6: Process Costing

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Chapter 6 Guided Practice Problems

6.1 Complications with Process Costing

In Chapter 4, I made a parenthetical comment about dividing overhead evenly between individual product units. When product units are relatively homogeneous (i.e. not customized, not given a job name, not given an order number), it probably isn’t worthwhile to apply overhead costs to each item as if it’s uniquely responsible for a different amount of overhead costs. If all the product units are the same, each product unit is probably responsible for the same amount of overhead cost. This leads to process costing, which tries to allocate actual overhead costs equally across homogeneous individual product units.

In this round of the game “the answer is in the name,” I want to point out that the term “process costing” implies homogeneous units. When each individual product unit is the same, managers are not going to spend time thinking about individual product units—they’re all the same! Instead they spend time thinking about and trying to improve the processes that spit out those individual product units.

In its simplest form, overhead cost applied to each product unit is exactly that: total actual overhead cost divided by total units. Because there’s no need to develop a budgeted PDOH rate beforehand, like with job-order costing, this allocation can take place after the close of the period. In that case it’s almost like a “post-determined overhead rate.”

NOTE: Do not use this equation for process costing calculations. It ignores key complications discussed below. It is shown for narrative purposes only.

While this is indeed the basic structure of process costing, there are three big complications.

6.1.1 Complication #1: Units in Ending WIP Inventory

For many process-costing firms, there are units still in process when the month or quarter or year ends. Some overhead cost should go to these units still in WIP, but probably not a full unit’s worth. They’re not complete yet and probably aren’t responsible for the same amount of overhead that fully complete units are.

How much overhead do they deserve? Probably depends on how complete they are.

So process-costing firms don’t use units in the denominator. Instead they use equivalent units (sometimes called equivalent units of production). Each product unit is scaled by its percent completion. (Firms examine what’s left unfinished at the end of the period to come up with those units’ “percent completion.”)

Using equivalent units, completed product units still count as whole units and units in ending WIP get fractional representation as units based on how complete they are.

The universe of product units the firm cares about are (1) the units completed and (2) the units still in ending WIP. When the firm wants to find total equivalent units, it calculates the following (this equation does change slightly under the FIFO method, as covered later).

Now our overhead allocation equation looks like this.

NOTE: Do not use this equation for process costing calculations. It ignores key complications discussed below. It is shown for narrative purposes only.

The overhead cost per unit number has now transformed into an overhead cost per equivalent unit number. So when overhead cost is allocated to ending WIP units, it’s allocated to the equivalent units those units represent. If ending WIP is 200, those product units that are 50% complete, that means 100 euivalent units. Ending WIP receives the equivalent amount of overhead cast as 100 units of completely finished goods.

A lot of textbooks or online resources out there have you calculate this by first completing a schedule of physical units and a schedule of equivalent units. I will simply refer to physical units as units and equivalent units as equivalent units. If creating a schedule for these two helps you, great. I prefer to use T-accounts to track physical units, making note of the percent completion on the side as necessary.

6.1.2 Complication #2: Non-uniform Consumption of Product Costs

There are two parts to this complication. First, product costs. Process-costing firms usually find it inefficient to trace any costs to individual product units. That even includes direct materials or direct labor. It just doesn’t make sense to track how many milliseconds workers spend on each product unit among a largely homogeneous sea of product units moving down the assembly line.

So when these firms allocate overhead, they also allocate direct costs. All product costs (which, remember, consists of direct materials, direct labor, and overhead) are put in the numerator, meaning the equation would look like this.

NOTE: Do not use this equation for process costing calculations. It ignores a key complication discussed below. It is shown for narrative purposes only.

The second part of this complication is non-uniform consumption. That sounds technical, but it’s actually pretty logical. I’ll walk you through it.

The actual manufacturing process used in process-costing firms is not uniform as to when costs are incurred. Specifically direct material costs are rarely incurred at the same time as labor and overhead costs.

In a standard scenario most if not all of the direct materials costs are incurred at the beginning of the process. A bunch of sheet metal is placed into the machine, a load of wood is placed on the assembly line, etc. These are standard examples of all direct materials costs being incurred at the beginning of the process.

