Process costing

Process costing is a costing method used when mass production of many identical products takes place, for example, the production of bars of chocolate, cans of soup or tins of paint. It is an example of continuous operation costing.

• One of the distinguishing features of process costing is that all the products in a process are identical and indistinguishable from each other.
• For this reason, an average cost per unit is calculated for each process.

• Expected output is what we expect to get out of the process.
• Another main feature of process costing is that the output of one process forms the material input of the next process.

• Also, where there is closing work-in-progress (WIP) at the end of one period, this forms the opening WIP at the beginning of the next period.

The details of process costs and units are recorded in a process account which shows (in very general terms) the materials, labour and overheads input to the process and the materials output at the end of the process.

Process costing with losses and gains

Normal losses

Sometimes in a process, the total of the input units may differ from the total of the output units. 

• Losses may occur due to the evaporation or wastage of materials and this may be an expected part of the process.
• Losses may sometimes be sold and generate a revenue which is generally referred to as scrap proceeds or scrap value.
• Normal loss is the loss that is expected in a process and it is often expressed as a percentage of the materials input to the process.

When calculating the cost per unit, the normal loss is anticipated by using the expected good output in the formula:

Normal loss and scrap value

If normal loss is sold as scrap the revenue is used to reduce the input costs of the process.

(1) If normal loss is sold as scrap then the formula for calculating the average cost of the units output does not really change -  simply the costs of inputs are reduced by the revenue received from the scrap that is sold i.e. giving the net cost.

(2) If normal loss has a scrap value, it is valued in the process account at this value.

(3) If normal loss does not have a scrap value, it is valued in the process account as $Nil.

Abnormal losses and gains

Normal loss is the expected loss in a process. Normal gain is the expected gain in a process. If the loss or the gain in a process is different to what we are expecting (i.e. differs from the normal loss or gain), then we have an abnormal loss or an abnormal gain in the process.

• The costs of abnormal losses and gains are not absorbed into the cost of good output but are shown as losses and gains in the process account.
• Abnormal loss and gain units are valued at the same cost as units of good output.

The process of calculation would thus be

(1) Calculate any normal loss units (forms part of the output units)

(2) By looking at actual output, determine whether there is an abnormal loss or gain.

(3) Value the inputs.

(4) Value the normal loss (if any).

(5) Calculate the average cost per unit:

(6) Value the good output and abnormal loss or gain at this average cost per unit.

Work-in-progress (WIP) and equivalent units (EUs)

WIP

At the end of an accounting period there may be some units that have entered a production process but the process has not been completed. These units are called closing work in progress (or WIP)units.

• If we assume that there is no opening WIP, then the output at the end of a period will consist of the following:
  • fully-processed units
  • part-processed units (closing WIP).
• Closing WIP units become the opening WIP units in the next accounting period.
• It would not be fair to allocate a full unit cost to part-processed units and so we need to use the concept of equivalent units (EUs) which spreads out the process costs of a period fairly between the fully- processed and part-processed units.

Concept of EUs

Process costs are allocated to units of production on the basis of EUs.

• The idea behind this concept is that a part-processed unit can be expressed as a proportion of a fully-completed unit.
• For example, if 100 units are exactly half-way through the production process, they are effectively equal to 50 fully-completed units. Therefore the 100 part-processed units can be regarded as being equivalent to 50 fully-completed units or 50 EUs.

In the weighted average method opening inventory values are added to current costs to provide an overall average cost per unit.

No distinction is made between units in process at the start of a period and those added during the period.

FIFO costing of production

In the weighted average method opening inventory values are added to current costs to provide an overall average cost per unit. With FIFO, opening WIP units are distinguished from those units added in the period. 

With FIFO it is assumed that the opening WIP units are completed first.

This means that the process costs in the period must be allocated between:

• opening WIP units
• units started and completed in the period (fully-worked units)
• closing WIP units.

This also means that if opening WIP units are 75% complete with respect to materials and 40% complete with respect to labour, only 25% 'more work' will need to be carried out with respect to materials and 60% with respect to labour.

Losses made part way through production

It is possible that losses (or gains) could be identified part way through a process. In such a case, EUs must be used to assess the extent to which costs were incurred at the time at which the loss was identified.

Further complications

Some processes produce more than one output. Depending on the relative importance of these products they may be known as joint or by products, a classification that affects the costing treatment.

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