Question

1. What are the concepts underlying a process costing system? How might a company identify and group activities into a particular process?

2. What information is contained in a production report? What are equivalent units and how would a company calculate them? How does the production report and equivalent units relate to unit costs?

3. Inventory in each process can be accounted for using first-in first-out (FIFO) or weighted average costing methods. Why would a company choose to use FIFO costing? Why would a company choose to use weighted average costing?

Answer 1

1.

Process Costing Overview

Process costing is used when there is mass production of similar products, where the costs associated with individual units of output cannot be differentiated from each other. In other words, the cost of each product produced is assumed to be the same as the cost of every other product. Under this concept, costs are accumulated over a fixed period of time, summarized, and then allocated to all of the units produced during that period of time on a consistent basis. When products are instead being manufactured on an individual basis, job costing is used to accumulate costs and assign the costs to products. When a production process contains some mass manufacturing and some customized elements, then a hybrid costing system is used.

Examples of the industries where this type of production occurs include oil refining, food production, and chemical processing. For example, how would you determine the precise cost required to create one gallon of aviation fuel, when thousands of gallons of the same fuel are gushing out of a refinery every hour? The cost accounting methodology used for this scenario is process costing.

Process costing is the only reasonable approach to determining product costs in many industries.   It uses most of the same journal entries found in a job costing environment, so there is no need to restructure the chart of accounts to any significant degree. This makes it easy to switch over to a job costing system from a process costing one if the need arises, or to adopt a hybrid approach that uses portions of both systems.

Example of Process Cost Accounting

As a process costing example, ABC International produces purple widgets, which require processing through multiple production departments. The first department in the process is the casting department, where the widgets are initially created. During the month of March, the casting department incurs $50,000 of direct material costs and $120,000 of conversion costs (comprised of direct labor and factory overhead). The department processes 10,000 widgets during March, so this means that the per unit cost of the widgets passing through the casting department during that time period is $5.00 for direct materials and $12.00 for conversion costs. The widgets then move to the trimming department for further work, and these per-unit costs will be carried along with the widgets into that department, where additional costs will be added.

Types of Process Costing

There are three types of process costing, which are:

1. Weighted average costs. This version assumes that all costs, whether from a preceding period or the current one, are lumped together and assigned to produced units. It is the simplest version to calculate.

2. Standard costs. This version is based on standard costs. Its calculation is similar to weighted average costing, but standard costs are assigned to production units, rather than actual costs; after total costs are accumulated based on standard costs, these totals are compared to actual accumulated costs, and the difference is charged to a variance account.

3. First-in first-out costing (FIFO). FIFO is a more complex calculation that creates layers of costs, one for any units of production that were started in the previous production period but not completed, and another layer for any production that is started in the current period.

There is no last in, first out (LIFO) costing method used in process costing, since the underlying assumption of process costing is that the first unit produced is, in fact, the first unit used, which is the FIFO concept.

Why have three different cost calculation methods for process costing, and why use one version instead of another? The different calculations are required for different cost accounting needs. The weighted average method is used in situations where there is no standard costing system, or where the fluctuations in costs from period to period are so slight that the management team has no need for the slight improvement in costing accuracy that can be obtained with the FIFO costing method. Alternatively, process costing that is based on standard costs is required for costing systems that use standard costs. It is also useful in situations where companies manufacture such a broad mix of products that they have difficulty accurately assigning actual costs to each type of product; under the other process costing methodologies, which both use actual costs, there is a strong chance that costs for different products will become mixed together. Finally, FIFO costing is used when there are ongoing and significant changes in product costs from period to period – to such an extent that the management team needs to know the new costing levels so that it can re-price products appropriately, determine if there are internal costing problems requiring resolution, or perhaps to change manager performance-based compensation. In general, the simplest costing approach is the weighted average method, with FIFO costing being the most difficult.

Cost Flow in Process Costing

The typical manner in which costs flow in process costing is that direct material costs are added at the beginning of the process, while all other costs (both direct labor and overhead) are gradually added over the course of the production process. For example, in a food processing operation, the direct material (such as a cow) is added at the beginning of the operation, and then various rendering operations gradually convert the direct material into finished products (such as steaks).

2.

In cost accounting, equivalent units are the units in production multiplied by the percentage of those units that are complete (100 percent) or those that are in process. That covers everything.

Say you’ve mixed enough sugar to make 600,000 units of candy. Assume that ending work in process is 25 percent complete for all components of production (material, labor, and overhead). The table below shows the computation of equivalent units.

