Chapter 4 : Analysis For Decision Making

TABLE OF CONTENTS
• Summary
• Record the flow of materials, labor, and overhead through a
process costing system
• Compute the equivalent units of production using the
weighted-average method
• Compute the cost per equivalent unit using the weighted-
average method
• Assign costs to units using the weighted-average method.
• Prepare a cost reconciliation report using the weighted-
average method.

SUMMARY
• Process costing is used when there is mass production of
similar products, where the costs associated with individual
units of output cannot be differentiated from each other. In
other words, the cost of each product produced is assumed to
be the same as the cost of every other product. Under this
concept, costs are accumulated over a fixed period of time,
summarized, and then allocated to all of the units produced
during that period of time on a consistent basis. When
products are instead being manufactured on an individual
basis, job costing is used to accumulate costs and assign the
costs to products. When a production process contains some
mass manufacturing and some customized elements, then a
hybrid costing system is used.

SUMMARY
• Examples of the industries where this type of production
occurs include oil refining, food production, and chemical
processing. For example, how would you determine the
precise cost required to create one gallon of aviation fuel,
when thousands of gallons of the same fuel are gushing out of
a refinery every hour? The cost accounting methodology used
for this scenario is process costing.
• Process costing is the only reasonable approach to
determining product costs in many industries. It uses most of
the same journal entries found in a job costing environment,
so there is no need to restructure the chart of accounts to any
significant degree. This makes it easy to switch over to a job
costing system from a process costing one if the need arises,
or to adopt a hybrid approach that uses portions of both
systems.

SUMMARY
There are three types of process costing, which are:
• Weighted average costs. This version assumes that all costs, whether
from a preceding period or the current one, are lumped together and
assigned to produced units. It is the simplest version to calculate.
• Standard costs. This version is based on standard costs. Its calculation is
similar to weighted average costing, but standard costs are assigned to
production units, rather than actual costs; after total costs are
accumulated based on standard costs, these totals are compared to
actual accumulated costs, and the difference is charged to a variance
account.
• First-in first-out costing (FIFO). FIFO is a more complex calculation that
creates layers of costs, one for any units of production that were started
in the previous production period but not completed, and another layer
for any production that is started in the current period.
• There is no last in, first out (LIFO) costing method used in process
costing, since the underlying assumption of process costing is that the
first unit produced is, in fact, the first unit used, which is the FIFO
concept.

SUMMARY
Why have three different cost calculation methods for process
costing, and why use one version instead of another? The
different calculations are required for different cost accounting
needs. The weighted average method is used in situations
where there is no standard costing system, or where the
fluctuations in costs from period to period are so slight that the
management team has no need for the slight improvement in
costing accuracy that can be obtained with the FIFO costing
method. Alternatively, process costing that is based on standard
costs is required for costing systems that use standard costs.

SUMMARY
It is also useful in situations where companies manufacture such a broad
mix of products that they have difficulty accurately assigning actual costs
to each type of product; under the other process costing methodologies,
which both use actual costs, there is a strong chance that costs for
different products will become mixed together. Finally, FIFO costing is
used when there are ongoing and significant changes in product costs
from period to period – to such an extent that the management team
needs to know the new costing levels so that it can re-price products
appropriately, determine if there are internal costing problems requiring
resolution, or perhaps to change manager performance-based
compensation. In general, the simplest costing approach is the weighted
average method, with FIFO costing being the most difficult.
The typical manner in which costs flow in process costing is that direct
material costs are added at the beginning of the process, while all other
costs (both direct labor and overhead) are gradually added over the
course of the production process. For example, in a food processing
operation, the direct material (such as a cow) is added at the beginning of
the operation, and then various rendering operations gradually convert
the direct material into finished products (such as steaks).

RECORD THE FLOW OF MATERIALS, LABOR, AND OVERHEAD THROUGH A
PROCESS COSTING SYSTEM
Section 1

SIMILARITIESBETWEENJOB-ORDERAND
PROCESSCOSTING
Both systems assign material, labor, and overhead costs
to products and they provide a mechanism for computing
unit product costs.
Both systems use the same manufacturing accounts,
including Manufacturing Overhead, Raw Materials, Work
in Process, and Finished Goods.
The flow of costs through the manufacturing accounts is
basically the same in both systems.

DIFFERENCESBETWEENJOB-ORDERAND
PROCESSCOSTING

PROCESSINGDEPARTMENTS
Any unit in an organization where materials, labor, or
overhead are added to the product.
The activities performed in a processing
department are performed uniformly on all
units of production. Furthermore, the output of
a processing department must be homogeneous.
Products in a process costing environment typically
flow in a sequence from one department to another.

