Module 6

Process Costing
Learning Objectives

1. Explain the concept and purpose of equivalent units.

2. Assign costs to products using a five-step process.

3. Assign costs to products using weighted-average costing.

4. Prepare and analyze a production cost report.

5. Assign costs to products using first-in, first-out (FIFO) costing.

6. Analyze the accounting choice between FIFO and weighted-average costing.

7. Know when to use process or job costing.

8. Compare and contrast operation costing with job costing and process costing.

1 Explain the concept and purpose of equivalent units.

♦ In job costing, each job is considered unique and can (but might not) follow the
same path through the production as other jobs. Processing costing assumes that
all units are homogeneous and follow the same path through the production
processes.

• Exhibit 8.1 provides a graphical comparison of typical cost flows in a job

costing and a process costing system.

♦ Equivalent units (EU) represent the number of complete physical units to which
units in inventories are equal in terms of work done to date.

• Equivalent units = Number of physical units × Estimated (average)

percentage of completion with respect to the individual resource.
 Example 1: The Blending Department’s total output during the current period
consists of 6,000 units of ending Work-in-process inventory which are 100
percent, 60 percent, and 75 percent complete as to materials, labor, and
overhead, respectively.

The equivalent units of production for the Blending Department are 6,000 units
(= 6,000 units × 100%) with respect to materials, 3,600 units (= 6,000 units
× 60%) with respect to labor, and 4,500 units (= 6,000 units × 75%) with
respect to overhead.

2 Assign costs to products using a five-step process.

♦ Five-step process of assigning costs to products:
(1) Measure the physical flow of resources.
(2) Compute the equivalent units of production.
(3) Identify the product costs for which to account.
(4) Compute the costs per equivalent unit.
(5) Assign product cost to batches of work.

• Inventory equation can be adapted to ensure that the work done has been
properly accounted for. That is,

Beginning work-in- + Unit = Units + Ending work-in-

process inventory started transferred out process inventory

• Another way to look at the inventory equation is the following statement

format:

Beginning work-in-process inventory xx

Plus: Units started xx
Total units to account for xx
Units transferred out xx
Plus: Ending work-in-process inventory xx
Total units accounted for xx

• A third way to study the inventory equation is through the T-account:

Work-in-process inventory account

Beginning balance
Plus: Units started Less: Units transferred out
Ending balance

• In cases where materials are added at the beginning of the production

process, while labor and overhead (conversion resources) are added
continuously throughout the process, the calculation of equivalent units has
to be done separately for each resource (materials and conversion)
introduced during the process.

• Managers often have incentives to manipulate income numbers. As

mentioned in the IN-ACTION box, managers in process industries can do so
by overstating the stage of completion of ending inventory. Since more costs
are assigned to ending inventory and less to goods transferred out, cost of
goods sold will be understated, leading to higher gross margin and net
income than they actually are.

• Once the work done has been accounted for, the next step is to collect data
on the costs incurred during the period.

• Consistent with the pace at which the resources are consumed during the
process, these costs must be collected separately.

• The costs collected include not only those incurred for production but also
those in the beginning work-in-process inventory.

• The work that has been done comes from two sources:
(1) Work done in current period, and
(2) Beginning work-in-process inventory (i.e., work done in previous period).

• Weighted-average process costing is an inventory costing method that

combines costs and equivalent units of a period with the costs and the
equivalent units in beginning inventory from the last period. That is, the
costs of the current work and the work in the beginning inventory are
averaged, with the weight being the number of equivalent units in each
batch.

Weighted-average unit cost =

• First-in, first-out (FIFO) process costing is another inventory costing

method whereby the first goods received are the first ones charged out when
sold or transferred. FIFO method separates the costs of the current work and
the work in the beginning work-in-process inventory, assuming that all
beginning work-in-process units are transferred out. This means that the
ending work-in-process inventory comes from the units started during the
current period.
 FIFO (beginning work-in-process) unit cost =

FIFO (current period) unit cost = .

3 Assign costs to products using weighted-average

costing.
• Once the costs per equivalent unit are computed using either weighted
average or FIFO method, the final step is to assign the total costs to the two
batches of work: units transferred out and units which are not yet completed
(i.e., ending work-in-process inventory).