Equivalent Units of Production

Units	Complete	Equivalent Units
Completed and transferred	600,000	100 percent	600,000
Work in process, ending	600,000	25 percent	150,000
Equivalent units			750,000

Although 25 percent of the units are unfinished, in “equivalent unit talk” you can treat them as 150,000 completed units. Add them to the really completed units to get 750,000 units, which represents the number of equivalent whole units you have produced. It’s a lot easier to talk about a whole unit than some whole units and some partially completed units.

The next step is to compute the cost per equivalent unit. Take the total costs of $101,800, and divide by the number of units. Remember that the total costs are the sum of the beginning inventory cost ($48,000) and the costs added during production ($53,800):

Cost per equivalent unit = total costs ÷ number of units
Cost per equivalent unit = $101,800 ÷ 750,000
Cost per equivalent unit = $0.1357

The calculation goes to four decimal places, because when you’re making candy that sells for 20 cents per unit, and you’re producing hundreds of thousands of units, every tiny fraction of a dollar counts.

Now assign the cost per equivalent unit to the completed work and the WIP. The table below shows the calculation (costs are rounded).

Assignment of Costs

Units	Cost/Unit	Cost Assigned
Completed and transferred	600,000	$0.1357	$81,440
Work in process, ending	150,000	$0.1357	$20,360
Equivalent units			$101,800

3.

At the end of every monthly and yearly period, it’s important for store owners to conduct a thorough physical inventory count to determine the number of inventory items presently on hand. And when it comes to accounting for inventory, businesses may use the following three chief methodologies:

• Weighted average cost accounting
• Last In, First Out (LIFO) accounting
• First in, First Out (FIFO) accounting

Each of these disciplines relies on a different method of calculating both the inventory and cost of goods sold, and each system is appropriate for different situations.

KEY TAKEAWAYS

• The weighted average method is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit.
• The FIFO accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time.
• The LIFO accounting method assumes that the latest items bought are the first items to be sold.

Weighted Average

The weighted average method, which is mainly utilized to assign the average cost of production to a given product, is most commonly employed when inventory items are so intertwined that it becomes difficult to assign a specific cost to an individual unit. This is frequently the case when the inventory items in question are identical to one another. Furthermore, this method assumes a store sells all of its inventories simultaneously.

To use the weighted average model, one divides the cost of the goods that are available for sale by the number of those units still on the shelf. This calculation yields the weighted average cost per unit—a figure that can then be used to assign a cost to both ending inventory and the cost of goods sold.

While the weighted average method is a generally accepted accounting principle, this system doesn’t have the sophistication needed to track FIFO and LIFO inventories.

FIFO

The FIFO accounting method relies on a cost flow assumption that removes costs from the inventory account when an item in someone’s inventory has been purchased at varying costs, over time. In other words, under FIFO, the oldest cost of an item in an inventory will be removed first when one of those items is sold. This oldest cost will then be reported on the income statement as part of the cost of goods sold.

LIFO

The LIFO accounting method assumes that the latest items bought are the first items to be sold. With this accounting technique, the costs of the oldest products will be reported as inventory. It should be understood that, although LIFO matches the most recent costs with sales on the income statement, the flow of costs does not necessarily have to match the flow of the physical units.

Generally speaking, FIFO is preferable in times of rising prices, so that the costs recorded are low, and income is higher. Contrarily, LIFO is preferable in economic climates when tax rates are high because the costs assigned will be higher and income will be lower.

Weighted Average vs. FIFO vs. LIFO: Example

Consider this example: Say you’re a furniture store and you purchase 200 chairs for $10/unit. The next month, you buy another 300 chairs for $20 each. At the end of an accounting period, assume you sold 100 total chairs. The weighted average costs, using both FIFO and LIFO considerations are as follows:

Example: 200 chairs @ $10 = $2,000. 300 chairs @ $20 = $6,000. Total number of chairs = 500

Weighted Average Cost: Cost of a chair: $8,000 divided by 500 = $16/chair. Cost of Goods Sold: $16 x 100 = $1,600. Remaining Inventory: $16 x 400 = $6,400

FIFO: Cost of goods sold: 100 chairs sold x $10 = $1,000. Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000

LIFO: Cost of goods sold: 100 chairs sold x $20 = $2,000. Remaining Inventory: (200 chairs x $10) + (200 chairs x $20) = $6,000