PROCESS COSTING
• Process costing is a method of
operation costing which is used to
ascertain the cost of production at each
process, operation or stage of
manufacture, where processes are
carried in having one or more of the
following features:
• i. Where the product of one process
becomes the material of another
process or operation
• ii. Where there is simultaneous
production at one or more process of
different products, with or without by
product,
• iii. Where, during one or more
processes or operations of a series, the
products or materials are not
distinguishable from one another, as for
instance when finished products differ
finally only in shape or form’.
Where the product of one process
becomes the material of another
process or operation
Where there is simultaneous
production at one or more process
of different products
The products or materials are not
distinguishable from one another, as
for instance when finished products
differ finally only in shape or form’.

PROCESS COSTING
• Process costing is defined by
Kohler as: “A method of
accounting whereby costs are
charged to processes or
operations and averaged over
units produced; it is employed
principally where a finished
product is the result of a more or
less continuous operation, as in
paper mills, refineries, canneries
and chemical plants;
distinguished from job costing,
where costs are assigned to
specific orders, lots or units.
“A method of
accounting
whereby costs
are charged to
processes or
operations
and averaged
over units
produced

APPLICATION PROCESS COSTING
• 1. Process Costing Method is
applicable where the output results
from a continuous or repetitive
operations or processes.
• 2. Products are identical and cannot
be segregated.
• 3. It enables the ascertainment of
cost of the product at each process
or stage of manufacture.
• 4. The output consists of products,
which are homogenous.
• 5. Production is carried on in
different stages (each of which is
called a process) having a continuous
flow.
Continuous
operation
Identical and not
segregated
Ascertainment of
product cost
Homogenous
products
Carried different
stages

APPLICATION OF PROCESS COSTING
• 6. The input will pass through two or more
processes before it takes the shape of the
output. The output of each process
becomes the input for the next process
until the final product is obtained, with the
last process giving the final product.
• 7. The output of a process except the last
may also be saleable in which case the
process may generate some profit.
• 8. The input of a process except the first
may be capable of being acquired from the
outside sources.
• 9. The output of a process is transferred to
the next process generally at cost to the
process. It may also be transferred at
market price to enable checking efficiency
of operations in comparison to the market
conditions.
• 10. Normal and abnormal losses may arise
in the processes.
Two or more processes
to shape the output
The output of a process
is saleable
The input acquired from
outside sources
The output is transferred
to next process
Normal and abnormal
losses

ADVANTAGES OF PROCESS COSTING
• 1. It is possible to determine process
costs periodically at short intervals.
Average unit cost can be computed
weekly or even daily.
• 2. It is simple and less expensive to
find out the process costs.
• 3. It is possible to have managerial
control by evaluating the
performance of each process.
• 4. It is easy to allocate the expenses
to processes in order to have
accurate costs.
• 5. It is easy to quote the prices with
standardization of process. Standard
costing can be established easily in
process type of manufacture.

DISADVANTAGES OF PROCESS COSTING
• 1. Cost obtained at the end of the
accounting period are only of historical
value and are not very useful for effective
control.
• 2. Valuation of work-in-progress is
generally done of estimated basis which
introduces further inaccuracies in total
cost.
• 3. Where different products arise in the
same process, it is not possible to exactly
ascertain the total cost of the products.
• 4. If any error occurs while calculating
average costs, it will be carried through all
the processes to the valuation of work in
process and finished goods.
• 5. The computation of average cost is
more difficult in those cases where more
than one type of product is manufactured
and a division of the cost element is
necessary.

FUNDAMENTAL PRINCIPLES OF PROCESS COSTING
• 1. Cost of material, wages and
overheads expenses are collected for
each process or operation in a period.
• 2. Adequate records in respect of
output and scrap of each processes
or operation during the period are
kept.
• 3. The cost per unit of each process
is obtained by dividing the total cost
incurred during a period by the
number of units produced during that
period after taking into consideration
the losses and amount realized from
sale of scrap.
• 4. The finished product of one
process is transferred as a raw
material to the next process.
Cost of material,
wages and overheads
expenses collected for
each process
Adequate records of
each processes kept
The cost per unit of
each process obtained
The finished product
transferred to next
process

TREATMENT OF LOSSES OF PROCESS COSTING
• It is rare that the output of a process
is equal to its input. In most of the
cases, the output of a process is less
than the input. The difference
between the input and output and
output is called process loss. The
process loss may be in the form of
loss in weight, scrapes or wastes.
These process losses may be
classified into:
• 1) Normal Loss
• 2) Abnormal Loss
• 3) Abnormal Gain
Normal Loss
Abnormal Loss
Abnormal Gain

• Normal Loss: The fundamental
principle of costing is that the good
units should bear the amount of
normal loss. Normal loss is
anticipated and in a process it is
inevitable. It is included in total cost
of the product due to which cost per
unit is increases. The cost of normal
loss is therefore not worked out. The
number of units of normal loss is
credited to the Process Account and
if they have some scrap value or
realizable value the amount is also
credited to the process account. If
there is no scrap value or realizable
value, only the units are credited to
the process account.

