to the next process account.
• After the final process completed units are transferred to the finished goods inventory account.

Process Costing Examples

Suppose a business manufactures a product which requires two sequential processes A and B to produce a completed unit.

For the sake of simplicity it is assumed that there is no work in process at the end of the accounting period. In situations where there is work in process involved, adjustment needs to be made to convert production units into equivalent units. This technique is more fully discussed in our post on equivalent units of production weighted average process costing.

The table below summarizes the relevant process costing production data for the accounting period.

Since the output from Process A becomes the input for Process B we need to deal with each of the processes in order.

Process A

Process A is the first process and the inputs are raw materials, labor, other costs and overheads. During the period the costs total 45,000 and these are considered sufficient to make 1,200 units of the product.

Normal Loss

Inherent in the process are expected (normal) losses calculated as follows.

Normal unit loss = Units x Loss %
Normal unit loss = 1,200 x 5% = 60

Allowing for the normal loss, the expected output units for the period are 1,200 – 60 = 1,140

Scrap Value

The business expects to lose 60 units during Process A and will eventually sell these for a scrap value calculated as follows.

Scrap value = Units x Scrap price
Scrap value = 60 x 9.00 = 540

Since this amount results from a normal loss it will be credited to the Process A account reducing the production costs for the period to 45,000 – 540 = 44,460

Unit Cost

The process costing unit cost is calculated as follows.

Unit cost = Production cost / Expected output units
Unit cost = 44,460 / 1,140 = 39.00

Allowing for normal losses the unit cost of the product after Process A is 39.00

Abnormal Loss

The expected output from Process A was calculated above as 1,140 units compared to the actual output shown in the production data table of 1,050 units. The shortfall of 1,140 – 1,050 = 90 represents an abnormal loss of units.

In process costing the costs associated with the abnormal loss units are removed from the process account at the full unit cost.

In this example the cost allocated to the units is as follows.

Abnormal loss = Units x Unit cost
Abnormal loss = 90 x 39.00 = 3,510

The scrap value associated with these units is.

Scrap value = Units x Scrap price
Scrap value = 90 x 9.00 = 810

Since the associated costs are removed from the process account, the scrap value is not credited to the process account but is used to reduce the abnormal loss to 3,510 – 810 = 2,700.

After the units and associated costs have been removed from the Process A account, the account is left with a balance of costs of 44,460 – 3,510 = 40,950 and a balance of units of 1,140 – 90 = 1,050.

Process A: Account Summary

The table below summarizes the movements on the Process A account for the period.

It should be noted that since the abnormal loss is removed at the full cost, the unit price for Process A based on the ending balances remains at 39.00.

Unit cost = Production cost / Expected output units
Unit cost = 40,950 / 1,050 = 39.00

Process A: Process Costing Account Journal Entries

The journal entries to reflect the above process costing transactions are as follows.

The output from Process A can now be used as the input for Process B.

Process B

The units (1,050) and the costs (40,950) from Process A are now transferred into Process B. The costs transferred from Process A together with the additional costs for the period (52,500) should be sufficient to manufacture and complete 1,050 units of product.

Normal Loss

Inherent in Process B are expected (normal) losses calculated as follows.

Normal unit loss = Units x Loss %
Normal unit loss = 1,050 x 10% = 105

Allowing for the normal loss, the expected output units for the period are 1,050 – 105 = 945

Scrap Value

The business expects to lose 105 units during Process B and will eventually sell these for a scrap value calculated as follows.

Scrap value = Units x Scrap price
Scrap value = 105 x 17.00 = 1,785

Since this amount results from a normal loss it will be credited to the Process B account. The production costs for Process B are then calculated as follows.

Costs = Process A costs + Process B costs - Scrap value
Costs = 40,950 + 52,500 - 1785 = 91,665

Unit Cost

The cost per unit for Process B is calculated as follows.

Unit cost = Production cost / Expected output units
Unit cost = 91,665 / 945 = 97.00

Allowing for normal losses the unit cost of the product after Process B is 97.00

Abnormal Loss

The expected output from Process B was calculated above as 945 units compared to the actual output shown in the production data table of 1,000 units. The excess of 1,000 – 945 = 55 represents an abnormal gain of units. The business has manufactured more units than it expected to.

In process costing the costs associated with the abnormal gain units are added to the process account at the full unit cost.

In this example the cost associated with the units is as follows.

Abnormal gain = Units x Unit cost
Abnormal gain = 55 x 97.00 = 5,335

The scrap value associated with these units is.

Scrap value = Units x Scrap price
Scrap value = 55 x 17.00 = 935

The scrap value is not credited to the process account but is used to reduce the abnormal gain to 5,335 – 935 = 4,400.

After the units and associated costs are added to the Process B account, the account is left with a balance of costs of 91,665 – 5,335 = 97,000 and a balance of units of 945 + 55 = 1,000.

Process B: Account Summary

The table below summarizes the movements on the Process B account for the period.

It should be noted that since the abnormal gain is added at the full cost, the unit price for Process B based on the ending balances remains at 97.00.

Unit cost = Production cost / Expected output units
Unit cost = 97,000 / 1,000 = 97.00

Process B: Process Costing Account Journal Entries

The journal entries to reflect the above process costing transactions are as follows.

It should be noted that the credit to the scrap account of 935 represents the abnormal gain of 55 units at 17.00. This reduces the balance on the scrap account to the 50 units (1,050 – 1,000) actually scrapped and available for sale for Process B.

A summary of the scrap account for process B is as follows.

The final process has now been completed and the output units (1,000) and the accumulated costs of 97,000 (unit cost 97.00) can now be transferred to the finished goods inventory account ready for sale.