Management Accounting Chapter 6: Process Costing Methods and Analysis

Process Costing Competencies and Learning Outcomes

Process costing is a fundamental method used in management accounting for allocating costs to units of inventory in specific manufacturing environments. The technical competencies associated with this lesson include evaluating cost classifications and costing methods for ongoing management operations ($3.3.1$) and applying cost management techniques appropriate for costing decisions ($3.3.2$). The specific learning outcomes focused on in this material are differentiating between job costing and process costing systems, describing basic process flows in manufacturing businesses, and mastering the weighted average and first in, first out (FIFO) methods of process costing. Additionally, the material covers the treatment of normal and abnormal spoilage within these systems.

Defining Process Costing and Differentiating it from Job Costing

Process costing is a methodology used by organizations whose products are produced in a continuous, homogeneous fashion through one or more production processes. This method typically employs absorption costing to ensure all production-associated costs are captured. In contrast, job costing is used for products or services that are uniquely identifiable, usually involving customization where each job consumes different amounts of resources.

Comparison of characteristics:

• Job Costing: Used for production on demand with intermittent production cycles. The processes are customized and heterogeneous. Each product is unique, and costs are accumulated on a job cost sheet. Examples include the construction of a custom home, individual print jobs at a copy center, or legal advice from a lawyer.

• Process Costing: Used for continuous, mass production of uniform or homogeneous products. Production is generally for stock rather than specific orders. Costs are collected by department or process and reported on a departmental production report. Examples include bags of dog food, cans of soup, boxes of toothpicks, bottles of soda pop, and bags of flour.

Similarities between the two systems include the primary purpose of assigning costs to products, the common focus on direct materials (DM), direct labor, and manufacturing overhead, and the fact that costs flow through a Work-in-Process (WIP) account.

Manufacturing Process Flow and Cost Accumulation

Using the manufacturing of a cola soft drink as an example, the process flow involves three distinct steps, each occurring in a separate division or department: making the syrup, canning or bottling the drink, and packaging. In the "Make Syrup" department, sugar and other ingredients are mixed. The syrup is then transferred to the "Canning/Bottling" department, which adds premeasured amounts of water and carbon dioxide before sealing the can. Finally, the "Packaging" department organizes the cans into cartons or six-pack plastic rings.

In process costing, each department maintains its own WIP account to accumulate product costs. When a product is completed in one department, its costs are transferred to the next department's WIP account. Additional direct materials or conversion costs (direct labor and overhead) are added as needed at each stage. Once all processing steps are complete, the product and its total accumulated costs are transferred from the final WIP account to Finished Goods inventory until the product is sold. Managers use this departmental cost data to identify opportunities for improving cost performance.

The Concepts of Equivalent Units (EU) and Cost Tracking

In continuous production, inventory exists at various stages of completion. To accurately cost this inventory, management uses the concept of Equivalent Units (EU), which translates partially completed units into an equivalent number of fully completed units. For instance, if there are two units that are each $50\%$ complete, they represent one EU.

Direct materials are often added at specific points (frequently at the beginning), while conversion costs (direct labor and overhead) are usually incurred uniformly throughout the process. Because of this variation, direct materials EU and conversion cost EU are tracked separately. There are two primary methods for calculating EU: the weighted average method and the FIFO method.

The Five-Step Guide to Process Costing

Regardless of the method used, process costing follows a consistent five-step guide:

1. Compute units to be accounted for: Identify the physical flow of goods. The sum of beginning WIP and units started must equal the sum of units completed, units in ending WIP, and spoiled goods.

2. Compute output in terms of EU: Calculate production for the period in equivalent units for each cost element (DM and conversion).

3. Compute costs to account for: Total the costs from beginning WIP (if any) and costs added during the current period.

4. Compute cost per EU: Divide the total costs to account for by the equivalent units calculated in Step 2.

5. Assign total costs to units completed and to ending WIP: Multiply the cost per EU by the number of units in each category.