• Abnormal Loss: If the units lost in the
production process are more than
the normal loss, the difference
between the two is the abnormal
loss. It is excluded from total cost
due to which it does not affect the
cost per unit of the product. The
relevant process of account is
credited and abnormal loss account is
debited with the abnormal loss
valued at full cost of finished output.
The amount realized from sale of
scrap of abnormal loss units is
credited to the abnormal loss account
and the balance in the abnormal loss
account is transferred to the Costing
Profit and Loss Account.

• Abnormal Gain: If the actual
production units are more than the
anticipated units after deducting the
normal loss, the difference between
the two is known as abnormal gain. It
is excluded from total cost due to
which it does not affect the cost per
unit of the product. The valuation of
abnormal gain is done in the same
manner like that of the abnormal
loss. The units and the amount is
debited to the relevant Process
Account and credited to the
Abnormal Gain Account.

THE FLOW OF MATERIALS, LABOR, AND
OVERHEAD COSTS – PART 1
Finished
Goods
Cost of
Goods
Sold
Work in
Process
Direct Materials
Direct Labor
Manufacturing
Overhead

THE FLOW OF MATERIALS, LABOR, AND
OVERHEAD COSTS – PART 2
Finished
Goods
Cost of
Goods
Sold
Jobs
Direct
Materials
Direct Labor
Manufacturing
Overhead
Job-order costing
systems trace and
apply manufacturing
costs to jobs

THE FLOW OF COSTS IN A PROCESS COSTING
SYSTEM
Costs are traced and
applied to departments
in a process cost system.
Finished
Goods
Cost of
Goods
Sold
Processing
Department
Direct
Materials
Direct Labor
Manufacturing
Overhead

FLOW OF RAW MATERIAL COSTS
For purposes of this example, assume there are two
processing departments – Departments A and B.
We will use T-accounts and journal entries.

FLOW OF RAW MATERIAL COSTS: T-ACCOUNT FORM
Raw Materials
Work in Process
Department B
Work in Process
Department A
•Direct
Materials
•Direct
Materials
•Direct
Materials

FLOW OF RAW MATERIAL COSTS: JOURNAL ENTRY FORM
Work in Process - Department A XXXXX
Work in Process - Department B XXXXX
Raw Materials XXXXX
As in job-order costing, materials are drawn from the
storeroom using a materials requisition form.
Materials can be added in any processing department.
Here is the journal entry to issue raw materials to
Processing Department A and Department B.

THE FLOW OF LABOR COSTS: T-ACCOUNT FORM
Work in Process
Department B
Work in Process
Department A
Salaries and
Wages Payable
•Direct
Materials
•Direct
Materials
•Direct
Labor
•Direct
Labor •Direct
Labor

THE FLOW OF LABOR COSTS: JOURNAL ENTRY FORM
Salaries and Wages Payable XXXXX
In process costing, labor costs are traced to
departments—not to individual jobs. The following
journal entry records the labor costs recorded to
Department A and Department B.

THE FLOW OF MANUFACTURING OVERHEAD
COSTS: T-ACCOUNT FORM
Work in Process
Department B
Work in Process
Department A
Manufacturing
Overhead
•Overhead
Applied to
Work in
Process
•Applied
Overhead
•Applied
Overhead
•Direct
Labor
•Direct
Materials
•Direct
Labor
•Direct
Materials
•Actual
Overhead

THEFLOWOFMANUFACTURINGOVERHEAD
COSTS:JOURNALENTRYFORM
Manufacturing Overhead XXXXX
In process costing, as in job-order costing, predetermined overhead rates
are usually used. Manufacturing overhead cost is applied according to the
amount of the allocation base that is incurred in the department. The
following journal entry records the overhead cost applied to Department A
and Department B.

TRANSFERS FROM WORK IN PROCESS-DEPT. A TO
WORK IN PROCESS-DEPT. B: T-ACCOUNT FORM
Work in Process
Department B
Work in Process
Department A
•Direct
Materials
•Direct
Labor
•Applied
Overhead
•Direct
Materials
•Direct
Labor
•Applied
Overhead
Transferred
to Dept. B
•Transferred
from Dept. A
The transferred-in costs from Department A are added to
the manufacturing costs incurred in Department B.

