Process costing is a cost accounting system in which direct costs are traced and indirect costs are allocated to processes carried out in different departments. The cost of finished goods is then computed based on average cost accumulated at the end of the last department.
Unlike job-order costing, which is another widely-used costing system, process costing averages out costs over all departments and values the finished products and closing work in process, if any, using either the first-in-first-out (FIFO) or weighted-average convention.
Companies that use process costing
Process costing is appropriate for companies that produce standardized products in large quantities. Since the products are very similar in nature, different departments specialize in different processes. In such situation, it is more efficient to accumulate costs at the process/department level and hence the name. Examples include oil refineries, paint and chemical manufacturers, fast moving consumer goods (FMCG) producers, etc.
Steps in process costing
Process costing involves preparing a process cost sheet using the following steps:
- Preparing the quantity schedule to account for the number of units.
- Finding the percentage of completion of units in closing work in process and calculating equivalent units using FIFO or weighted average convention, whichever is relevant.
- Accumulating costs brought forward from previous department, if any, and costs incurred in current department, including manufacturing overheads.
- Finding cost per equivalent unit.
- Valuing units transferred to finished goods and units in closing work in process at the cost per equivalent unit and their relevant percentage of completion.
International Chemicals (IC) is engaged in preparation of affordable quality paints by exploiting economies of scale. It has four departments: pigment dispersing, letdown, testing and canning. Let us post some hypothetical journal entries for IC's process costing.
1. Assume $10,000 worth of pigments and resins are introduced in pigment dispersing department as direct materials.
|Work in Process—pigment dispersing||$10,000|
2. 50 hours of direct labor @ $25 per hour are used.
|Work in Process—pigment dispersing||$1,250|
3. Manufacturing overheads are allocated to each department at $500 per direct labor hour worked.
|Work in Process—pigment dispersing||$25,000|
4. Actual manufacturing overheads are $24,250.
5. Total cost of pigment dispersing department which comes to be $36,250 ($10,000 + $1,250 + $25,000), is transferred to let down department.
|Work in Process—let down||$36,250|
6. Total cost of pigment dispersing department are debited to work in process account for letdown department using scheme of journal entries given from 1-4 and the accumulated cost is then transferred to testing department and so on till the finished goods are transferred out from canning department to finished goods account.