Using a simple example (Ex Co.), which started and completed $18,000$ units with no beginning or ending WIP: Material A ($\$90,000$), Packaging Material B ($\$1,800$), and Conversion Costs ($\$36,000$) resulted in a total cost of $\$127,800$. With $18,000$ EU for each category, the costs per EU were $\$5.00$ for Material A, $\$0.10$ for Material B, and $\$2.00$ for conversion, totaling $\$7.10$ per unit.

Application of the Weighted Average Method: Big White Hats Case Study

Big White Hats manufactures knit hats where DM is added at the start and conversion costs are added evenly. In December, they had the following data:

• Beginning WIP: $5,000$ units ($100\%$ DM, $70\%$ conversion) with costs of $\$75,000$ DM and $\$91,000$ conversion.

• Started: $60,000$ units.

• Completed: $45,000$ units.

• Ending WIP: $20,000$ units ($100\%$ DM, $50\%$ conversion).

• Costs added in December: $\$300,000$ DM and $\$423,000$ conversion.

Calculations for Weighted Average:

• Step 1 (Units): $5,000 + 60,000 = 65,000$ units.

• Step 2 (EU): DM EU = $45,000 + (20,000 \times 100\%) = 65,000$. Conversion EU = $45,000 + (20,000 \times 50\%) = 55,000$.

• Step 3 (Total Costs): DM = $\$75,000 + \$300,000 = \$375,000$. Conversion = $\$91,000 + \$423,000 = \$514,000$. Total = $\$889,000$.

• Step 4 (Cost per EU): DM = $\frac{\$375,000}{65,000} = \$5.77$. Conversion = $\frac{\$514,000}{55,000} = \$9.35$.

• Step 5 (Assignment): Completed units costs = $45,000 \times (\$5.77 + \$9.35) = \$680,400$. Ending WIP DM = $20,000 \times \$5.77 = \$115,400$. Ending WIP Conversion = $10,000 \times \$9.35 = \$93,500$. Total accounted for = $\$889,300$ (slight variance due to rounding).

Application of the First In, First Out (FIFO) Method: Big White Hats Case Study

FIFO separates the costs and work of the current period from the previous period. It is theoretically superior as it accounts for the fact that beginning WIP was partially produced previously. Using the same Big White Hats data:

• Step 2 (EU):   - From Beginning WIP (Conversion only): $5,000 \times (100\% - 70\%) = 1,500$ EU.   - Units Started and Completed: $(45,000 \text{ completed} - 5,000 \text{ from beg WIP}) = 40,000$ units ($40,000$ EU DM and $40,000$ EU Conversion).   - Ending WIP: DM EU = $20,000 \times 100\% = 20,000$; Conversion EU = $20,000 \times 50\% = 10,000$.   - Total EU: DM = $60,000$; Conversion = $51,500$.

• Step 4 (Cost per EU): Based only on costs added this period. DM = $\frac{\$300,000}{60,000} = \$5.00$. Conversion = $\frac{\$423,000}{51,500} = \$8.21$.

• Step 5 (Assignment):   - Cost of completed units: $\$166,000$ (Beg WIP costs) + $\$12,315$ (to complete beg WIP) + $\$528,400$ (started and completed) = $\$706,715$.   - Cost of Ending WIP: $\$100,000$ DM + $\$82,100$ Conversion = $\$182,100$.   - Total accounted for: $\$888,815$ (slight variance due to rounding).

Treatment of Normal and Abnormal Spoilage

Spoilage represents units that do not meet quality standards.

• Normal Spoilage: Occurs as a regular part of operations. Its cost is typically included in the cost of good units transferred out, thereby increasing the unit cost of good production. It does not encourage quality investigation.

• Abnormal Spoilage: Occurs under atypical circumstances. The cost is removed from WIP inventory and charged as a period expense (loss account), which highlights the issue for further analysis and quality improvement.

The formula for determining abnormal spoilage is: $\text{WIP}<em>{\text{beginning}} + \text{Started} - \text{Units transferred out} - \text{Normal spoilage} - \text{WIP}</em>{\text{ending}} = \text{Abnormal spoilage}$.

Advanced Case Study: Spoiled Inc. Spoilage Analysis

Spoiled Inc. manufactures vanity mirrors. Inspection occurs at $40\%$ of the cutting process for conversion costs. DM is added at the start. Normal spoilage is expected to be $15\%$ of good units passing inspection.