TRANSFERS FROM WORK IN PROCESS-DEPT. A TO
WORK IN PROCESS-DEPT. B: JOURNAL ENTRY FORM
Once processing has been completed in a department, the units are
transferred to the next department for further processing.

TRANSFERS FROM WORK IN PROCESS–DEPT. B
TO FINISHED GOODS: T-ACCOUNT FORM
Finished Goods
Work in Process
Department B
•Cost of
Goods
Manufactured
•Direct
Materials
•Direct
Labor
•Applied
Overhead
•Transferred
from Dept. A
•Cost of
Goods
Manufactured

TRANSFERS FROM WORK IN PROCESS–DEPT. B
TO FINISHED GOODS: JOURNAL ENTRY FORM
Finished Goods XXXXX
After processing has been finished in Department B, the
costs of the completed units are transferred to the Finished
Goods inventory account:

TRANSFERS FROM FINISHED GOODS INVENTORY TO
COST OF GOODS SOLD: T-ACCOUNT FORM
Finished Goods
Cost of Goods Sold
Work in Process
Department B
•Cost of
Goods
Manufactured
•Direct
Materials
•Direct
Labor
•Applied
Overhead
•Transferred
from Dept. A
•Cost of
Goods
Sold
•Cost of
Goods
Sold
•Cost of
Goods
Manufactured

TRANSFERS FROM FINISHED GOODS TO COST
OF GOODS SOLD: JOURNAL ENTRY FORM
Cost of Goods Sold XXXXX
Finished Goods XXXXX
Finally, when a customer’s order is filled and units
are sold, the cost of the units is transferred to Cost
of Goods Sold:

PROCESS COSTING COMPUTATIONS: THREE KEY CONCEPTS – PART 1
In process costing, each department needs to calculate two
numbers for financial reporting purposes—the cost of its
ending work in process inventory and the cost of its completed
units that were transferred to the next stage of the production
process. The key to deriving these two numbers is calculating
unit costs within each department.
Key Concept #1: There are two methods for performing the
computations, the weighted-average method and the FIFO
method. The weighted-average method of process costing
calculates unit costs by combining costs and outputs from the
current and prior periods. The FIFO method of process costing,,
calculates unit costs based solely on the costs and outputs from
the current period.

Characteristics of the weighted-average method:
a)This method makes no distinction between work done in the
prior and current periods. It blends together units and costs from
the prior and current periods.
b)The equivalent units of production for a department are the
number of units transferred to the next department (or finished
goods) plus the equivalent units in the department’s ending work
in process inventory.

Key Concept #2: Conversion Costs
Direct labor costs are often small in
comparison to the other product costs in
process cost systems.

PROCESSCOSTINGCOMPUTATIONS:THREEKEYCONCEPTS –PART4
Therefore, direct labor and manufacturing overhead are often combined
into one classification of product cost called conversion costs.
The example combines these costs:
Type of Product Cost
DollarAmount
Conversion
Direct
Materials
Direct
Labor
Direct Labor
Manufacturing
Overhead

Key Concept #3: Equivalent Units
a)Equivalent units  Defined as the product of the number
of partially completed units and the percentage completion
of those units.
b)Equivalent units need to be calculated because a
department usually has some partially completed units in
its beginning and ending inventories. These partially
completed units complicate the determination of a
department’s output for a given period, and the unit cost
that should be assigned to that output.

CALCULATING EQUIVALENT UNITS
Equivalent units is the product of the number of partially completed units
and the percentage completion of those units with respect to the
processing in the department. The equivalent units is the number of
complete units that could have been obtained from the materials and
effort that went into the partially complete units.
Assume Department A has 500 units in its ending work in process
inventory that are 60% complete with respect to processing in the
department. These 500 partially complete units are equivalent to 300
fully complete units (500 × 60% = 300). Department A’s ending work in
process inventory would contain 300 equivalent units for the period.

COMPUTE THE EQUIVALENT UNITS OF PRODUCTION USING THE WEIGHTED-
AVERAGE METHOD
Section 2

STEP 1: COMPUTE THE EQUIVALENT
UNITS OF PRODUCTION – PART 1
Smith Company reported the following activity in the Assembly Department
for the month of June:
Percent Completed
Units Materials Conversion
Work in process, June 1 300 40% 20%
Units started into production in June 6,000
Units completed and transferred out 5,400
of Department A during June
Work in process, June 30 900 60% 30%

Begin by calculating the equivalent units completed and transferred
out of the Assembly Department in June (5,400 units).
Materials Conversion
Units completed and transferred
out of the Department in June 5,400 5,400

Next, identify the equivalent units of production in ending work in
process with respect to materials for the month (540 units) and
adding this to the 5,400 units from step one.
Work in process, June 30:
900 units × 60% 540
Equivalent units of Production in
the Department during June 5,940

900 units × 60% 540
900 units × 30% 270
the Department during June 5,940 5,670
Finally, identify the equivalent units of production in ending work in
process with respect to conversion for the month (270 units) and
adding this to the 5,400 units.

