Process costing is an accounting technique generally employed by businesses that mass manufacture identical or highly identical goods or output units. It is typical in industrial sectors where the production costs of every individual output unit are very comparable and it is not practical to track expenses for each item separately all through the production chain.
Do you know that many businesses, including those that produce food, chemicals, textiles, glass, cement, and paint, employ process costing extensively for accounting purposes?
What Is Process Costing?
Instead of recording expenses for every individual item, process costing allows businesses to calculate product costs by keeping track of the costs associated with each step in the manufacturing process. They divide the overall cost by the number of products after totalling up the costs of each stage in the process. It is known as the cost per unit.
Process Costing Explained
Products that are identical cannot be differentiated from one another, such as a box of identical bolts that are the exact size and kind. During the course of production, these related items all often pass through a number of phases. Companies calculate the direct expenses and production overhead for every one of these processes in order to employ the process costing method in accounting.
Direct and indirect expenditures are involved in these phases. Raw materials and the salary of equipment operators are examples of direct manufacturing expenses. Indirect expenses like building leases and machinery upkeep are sometimes included in overhead, along with salaries paid to administrative workers who aren't physically involved in producing the goods.
These expenses are frequently divided into direct material and conversion costs by businesses. Conversion costs are expenses associated with the procedure, such as labour costs and expenses in the production line, whereas direct materials are the resources used at each stage.
Each stage of the production process is often handled by a dedicated team at many businesses. The expenses of every department's direct material, production overhead, and manufacturing overhead are included in a report that is created. The business then combines these statistics to examine the overall cost of the product.
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Process vs. Job Costing
Process costing and job costing are the two primary ways to calculate the price of every product. Process costing is especially helpful in companies that create similar goods in large quantities and find it difficult to track the expenses of every individual product throughout the manufacturing process. Contrarily, job costing keeps track of every item's or project's total direct and indirect expenses. This is most frequently utilized by businesses that offer customized goods or services and charge separately for each of them.
Importance of Process Costing
In the oil, petrochemical, timber, textile, and food manufacturing sectors, process costing is especially crucial. These businesses may establish the appropriate pricing for their goods and assess if costs are following forecasts if they have a grasp on the manufacturing costs. They can assess the expenses associated with each stage of the manufacturing and distribution chain using a process costing, and then utilise the results to pinpoint areas whereby costs can be cut.
Steps in Process Costing
Process costing accounts for work in progress, or things that have started the manufacturing process but haven't finished it, at the beginning and end of every cycle to precisely estimate the expense of creating each unit. Here are the top five process costing steps.
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Analyse Inventory:
Determine the quantity of inventory at the start of the period, the number of tasks that were initiated throughout the period, the number that was finished and moved out, and the number that remained unfinished at the conclusion of the period by analysing the movement of the goods during the time frame.
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Calculate Equivalent Units:
The idea of comparable units is used in process costing to compensate for items that remain incomplete at the conclusion of each cycle. Multiply the number of unfinished units at the conclusion of the cycle by a percentage that represents how far along in the process of production they are.
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Calculate Applicable Costs:
Add up all production-related expenses, including those for direct materials and conversion.
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Calculate Cost per Unit:
By the number of units, divide the overall cost. Both finished units and comparable units are included in this computation.
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Allocate Costs to Complete and Incomplete Products:
Assign expenses to the respective accounts for the work-in-progress inventories that have been completed and are terminated. This makes it easier to calculate how much cash is locked up in the present inventory of work-in-progress.
Also Read: Different Types of Accounts in Accounting - 3 Types of Accounts
Types of Process Costing:
Three methods of cost calculation are available in process costing. A recommended approach in accounting is to carefully choose the approach that best suits your company's needs.
1. Weighted average costs:
This is the easiest way to determine cost. The number of pieces finished, handed out, and comparable units of work-in-progress at the conclusion of the period are added together, and all expenses for the current cycle are then divided by that number. It is applied in situations where small changes in costs between periods are present.
2. Standard costs:
Instead of using actual prices, this technique estimates a cost model for each phase of the process. Manufacturers often choose this technique when gathering updated data on actual expenses would be too time- or labour-intensive. Additionally, it might be helpful for companies who produce a variety of goods but find it difficult to assign specific pricing to every single one of them. After a production model is complete, the approximated sums are compared to the actual statistics, and the discrepancy is added to a deviation account.
3. First in, first out (FIFO):
FIFO, the most challenging process costing method, is used to get more accurate product pricing, particularly when expenses vary dramatically from one cycle to the next. The first units in the production chain are assumed by FIFO to be the first to be finished. It does not include expenditures from the previous cycle for those starting work-in-progress units when figuring expenses for the current quarter.
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Pros and Cons of Process Costing
Process costing provides the most efficient and practical accounting technique for calculating product costs for some firms. Nevertheless, there are benefits and drawbacks to this approach. For example, it might be challenging to precisely attribute expenses to work that is still being done.
Pros of process costing:
Process costing can be more user-friendly than other costing techniques and aid businesses in identifying possible cost-saving opportunities.
Ease of use:
Process costing is more realistic and user-friendly for businesses that produce many of comparable products than some other cost accounting techniques like job costing, which entails keeping track of the costs of each product and constituent part in addition to handling salary, other supplies, and overhead.
Flexibility:
Process costing may assist businesses in streamlining their processes to cut expenses so they can sell their goods at much more affordable pricing. It exposes the costs associated with each stage of the production process, assisting businesses in identifying unnecessary, antiquated, or ineffective operations.
Standardized:
Process costing uses the very same standardised costing methodology every time, allowing businesses to assess how expenses have changed over time. This assists businesses in making sure expenses are in accord with planned budgets and identifying potential problem areas.
Cons of process costing:
Accuracy is one of the process costing's potential drawbacks.
Errors:
Using process costing, every unit's price is calculated based on the total costs of the many production departments and phases. By factoring in non-production expenditures, the computation may contain errors.
Calculation difficulties (equivalent units):
Estimates of comparable units, which are made by allocating costs to unfinished items at the beginning or end of an accounting cycle, are another foundational component of process costing. Companies' balance sheets reflect the value of this work-in-progress. The actual cost of these unfinished items may differ, for instance, depending on how many raw materials change from month to month. Businesses will wind up with erroneous product pricing if they don't correctly estimate the expense of work-in-progress products.
Time-consuming:
Equivalent unit calculations might take some time. Management accountants must ascertain where these unfinished items are in the manufacturing process in order to assign costs appropriately.
Also Read: What Are Different Types of Accounting Explained With Examples & Importance
Conclusion:
For firms who produce vast quantities of identical goods, such as businesses in the food manufacturing, petroleum, and chemicals sectors, process costing is a crucial accounting technique. It may be challenging or impractical for these businesses to directly assign expenses to each product as it is manufactured. By summing up the costs associated with each stage of the production process and dividing by the number of products, process costing enables businesses to approximate item costs. Companies must accurately allocate expenses to work-in-progress at each step and only include product-related expenditures from every department participating in the process in order to assure accuracy.
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