Data:

• WIP beg: $2,300$ ($50\%$ complete).

• Started: $20,200$.

• Completed: $18,000$.

• WIP end: $1,500$ ($30\%$ complete).

Normal Spoilage Calculation: Since beginning WIP was already $50\%$ complete, it passed inspection in the prior period. Thus, only units started and completed this period ($18,000 - 2,300 = 15,700$ units) will pass inspection. Normal Spoilage = $15,700 \times 15\% = 2,355$.

Abnormal Spoilage Calculation: $2,300 \text{ (beg)} + 20,200 \text{ (started)} - 18,000 \text{ (comp)} - 2,355 \text{ (norm)} - 1,500 \text{ (end)} = 645$ units.

Under Weighted Average:

• Step 2 (EU): DM = $18,000 + 2,355 + 645 + 1,500 = 22,500$. Conversion = $18,000 + (2,355 \times 40\%) + (645 \times 40\%) + (1,500 \times 30\%) = 19,650$.

• Step 4 (Cost/EU): DM = $\$4.04$, Conversion = $\$10.76$.

• Step 5 (Assignment): Completed units = $\$286,050$ (includes normal spoilage cost); Abnormal spoilage expense = $\$5,382$; Ending WIP = $\$10,902$.

Under FIFO:

• Step 2 (EU): DM = $20,200$. Conversion = 1,150 \text{ (to finish beg WIP)} + 15,700 \text{ (S&C)} + 942 \text{ (norm)} + 258 \text{ (abnorm)} + 450 \text{ (end)} = 18,500.

• Step 4 (Cost/EU): DM = $\$4.05$, Conversion = $\$10.81$.

• Step 5 (Assignment): Completed units = $\$286,155$; Abnormal spoilage expense = $\$5,401$; Ending WIP = $\$10,940$.

Questions and Discussion

Practice Scenario 1: The moulding department's WIP on May 1 was $1,400$ units and on May 31 was $1,100$ units. If $22,000$ units were completed, how many were started? Calculation: $\text{Started} = \text{Completed} + \text{WIP ending} - \text{WIP beginning} = 22,000 + 1,100 - 1,400 = 21,700$ units.

Practice Scenario 2 (Scott's Ready Meals): Using weighted average, calculate conversion cost for February ending WIP. DM added at start; conversion incurred evenly.

• WIP beginning: $80,000$; Started: $250,200$ units; Total: $330,200$ units.

• Finishing: $379,840$ units completed? (Correction: Units started and costs are separate).

• Costs: Beg WIP Conv = $\$379,840$. Costs added Conv = $\$1,545,920$. Total Conv Cost = $\$1,925,760$.

• Units: WIP beg $80,000$ ($40\%$); Units started $220,000$; Total $300,000$ units. WIP end $60,000$ ($80\%$).

• EU Conversion = $(240,000 \text{ completed} + (60,000 \times 80\%)) = 288,000$ EU.

• Cost per EU = $\frac{\$1,925,760}{288,000} = \$6.686…$ units.

• Conversion in Ending WIP = $(60,000 \times 80\%) \times \text{Cost per EU}$.

Practice Scenario 4 (BlackBird Co.): FIFO EU for March conversion.

• Beg WIP: $6,000$ units ($60\%$ CC).

• Started: $42,000$ units.

• End WIP: $8,000$ units ($3,000$ @ $40\%$, $5,000$ @ $80\%$).

• Completed: $6,000 + 42,000 - 8,000 = 40,000$.

• EU = $(6,000 \times 40\%) + (40,000 - 6,000) + (3,000 \times 40\%) + (5,000 \times 80\%) = 2,400 + 34,000 + 1,200 + 4,000 = 41,600$.

Practice Scenario 5 (Delta Products Ltd.): FIFO EU for conversion of units completed and transferred out.

• Beg WIP: $8,000$ ($25\%$).

• Transferred out: $38,000$.

• EU for units completed = $(8,000 \times 75\% \text{ to complete}) + (38,000 - 8,000) = 6,000 + 30,000 = 36,000$ units.