900 units × 60% 540
900 units × 30% 270
the Department during June 5,940 5,670
Equivalent units of production always equals:
+ Equivalent units remaining in work in process

Beginning
Work in Process
300 Units
40% Complete
Ending
Work in Process
900 Units
60% Complete
6,000 Units Started
5,400 Units Completed
5,100 Units Started
and Completed
Materials
540 Equivalent Units 900 × 60%
5,940 Equivalent units
of production

6,000 Units Started
5,100 Units Started
and Completed
270 Equivalent Units
900 × 30%
5,670 Equivalent units
of production
Beginning
Work in Process
300 Units
20% Complete
Ending
Work in Process
900 Units
30% Complete
Conversion

COMPUTE THE COST PER EQUIVALENT UNIT USING THE WEIGHTED-AVERAGE
METHOD
Section 3

STEP 2: COMPUTE THE COST PER
EQUIVALENT UNIT – PART 1
Beginning Work in Process Inventory: 300 units
Materials: 40% complete $ 6,119
Conversion: 20% complete $ 3,920
Production started during June 6,000 units
Production completed during June 5,400 units
Costs added to production in June
Materials cost $ 118,621
Conversion cost $ 81,130
Ending Work in Process Inventory: 900 units
Materials: 60% complete
Conversion: 30% complete

The formula for computing the cost per
equivalent unit is:

Here is a schedule with the cost and equivalent
unit information.
Total
Cost Materials Conversion
Cost to be accounted for:
Work in process, June 1 10,039$ 6,119$ 3,920$
Cost added in Assembly 199,751 118,621 81,130
Total cost 209,790$ 124,740$ 85,050$
Equivalent units 5,940 5,670

Total
Cost Materials Conversion
Cost to be accounted for:
Work in process, June 1 10,039$ 6,119$ 3,920$
Cost added in Assembly 199,751 118,621 81,130
Total cost 209,790$ 124,740$ 85,050$
Equivalent units 5,940 5,670
Cost per equivalent unit 21.00$ 15.00$
Here is a schedule with the cost and equivalent unit information.
$124,740 ÷ 5,940 units = $21.00 $85,050 ÷ 5,670 units = $15.00
Cost per equivalent unit = $21.00 + $15.00 = $36.00

ASSIGN COSTS TO UNITS USING THE WEIGHTED-AVERAGE METHOD.
Section 4

STEP 3: ASSIGN COSTS TO UNITS – PART
1
Materials Conversion Total
Ending WIP inventory:
Equivalent units 540 270
Assembly Department
Cost of Ending WIP Inventory and Units Transferred Out

2
Assembly Department

3
Cost of Ending WIP inventory 11,340$ 4,050$ 15,390$
Assembly Department

STEP 3: COMPUTE COST OF UNITS TRANSFERRED OUT
Units completed and transferred out:
Units transferred 5,400 5,400
Assembly Department

4
Assembly Department

5
Cost of units transferred out 113,400$ 81,000$ 194,400$
Assembly Department

PREPARE A COST RECONCILIATION REPORT USING THE WEIGHTED-AVERAGE
METHOD.
Section 5

STEP 4: PREPARE A COST RECONCILIATION REPORT –
PART 1
Costs to be accounted for:
Cost of beginning Work in Process Inventory 10,039$
Costs added to production during the period 199,751
Total cost to be accounted for 209,790$
Assembly Department
Cost Reconciliation

STEP 4: PREPARE A COST RECONCILIATION REPORT –
PART 2
Costs to be accounted for:
Cost of beginning Work in Process Inventory 10,039$
Costs added to production during the period 199,751
Total cost to be accounted for 209,790$
Cost accounted for as follows:
Cost of ending Work in Process Inventory 15,390$
Cost of units transferred out 194,400
Total cost accounted for 209,790$
Assembly Department
Cost Reconciliation

OPERATION COSTING
Operation costing is a hybrid of job-order and process
costing because it possesses attributes of both
approaches.
Operation costing is commonly used when batches
of many different products pass through the same
processing department.

Chapter 4 : Analysis For Decision Making

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Chapter 4 : Analysis For Decision Making