Process Costing System

INTRODUCTION

Nowadays, the business environment has become more and more competivive. Therefore managers need to determine the best strategies, to develop long and short term planning, to measure their performance, and to make the best decision for achiving the goals. For all these it’s important that managers know the product costs and to choose the best method for determining the costs.

Process costing is a method of costing applied to production when the process is executed in many operations or stages of manufacture. This method of costing is used in those industries with a standardized production process, where the final products are more or less equal, such as chemical works, soap-making, food products, textiles, drugs, paper, automobile production lines and so on, as well as in utilities producing gas, water, and electricity.

Because managers must to measure their performance, it’s important that all the strategies and decisions to be monitored continuously. Process costing allows monthly or periodic monitoring of the unit costs of any product a firm manufactures. Thus, managers will know whether they should to improve the processes or to change the tactics. Also, process costing helps accountants to find out unit costs needed for the stock assessment and the cost of good sold for external financial reports.

In a process costing , production is transferred from one process to the next until the final product is obtained. Each production department executs some part of the total operation and then transfers its completed production to the next department where it become the input for another process. At the end of all the stages, the completed production is sold or moved to the finished goods stock. Another feature of this method of costing is that during these processes, the products cannot be differentiated from one another, and finished products differ finally only in shape or form.

In this production flow direct costs (material and labour) and manufacturing overhead are allocated to each process, and in the same time with the production, all manufacturing costs are accumulated and transferred from one process to another. Therefore, when the costs of the last production department are added the total cost of production will be determinate. Thus, the costs are accumulated by department. Each department prepares a document, called production report, which provides a summary of the number of units moving through a department during a period, and a computation of unit costs. It also show what costs were charged to a department during a period and what disposition was made of these costs. Therefore, this report represent a key document in a process costing system.

The manufacturing individual cost of one product cannot be identified from many others. But, because all are made from the same raw-materials, and all are subject to the same repetitive operation and processes, the cost per unit is obtained dividing the costs of production incurred during the period by the number of units made in that period .

Average cost per unit = (Costs incurred during the period)/(Number of units produced)

In a manufacturing firm there is the possibility that at the end of the period to be some units which are not yet complete because they have only been partly processed. These unfinished products which remain in the production operation is known as work in progress or work in process (WIP). The costs incurred for a period are for all the units either finished or only partly finished. Thus, process costing had to find the combined unit cost of all the product units processed in that period. For this managers must to convert this partly completed units to equivalent units . For exemple, if a firm produced 50 refrigerators last month, but 30 are completed and 20 are 50% completed, therefore these 20 refrigerators represent 10 equivalent units (20 x 50%). The physical units were 50, but the equivalent units were only 40.

In this case the formula will be:

Average cost per unit = (Costs incurred during the period)/(Completed units produced+Equivalents units in WIP)

The equivalent costs should be calculated separately for each category of cost (direct materials, direct labour, and factory overhead) because the work performed on the products from WIP is not always the same for each cost element.