CHAPTER

PROCESS COSTING
6

Learning Objectives
After reading and studying Chapter 6, you should be able to answer the following
questions:

1. How does process costing differ from job order costing?

2. For what reason are equivalent units of production used in process costing?

3. How are equivalent units of production, unit costs, and inventory values
determined using the weighted average method of process costing?

4. How are equivalent units of production, unit costs, and inventory values
determined using the FIFO method of process costing?

5. How can standard costs be used in a process costing system?

6. Why would a company use a hybrid costing system?

7. What alternative methods can be used to calculate equivalent units of

production?

8. How are normal and abnormal spoilage losses treated in an EUP schedule?
Terminology
Continuous loss is a loss that occurs fairly uniformly through the production process.

Cost of production report a process costing document that details all operating and cost
information, shows the computation of cost per equivalent unit, and indicates cost assignment
to goods produced during the period

Discreet loss is assumed to occur at a specific point and is detectible only when a quality check
is performed.

Equivalent units of production (EUP) are approximations of the number of whole units of
output that could have been produced during a period from the actual effort expended during
that period; used in process costing systems to assign costs to production

FIFO method (of process costing) is a method that separates beginning inventory and current
period production and their costs so that a current period cost per unit can be calculated. The
denominator used in the cost formula to determine the unit cost differs, depending on whether
the FIFO or weighted average methods are used.

Hybrid costing system a costing system combining characteristics of both job order and process
costing systems

Method of neglect simply excludes the spoiled units in the equivalent units schedule. The costs
of normal shrinkage and normal continuous losses in a process costing environment are
handled through the method of neglect. Ignoring the spoilage results in a smaller number of
equivalent units of production (EUP), and dividing production costs by a smaller EUP raises the
cost per equivalent unit, thus spreading the cost of lost units proportionately over the good
units transferred and those remaining in WIP.

Total cost to account for the sum of the balance in Work in Process Inventory at the beginning
of the period plus all current costs for direct material, direct labor, and overhead.

Total units to account for the sum of the whole and partial units worked on in the department
using the current period: It is equal to actual beginning inventory units and units started during
the current period

Units started and completed during a period is equal to units completed during the period
minus units in beginning inventory. It can also be computed as the number of units started
during the period minus the units in ending inventory

Weighted average method (of process costing) is a method of cost assignment that computes a
single average cost per unit of the combined beginning inventory and current period
production.
 Lecture Outline
A. Introduction to Process Costing.

1. Introduction to Process Costing.

i. Job-order costing is appropriate for companies making products or providing

services in limited quantities that conform to customer specifications.

ii. Both job-order costing and process costing accumulate costs by cost component in
each production department. However, the tow systems assign costs to
departmental output differently.

• In job-order costing, costs are assigned to specific jobs and then, if possible, to
units contained within the job.

• Process costing uses an averaging technique to assign costs directly to units

produced during the period.

iii. Process costing is a method of accumulating and assigning costs to units of

production in companies that make large quantities of homogeneous products.

b. Cost assignment in any production environment is essentially an averaging process.

c. The actual unit cost of a product is found by dividing a period’s departmental

production costs by the period’s departmental quantity of production, the average
being expressed by the following formula:

Sum of Production Costs

Unit Cost =
Production Quantity

2. The numerator.

a. The numerator in the average product cost fraction is the sum of the actual direct
materials cost, actual direct labor cost, and actual or predetermined overhead cost
for the period.

b. Cost accumulation in a process costing system differs from job order costing in two
ways:

i. the quantity of production for which costs are being accumulated at any one time
and:

• in job order costing, the direct materials, direct labor, and overhead costs are
accumulated for each job; or
 • in process costing, much larger amounts of direct materials, direct labor, and
overhead are accumulated for each department of a production process.

ii. the cost object to which the costs are assigned:

• in job order costing the cost object is the job; or

• in process costing, the costs assignable to each product type are designated
and attached to the specific production runs; then the costs are assigned to
the units worked on during the period.

