In accounting, process costing is a method of assigning production costs to units of output. In process costing systems, production costs are not traced to individual units of output. Costs are assigned first to production departments and then to units of output as they move through the departments. The process costing method is typically used for processes that produce large quantities of homogeneous products.
The process costing method is in contrast to other costing methods, such as product costing, job costing, or operation costing systems. Using the process costing method is optimal under certain conditions. If the output products are homogeneous, that is, the units of output are relatively indistinguishable from one another, it may be beneficial to use process costing. If the output products are of low value, meaning each individual unit of output is not worth much, it may be beneficial to use process costing. And if it is difficult or infeasible to trace production costs directly to individual units of output, it may be beneficial to use the process costing method.
Examples of operations that are likely to use the process costing method as opposed to another costing method include a cola bottling plant, a breakfast cereal maker, a company that makes computer chips, and company that produces lumber, and a company that produces bricks. For example, for the company that bottles cola, it would not be feasible or worthwhile to separate and record the cost of each bottle of cola in the bottling process. Therefore, the company would assign costs to the bottling process as a whole for a period of time, and then divide that overall process cost by the number of bottles produced during that period of time to assign production costs to each bottle of cola.
Steps in Process Costing
Five Steps for Process Costing are;
- Analyze inventory flow: First, analyze the cost-flow model of the relevant inventory account to determine how much inventory was there at the beginning of the period, how much was started during the period, how much as completed during the period, and how much is left as work-in-process at the end of the period.
- Convert in-process inventory to equivalent units: Second, convert the work-in-process ending inventory into a number of equivalent units produced. This means if there are 1,000 units of inventory in work-in-process, and these units are all 50% complete, then you consider this as the equivalent of 500 units produced (500 = .50 x 1,000).
- Compute all applicable costs: Third, compute the total direct and indirect costs incurred by the production process that need to be assigned to the units completed and the units still in process. This includes the costs associated with the beginning inventory and the costs incurred during the relevant period.
- Calculate the cost per unit of finished and in-process inventory: Fourth, calculate the amount of cost to be assigned to the completed units of output and the equivalent of completed units of output still in the ending inventory. For example, if 2,000 units were completed, and 1,000 units were left half-finished, then you would divide the applicable costs by 2,500 units.
- Allocate costs to units of finished and in-process inventory: Fifth, allocate the relevant costs to the units of product that were completed and to the units of product that remain in the work-in-process account.
Characteristics of Process Costing
The characteristics of process costing are:
- A cost of production report is used to collect, summarize, and compute total and unit cost.
- Production is accumulated and reported by departments.
- Costs are posted to departmental work in process accounts.
- Production in process at the end of a period is restated in terms of completed units.
- Total costs charged to a department are divided by total computed production of the department in order to determine a unit cost for a specific period.
- Costs of completed units of a department are transferred to the next processing department in order to arrive at the total costs of the finished products during a period. At the same time, costs are assigned to units still in process.