Chapter 4, Costing Systems: Process Costing

Chapter 4

Review of Learning Objectives

LO1Describe the process costing system, identify the reasons for its use, and discuss its role in the management process.

A process costing system is a product costing system used by companies that produce large amounts of similar products or liquid products or that have long, continuous production runs of identical products. Because these companies have a continuous production flow, it would be impractical for them to use a job order costing system, which tracks costs to a specific batch of products or a specific job order. In contrast to a job order costing system, a process costing system accumulates the costs of direct materials, direct labor, and overhead for each process, department, or work cell and assigns those costs to the products as they are produced during a particular period.

The product costs provided by a process costing system play a key role in the management process. When managers plan, they use past and projected information about product costs to set selling prices and prepare budgets. Each day, managers use cost information to make decisions about controlling costs, managing the company's volume of activity, ensuring quality, and negotiating prices. Actual costs are incurred as units are produced, so actual unit costs can be computed. When managers evaluate performance results, they compare targeted costs with actual costs. When managers communicate with external stakeholders, they use actual units produced and costs incurred to value inventory on the balance sheet and cost of goods sold on the income statement. They also analyze internal reports that compare the organization's measures of actual and targeted performance to determine whether cost goals for products or services are being achieved.

LO2Relate the patterns of product flows to the cost flow methods in a process costing environment.

During production in a process costing environment, products flow in a first-in, first-out (FIFO) fashion through several processes, departments, or work cells. As they do, the process costing system accumulates their costs and passes them on to the next process, department, or work cell. At the end of every accounting period, the system generates a report that assigns the costs that have accumulated during the period to the units that have transferred out of the process, department, or work cell and to the units that are still work in process. The process cost report may assign costs by using the FIFO costing method—in which the costs assigned to the first products processed are the first costs transferred out when those products flow to the next process, department, work cell—or the average costing method, which assigns an average cost to all products made during an accounting period.

LO3Explain the role of the Work in Process Inventory accounts in a process costing system.

The Work in Process Inventory accounts are the focal point of a process costing system. Each production process, department, or work cell has its own Work in Process Inventory account. All costs charged to that process, department, or work cell flow into its Work in Process Inventory account. A process cost report prepared at the end of every accounting period assigns the costs that have accumulated during the period to the units that have flowed out of the process, department, or work cell (the cost of goods transferred out) and to the units that are still in process (the cost of ending inventory).

LO4 Define equivalent production, and compute equivalent units.

Equivalent production is a measure that applies a percentage-of-completion factor to partially completed units to compute the equivalent number of whole units produced in an accounting period for each type of input. Equivalent units are computed from (1) units in the beginning work in process inventory and their percentage of completion, (2) units started and completed during the period, and (3) units in the ending work in process inventory and their percentage of completion. The computation of equivalent units differs depending on whether the FIFO method or the average costing method is used.

LO5Prepare a process cost report using the FIFO costing method.

In a process cost report that uses the FIFO costing method, the cost flow follows the logical physical flow of production—that is, the costs assigned to the first products processed are the first costs transferred when those products flow to the next process, department, or work cell. Preparation of a process cost report involves five steps. Steps 1 and 2 account for the physical flow of products and compute the equivalent units of production. Once equivalent production has been determined, the focus of the report shifts to accounting for costs. In Step 3, all direct materials costs and conversion costs for the current period are added to arrive at total costs. In Step 4, the cost per equivalent unit for both direct materials costs and conversion costs is found by dividing those costs by their respective equivalent units. In Step 5, costs are assigned to the units completed and transferred out during the period, as well as to the ending work in process inventory. The costs assigned to units completed and transferred out include the costs incurred in the preceding period and the conversion costs that were needed to complete those units during the current period. That amount is added to the total cost of producing all units started and completed during the period. The result is the total cost transferred out for the units completed during the period. Step 5 also assigns costs to units still in process at the end of the period by multiplying their direct materials costs and conversion costs by their respective equivalent units. The total equals the balance in the Work in Process Inventory account at the end of the period.

LO6Prepare a process cost report using the average costing method.

The average costing method is an alternative method of accounting for production costs in a manufacturing environment characterized by a continuous production flow. The difference between a process costing report that uses the FIFO method and one that uses the average costing method is that the latter does not differentiate when work was done on inventory. When the average costing method is used, the costs in beginning inventory are averaged with the current period costs to compute the product unit costs. These costs are used to value the ending balance in Work in Process Inventory and the goods completed and transferred out of the process, department, or work cell.

LO7Evaluate operating performance using information about product cost.

Both the job order and process costing systems supply information that managers can use to evaluate operating performance. Such an analysis may include consideration of the cost trends for a product or product line, units produced per time period, materials usage per unit produced, labor cost per unit produced, special needs of customers, and the cost-effectiveness of changing to a more advanced production process.