3. The denominator.

a. The denominator in the average product cost fraction represents total departmental
production for the period.

b. If all units were 100% complete at the end of the period, we would simply count the
units to obtain the denominator.

c. However, WIP at the end of the period represent partially completed units that
become beginning inventory for the next accounting period. T

d. Process costing assigns costs to both fully completed units in finished goods
inventory and to the partially completed units in WIP.

e. We mathematically convert partially completed units into equivalent whole units by

calculating equivalent units of production (EUP).

4. Equivalent units of production (EUP) are an approximation of the number of whole

units of output that could have been produced during a period from the actual effort
expended during that period. Two facts are recognized by the use of equivalent units of
production.

a. Goods that were incomplete at the end of the last period are the first ones completed
during the current period. The units in the beginning Work in Process were started
last period, but will be completed during the current period—meaning that some
costs related to these units were incurred last period and additional costs will be
incurred in the current period.

b. Some units are begun but not completed during the current period. These partially
completed units in the ending Work in Process Inventory were started in the current
period, but will not be completed until the next period—meaning that costs were
incurred in this period and additional costs will be incurred next period, due to
current production efforts on the ending Work in Process Inventory.

c. Assuming no beginning inventory, equivalent units of production are calculated

using the following simple example:

The department worked on 220,000 units in November

 200,000 units were completed and 20,000 units were 40% complete at the end of
the period

200,000 completed units + (20,000 x 40%) = 208,000 EUP

B. Weighted Average and FIFO Process Costing Methods

1. The weighted average method is a method of process costing that computes an average
cost per equivalent unit of production; it combines beginning inventory units and costs
with current production and costs, respectively, to compute that average.

a. The weighted average method is not concerned about what quantity of work was
performed in the prior period on the units in beginning inventory; it only focuses on
units that are completed in the current period and units remaining in ending
inventory.

b. The method does not distinguish between units in beginning inventory and units
entering production during a period.

c. Average unit cost is found by dividing the total cost to be accounted for by the total
equivalent units of production and is calculated as follows:

Beginning Inventory Cost + Current Period Cost

Unit Cost =
Weighted Average Equivalent Units of Production
Total Cost Incurred
=
Total Equivalent Units of Effort

2. The FIFO method is a method of process costing that computes an average cost per
equivalent unit of production using only current period production and cost
information; units and costs in beginning inventory are separately sent to the next
department or to Finished Goods Inventory, as is appropriate.

a. The FIFO method separates beginning inventory and current period production and
their costs so that a current period cost per unit can be calculated.

b. The FIFO method more realistically reflects the way in which most goods actually
flow through the production system.

c. The method does not commingle units and costs of different periods, so that
equivalent units and costs of beginning inventory are withheld from the
computation of average current period cost.

d. The focus is specifically on the work performed during the current period, and the EUP
schedule shows only that work.
 e. The FIFO average cost per equivalent unit is calculated as follows:

Current Period Costs

Unit Cost =
Equivalent Units of Production

3. Separate EUP calculations must be made for each cost component.

a. Some direct material must be introduced at the start of a production process or there
would be no need for labor or overhead to be incurred. The beginning material is
one hundred percent complete throughout the process regardless of the percentage
of completion of labor and overhead.

b. Additional materials may be added at any point—continuously during processing,

or even at the end of processing.

c. A single materials computation may be made if all materials are at the same degree
of completion, or multiple equivalent unit calculations will have to be made if
multiple materials are used and are placed into production at different points in
time.

d. One percentage of completion estimate may be made and used for direct labor and
overhead if overhead is applied on a direct labor basis, or direct labor and overhead
are added to the product at the same rate.

e. Overhead costs are more likely to be caused by cost drivers other than direct labor
today, so companies probably will make single computations for “conversion
equivalent units” less often than in the past.

f. The calculation of equivalent units of production requires that a cost flow be

specified—either weighted average or FIFO.

g. The only difference between the calculations under the two methods is that the work
performed in the prior period on beginning inventory is not included in the current
period EUP using FIFO.

