Process Costing, Features, Types, Advantages & Limitations, Process

  • Post last modified:20 February 2021
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What is Process Costing?

Process Costing refers to a method of accumulating cost of production by process. It represents a method of cost procedure applicable to continuous or mass production industries producing standard products. Costs are compiled for each process or department by preparing a separate account for each process.

Process Costing Definition

Process Costing is that form of operating costing which applies where standardised goods are produced”.ICMA
Process Costing as “a method of cost accounting whereby costs are charged to processes or operations and averaged over units produced.Kohler

Features of Process Costing

Process costing has the following important features :

  1. Sequence of Production
  2. Homogeneous Product
  3. Computing Costs

Sequence of Production

Process costing is used by the industries where the goods are produced through the sequence of several processes. Process costing is suitable for industries like paint, oil refining, rubber, chemicals, sugar, paper, soap-making, textiles, etc.

This method is also employed where it is not possible to ascertain the prime cost of a specific order.

Homogeneous Product

Units of production are uniform and homogeneous. As a result, unit cost of each process is obtained by averaging the total cost of each process.

Computing Costs

we know that, there will be Work in progress during the opening and closing of a period and thus an organization needs to decide on the cost flow assumptions. For computing costs under process costing the organization can use either the FIFO or weighted average cost flow assumption.

Using the FIFO method:

The first in first out (FIFO) method of costing is used to introduce the subject of materials costing. The FIFO method of costing issued materials follows the principle that materials used should carry the actual experienced cost of the specific units used.

The method assumes that materials are issued from the oldest supply in stock and that the cost of those units, when placed in stock, is the cost of those same units when issued. However, FIFO costing may be used even though physical withdrawal is in a different order.

Costs follow the production process, i.e., costs incurred in one process are transferred to the next process along with the output.

The entire production activity is characterised by a number of stages of production, i.e., processes. Each process includes a number of operations. The boundaries of the process are determined by similarity of work performed, supervision and physical location of men and machines in the plant.

The products and processes are standardized.

Production is in continuous flow and the output of Process I becomes the input of Process II and so on until the finished product is obtained.

Total cost of the process is adjusted with normal losses, abnormal losses, abnormal gains and scrap of the process.


Types of Process Costing

  1. First In First Out Method [FIFO]
  2. Average Method
  3. Weighted Average Method

First In First Out Method [FIFO]

In this method, the assumption is that the incomplete units from the opening stock are completed first and then the units introduced in the process are completed. The costs added in each process during the current period is prorated to the production necessary to complete the opening work in progress, to complete the units added in the process and units in the work in progress.

The objective of the first in first out method is to value the inventory at the current costs and as such the main problem is to calculate the equivalent production under this method.

Average Method

Process costs are sometimes computed on the basis of average costs. Where degree of completion of opening work in progress is not given, average method is used.

The average process cost is obtained by adding the cost of opening work in progress and the cost of units introduced in the process during the current period and dividing this total cost by total equivalent units obtained by adding the number of units completed and equivalent units of the closing work in progress of each element, material, labor and overheads.

The main object of average method is to even out the fluctuations in prices and hence is used when the prices fluctuate widely during a particular period.

Weighted Average Method

If a manufacturing unit is manufacturing two or more products, which are quite dissimilar to each other, weighted average method is used. Under this method, weighted average is computed and used in valuation of the incomplete units.


Advantages and Limitations of Process Costing

The Advantages and Limitations of Process Costing are as follows :

PointsAdvantages of Process CostingLimitations of Process Costing
MeaningJob costing is form of specific order costing which applies where work is undertaken to customer’s specific requirement. It is the process of assigning costs to products or services.The costing method applicable where goods or services result from a sequence of continuous or repetitive operations or processes.
CostsCosts are traced to individual jobs, and pro- duction overhead is allocated.Costs are averaged over the units produced during the period.
UnitIt may be related to a single unit or a batch of similar units.It is applied to a large number of units.
ProductA job is carried out or a product is produced to meet the specific requirements of the order.All the products are identical and there is a con- tinuous flow of production.
Work in-ProgressWork-in-progress may or may not exist at the end of accounting period.Normally, there will be opening and closing work- in-progress for the accounting period.
ControlStandardization of controls is comparatively difficult as each job differs and more detailed supervision and control is necessary.Proper control is relatively easy as there are stan- dard applied for costs, process loss, time of pro- duction, etc.

Difference between Job Costing and Process Costing

Difference between Job costing and Process Costing can be stated as follows:

Basis for ComparisonJob CostingProcess Costing
MeaningJob costing refers to calculating the cost of a special contract, work order where work is performed as per client’s or customer’s instructions.A costing method, in which the costs which are charged to various processes and operations is ascertained, is known as Process Costing.
NatureCustomized productionStandardized production
Assignment of CostCalculating cost of each job.First of all, cost is determined for the process, thereafter spread over the produced units.
Cost CenterJobProcess
Scope of cost reductionLessHigh
Transfer of CostNo transferCost is transferred from one process to another.
IdentityEach job is different from another.Products are manufactured consecutively and so they lose their identity.
Cost AscertainmentCompletion of the job.End of the cost period.
Industry TypeJob costing is suitable for the industries which manufactures products as per customer’s order.Process costing is perfect for the industry where mass production is done.
LossesLosses are usually not
segregated.
Normal losses are carefully ascertained and abnormal losses are bifurcated.
Work in progress (WIP)WIP may or may not exist at the beginning or at the end of the financial year.WIP will always be present in the beginning or at the end of the accounting period.