Labor and overhead costs, then, are incurred only after there’s a piece of direct material in the machine or on the assembly line for workers and/or machines to work on. We call the sum of labor and overhead conversion costs because they are costs incurred to convert raw materials into finished goods.

Assume a unit in ending WIP is about halfway through the process of completion. Halfway painted, halfway baked, halfway polished. Whatever. It would be natural to assume it is about 50% complete and thus about 0.5 equivalent units.

However this unit probably already has most if not all of its direct materials already. That is, it’s probably already 100% complete with respect to direct materials. 100% of the wood that needs to be painted, 100% of the clay that needs to be baked, or 100% of the metal that needs to be polished is already on the assembly line. It might be 50% complete with respect to the conversion process that transforms those raw materials into finished products. But it is not 50% complete with respect to the direct materials themselves.

As a result of the fact that the completion level of direct materials and conversion costs often mismatch, process-costing firms use two separate per-equivalent-unit numbers: one for direct materials per equivalent unit and the other for conversion costs per equivalent unit.

6.1.3 Complication #3: Transfers between Departments

Process-costing firms usually have several departments that products must pass through before they’re complete. For responsibility accounting purposes these departments costs are kept separate. So each department allocates costs at the end of the period and then transfers its costs onward.

When I say transfers costs onward, I mean a journal entry between two departmental WIP accounts. Each department will have it’s own WIP account. If a firm uses three different departments—mixing, assembly, and packaging—then it will also have three different WIP accounts—WIP-mixing, WIP-assembly, and WIP-packaging.

Notice that the number of T-accounts matches what I said earlier: process-costing firms place more emphasis on departments/processes than individual units. There’s a separate WIP account for each job in job-order costing, and jobs are the focus of management’s attention. In process-costing firms there’s a separate WIP account for each department, since departments usually approximate the firm’s processes and these processes are the focus of management’s attention.

When Department A is done with product units, it credits the WIP-A account for the cost of those units and debits the WIP-B account for the cost of those units.

Department B then treats this cost as a transferred-in cost. Often it creates a separate per-equivalent-unit equation for transferred in costs. (Thus the first department in the process wouldn’t have transferred-in costs.)

If this seems daunting, just remember that the percent completion for transferred-in costs is always 100%. These costs were incurred in a different department during a process completed in that department. If those costs were not 100% complete, the product wouldn’t have been transferred out of that department! This can simplify transferred-in costs somewhat.

6.2 Weighted Average and FIFO Methods

The three equations a firm needs to calculate process-costing numbers are as follows. (Do use these equations!)

There are six terms on the left-hand side of these equations. Firms have to decide whether or not to define these six terms so they include beginning WIP costs and equivalent units. If these terms include beginning WIP, the firm is using the weighted average method. If not, the firm is using the FIFO method.

(For the LIFO me I can’t seem to think of what a third method would look like….Just kidding. No, there’s no LIFO method.)

6.2.2 Weighted Average Method

The weighted average method is more or less what we’ve considered thus far: total equivalent units is calculated using all units completed, whether they were started this period or last period.

In the numerator, beginning balances (incurred last period) are added to current period costs.

Here’s an example of weighted average conversion cost per unit. Assume a firm completes 20,000 units this period and has 500 units left in ending WIP that are 40% complete with respect to conversion costs. At the end of last period, 600 units were still unfinished. These become this period’s beginning WIP units. These 600 beginning WIP units are 60% complete with respect to conversion costs. The beginning balance conversion costs are $15,000 and current period conversion costs are $300,000.

In this case the conversion cost per equivalent unit would be $15.59 ([$300,000 + $15,000] / [20,000 * 1 + 500 * 0.4]).

In the weighted average method, the $15,000 of conversion costs in beginning inventory are ripped away from the 600 units in beginning inventory and redistributed across all equivalent units at the end of the period. The units in beginning WIP are treated as if they had no work done on them at all. They are lumped in with all the other units completed this period.