C. EUP Calculations and Cost Assignments

1. EUP calculations and cost assignments.

a. Cost must be assigned to goods transferred from WIP to Finished Goods Inventory
(or to another department).

b. In addition, at the end of any period, a value must be assigned to goods still in WIP.

c. Six steps in a process costing system.

i. Step 1: Calculate the physical units to account for;

 ii. Step 2: Calculate the physical units accounted for (verify that step a equals step
b);

iii. Step 3: Determine the equivalent units of production;

iv. Step 4: Determine the total cost to account for;

v. Step 5: Calculate the cost per equivalent unit; and

vi. Step 6: Assign the costs to inventories (verify that the total costs transferred out
plus the costs in ending inventory equal step d).

d. The total units to account for are the sum of whole and partial units worked on in
the department during the current period. It is equal to actual beginning inventory
units plus actual units started.

e. The total cost to account for is the sum of the balance in WIP at the beginning of the
period plus all current costs for direct material, direct labor, and overhead.

f. The six steps listed above can be combined into a cost of production report.

g. A cost of production report is a process costing document that details all operating
and cost information, shows the computation of cost per equivalent unit, and
indicates cost assignment to goods produced during the period.

D. Process Costing in a Multidepartment Setting.

1. Goods are transferred from a predecessor department to a successor department.

2. A successor department may or may not add additional raw materials to the units that
were transferred in or may provide additional labor with a corresponding incurrence of
overhead.

3. Successor departments may change the unit of measure from that of predecessor
departments.

E. Process Costing with Standard Costs.

1. Standard costing eliminates the periodic recomputation of production cost that is

required under actual costing.

2. Standard cost usage simplifies process costing and allows variances to be measured
during the period.

F. Hybrid Costing Systems.

1. A hybrid costing system is a costing system that combines certain characteristics of both
job order and process costing.
 2. A hybrid system would be used in a manufacturing environment in which various
product lines have different direct materials, but similar processing techniques.

3. Job order and process costing are two ends of a continuum.

4. As the use of flexible manufacturing processes increase, so will the use of hybrid costing
systems.

G. Appendix 1 Alternative Calculations of Weighted Average and FIFO Methods

1. Alternatively, EUP under the weighted average method may be calculated as follows:

Units transferred out (whole units)

+ Ending WIP (equivalent units)
= Weighted average EUP

2. Alternatively, EUP under the FIFO method may be calculated as follows:

Weighted average EUP

- Beginning WIP (equivalent units)
= FIFO EUP

3. In addition to the first alternative calculation above, weighted average and FIFO EUP
can also be calculated as follows:

a. Alternatively, EUP under the weighted average method may be calculated as

follows:

Total units to account for

- EUP to be completed in the next period (EI x % not completed)
= Weighted average EUP

b. Alternatively, EUP under the FIFO method may be calculated as follows:

Weighted average EUP

- EUP completed in the prior period (BI x % complete)
= FIFO EUP

4. These alternative calculations can be used as a confirmation of answers or as a shortcut

to initially compute EUP.

H. Appendix 2 Spoilage.

1. Spoilage represents units from the production process that does not meet specifications.

2. Losses in a production process may occur continuously or at a specific point in the

production process.
 a. Continuous loss: losses in a production process that occurs fairly uniformly through
the process.

b. Discrete loss: a loss that occurs at a specific point in the production process.

3. Several methods may be used to account for units lost during production

a. Normal continuous losses.

i. In process costing, the cost of normal continuous losses are handled through the
method of neglect, which excludes the spoiled units from EUP.

ii. This results in smaller EUP and raises the cost per equivalent unit.

iii. Therefore, the cost of the normal spoilage is spread proportionately over good
units transferred and those remaining in WIP.

iv. The cost of normal continuous losses is a product cost.

b. Normal discrete losses.

i. The cost of normal discrete losses are assigned only to units that have passed the
inspection point because assigning loss costs to units that may be found to be
defective in the next period would not be reasonable.

ii. The cost of normal discrete losses is a product cost.

c. Abnormal losses, both continuous and discrete, are expensed in the current period.