Process of Collection Costs

The whole industrial unit is divided into distinct processes to which all amounts of direct material, direct labour, direct expenses and overheads are debited:

  1. Direct Materials
  2. Direct Labour
  3. Direct Expenses
  4. Overheads

Direct Materials

With the help of material requisition, costs of raw materials are debited to the process concerned

Direct Labour

Wages paid to the labourers and other staff engaged in particular process are charged to the concerned process. Sometimes, many workers are engaged in more than one process, the gross wages paid concerned are to be allocated on the basis of time spent.

Direct Expenses

There are certain expenses chargeable to the process concerned e.g. electricity bill, depreciation etc.

Overheads

There are many expenses which are incurred for more than two processes the total of such expenses may be apportioned either on suitable basis or at predetermined rate based on direct labour charges or prime cost etc.

Procedure

  1. For the purpose of cost accounting, process industries are divided into departments, each department representing a particular process. A process may consist of a separate operation or series of operations. A foreman or supervisor is appointed for each department. He is responsible for efficient functioning of his department.

  2. A separate account is maintained for each process and it is debited with the value of raw material, labour and overheads relating to the process.

  3. Output is recorded in terms of units (e.g. tons, litres, kg., etc.) on daily, weekly or suitable periodical basis depending upon processing time.

  4. Average cost per unit is found out by dividing the total cost of each process by total production of that process. In arriving at average unit costs/costs normal loss in production and incomplete units in the beginning and at the end of the period, are taken into consideration.

  5. Cost of previous process is transferred to the subsequent process so that the total cost and unit cost of products are accumulated.

  6. Products remaining unfinished in the process at the close of the period are to be assessed in terms of equivalent completed units on the basis of percentage/degree of completion.

Important Terms of Process Costing

In a manufacturing process the number of units of output may not necessarily be the same as the number of units of inputs. There may be a loss.

  1. Normal Loss
  2. Abnormal Loss
  3. Abnormal Gain
  4. Work in Progress (WIP)
  5. Scrap Value
  6. Equivalent Units

Normal Loss

This is the term used to describe normal expected wastage under usual operating conditions. This may be due to reasons such as evaporation, testing or rejects.

Abnormal Loss

This is when a loss occurs over and above the normal expected loss. This may be due to reasons such as faulty machinery or errors by labourers.

Abnormal Gain

This occurs when the actual loss is lower than the normal loss. This could, for example, be due to greater efficiency from newly-purchased machinery.

Work in Progress (WIP)

This is the term used to describe units that are not yet complete at the end of the period. Opening WIP is the number of incomplete units at the start of a process and closing WIP is the number at the end of the process.

Scrap Value

Sometimes the outcome of a loss can be sold for a small value. For example,
in the production of screws there may be a loss such as metal wastage. This
may be sold to a scrap merchant for a fee.

Equivalent Units

This refers to a conversion of part-completed units into an equivalent number of wholly-completed units.

For example, if 1,000 cars are 40% complete then the equivalent number of completed cars would be 1,000 x 40% = 400 cars. Note:

If 1,000 cars are 60% complete on the painting, but 40% complete on the testing, then equivalent units will need to be established for each type of cost.


Inter Process Profit

Sometimes, the output from one process is transferred to the next process at market value or cost plus certain percentage of profit. It is considered desirable by a manufacturing concern to value output of each process at a price corresponding to a market price of comparable goods . Thus, profit or loss made by each process is revealed. The market price of the output processed being generally higher than that the cost to the process, each process will show some profit.

The profit is termed as ‘Inter Process Profit’. In other words, inter process profits can be defined as profits made by the transfer of process from transfer of output to the subsequent process. The advantages and disadvantages of inter process profit are as follows :

Advantages

  • To show whether the cost of production competes with the market price.
  • On the basis of this conclusion a management can decide whether a product should be processed internally or to be brought in the market. In short, it assists the management in make or buy decision.
  • To make each process self-efficient because the transfer processes are not given the benifits of economies effected in the earlier process.
  • The true profit or loss of each process can be ascertained and appropriate action can be taken if profit of any process is insufficient.

Disadvantages

  • It becomes necessary to adjust closing stock value to its cost price because closing stock is valued in the balance sheet at cost price.
  • If the adjustment is not effected in the closing stock, such valuation is not accepted by auditor and tax authorities.
  • The method involves additional clerical work by way of calculating transfer price and then ascertaining the value of closing stock at its cost price.

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