This is what makes this method a “weighted average.” Performance last period can affect costs this period and next period. Let’s say the firm was not very cost-effective last period and $15,000 in beginning WIP is a really high cost to incur for 600 beginning WIP units at 60% completion for conversion costs. Under the weighted average method, the firm calculates the current period’s unit cost using this $15,000. Thus this period’s EWIP is higher than it otherwise would be due to the firm’s inefficiency last period. And EWIP balance this period will affect next period’s cost rates.

If the firm frequently has significant swings in per-unit costs, the weighted average method is less appropriate. It holds workers and managers accountable, in part, for cost decisions in prior periods.

6.2.2 FIFO Method

Under the FIFO method the firm keeps beginning inventory costs attached to beginning inventory units. This keeps BWIP costs out of EWIP. When you calculate the cost reates, BWIP costs are not included in total costs (i.e. in the numerator), and BWIP equivalent units are subtracted out of the denominator.

Using the same numbers as earlier, total conversion costs (the numerator) are only the $300,000 incurred this period. You do not include the $15,000 in beginning WIP. The denominator is 19,840 equivalent units ([20,000 * 1 + 500 * 0.4 – 600 * 0.6]). You subtract out 360 equivalent units in beginning WIP.

Thus conversion costs per equivalent unit, under the FIFO method, are $15.12.

6.3 Applying Costs per Equivalent Unit

Firms apply costs to equivalent units after finding all three of these per-equivalent-unit rates (notice the abbreviations, which I’ll use a lot in this section).

  • The direct materials (DM) cost per equivalent unit.
  • The conversion costs (CC) per equivalent unit. 
  • Transferred-in (TI) costs per equivalent unit.

Once the firm has these cost per equivalent units rates, it uses them to apply product costs to two places: equivalent units in ending WIP, and units completed. These two cost numbers are important for financial reporting as well as management decision making.

EWIP cost is important so the firm can determine the value of inventory accounts on its balance sheet. The cost of units completed is important so the firm can credit that number to this department’s WIP account and debit that number to the next department’s WIP account or finished goods (if it’s the last department in the process).

6.3.1 Applying Costs to EWIP and Completed Units

For the weighted average method, applying costs is relatively simple. You apply costs by multiplying the DM, CC and TI cost per equivalent units rates by the equivalent units EWIP and by the number of completed units (completed units are 100% complete, so the raw physical number of units completed is the same as the equivalent number of units).

This gives you the six numbers: total DM, CC, and TI cost for EWIP and units completed. Summing these three cost categories gives you the total cost in EWIP or for units completed.

So, adding DM and TI cost per equivalent unit to the above CC example, we get the following. (I assume materials are added at the beginning of the process, so EWIP units are 100% complete with respect to direct materials.)

This leads to $1,006,881.19 would be credited to this department’s WIP account and debited to the next department’s WIP account or finished goods if this is the last department in the process.

Even though the firm needs the aggregate number in EWIP, the firm would also want to keep data on how much of that $20,493.81 is due to conversion costs, direct materials, and transferred-in costs, since those disaggregated figures will be required for next period’s cost calculation. Each department may maintain separate T-accounts for DM, CC, and TI (instead of a signle department WIP account) to keep track of these different cost types.

6.3.2 FIFO Cost Application

If you are using FIFO, the procedure is only slightly different. And the differences follow the logic of keeping BWIP costs out of EWIP.

Notice two big changes in FIFO that keep the cost of work done last period out of EWIP.

  1. The equivalent units in BWIP are subtracted away from “units completed.” FIFO recognizes that BWIP equivalent units weren’t completed this period, so you wouldn’t apply this period’s cost rates to them. (Sometimes textbooks use the term “units started and completed” as part of this. I’m not getting into that.)
  2. You directly add BWIP cost to the cost of units completed (see cells D6, D13, and D20 in the above figure). These are costs you kept out of the numerator when you calculated this period’s cost rates. FIFO assumes that units in BWIP (i.e. the “first-in” units) are the first units completed, so 100% of BWIP costs go directly to the cost of units completed.