Costs in Beginning work-in-process inventory $xx

Plus: Current period costs xx
Total costs to account for $xx
Costs assigned to units transferred out $xx
Plus: Costs assigned to ending work-in-process inventory xx
Total costs accounted for $xx

The T-accounts. A general format for the work-in-process inventory account

follows.

Work-in-process inventory account

Beginning balance
Plus: Current period costs Less: Cost of units transferred out
Ending balance

Problem
Process Excellence (PE), Inc. has two production departments: Mixing and
Packaging.

Mixing Department Packaging Department Warehouse

At Mixing Department, all materials are added at the beginning of the process.
Labor and overhead (conversion resources) are added evenly throughout the
process. The following information pertains to the Mixing Department for the month
of July.
 Physical units Materials Conversion
Beginning work-in-process inventory 1,000 units $8,500 $7,552
(40% complete)
Units started in July 5,000 units
Ending work-in-process inventory 400 units
(30% complete)
Costs added in July 60,500 130,872

Required:
1. Determine the number of units completed and transferred to the Packaging
Department in July.
2. Compute the equivalent units using the weighted-average method.
3. Compute the costs per equivalent unit using the weighted-average method.
4. Compute the costs of goods transferred out and the ending work-in-process
inventory using the weighted-average method.

Solution:
1.
Work-in-process inventory account
Beginning balance 1,000
Plus: Units started 5,000 Less: Units transferred out?
Ending balance 400

1,000 + 5,000 = Units transferred out (?) + 400.

The number of units completed and transferred to the Packaging Department
in July was 5,600 units.

2. Since materials and conversion (labor and overhead) were added at different
pace during the production process, separate equivalent units have to be
calculated, one for materials and the other for conversion.

Equivalent Units
Physical units Materials Conversion
Units transferred out 5,600 5,600 5,600
Ending WIP inventory a
400 400 120
Total work 6,000 5,720
30% complete with respect to conversion.
a

3. Under the weighted-average method, the costs for current work and work in
beginning work-in-process inventory are combined. This total cost is then divided
by the total equivalent units of production for July.

Total Materials Conversion

costs costs costs
 Beginning work-in-process $16,052 $8,500 $7,552
inventory
Current costs 191,372 60,500 130,872
Total costs $207,424 $69,000 $138,424
Total equivalent units 6,000 5,720
Cost per equivalent unit $11.5 $24.2

4.

Total Materials Conversion

Transferred out:
Equivalent units 5,600 5,600
Cost per equivalent unit $11.5 $24.2
Cost assigned $199,920 $64,400 $135,520
Ending WIP inventory:
Equivalent units 400 120
Cost per equivalent unit $11.5 $24.2
Cost assigned 7,504 $4,600 $2,904
Total costs assigned $207,424 $69,000 $138,424

As a final check, the following T-account summarizes the flow of costs for the
Mixing Department for the month of July.

Work-in-process inventory account

16,052
191,372 199,920
7,504

4 Prepare and analyze a production cost report.

♦ Production cost report summarizes production and cost results for a period and
is generally used by managers to monitor production and cost flows.

• As illustrated in Exhibit 8.11, the report is presented in five sections, each

of which corresponds to a step for assigning costs to goods transferred out
and to ending work-in-process inventory.
(1) Section 1 summarizes the flow of physical units.
(2) Section 2 shows the equivalent unit calculation.
(3) Section 3 shows the costs to be accounted for.
(4) Section 4 shows how to compute the cost per equivalent unit for each
resource.
(5) Section 5 shows the cost assignment.

5 Assign costs to products using first-in, first-out (FIFO)

costing.
♦ A disadvantage of the weighted-average method is that it mixes current period
costs with the costs of products from the last period in the beginning inventory,
making it impossible for managers to know how much it cost to make a product this
period.

• First-in, first-out (FIFO) method assumes that the first units worked on are
the first units transferred out of a production department.

• FIFO method separates current period costs from those in the beginning
inventory.

• FIFO method gives managers better information about the work done in the
current period.

• If the production process is a FIFO process, the inventory numbers are

more likely to reflect reality under FIFO costing than under weighted-average
costing because the units in ending work-in-process inventory are likely to
have been produced in the current period.

♦ Computing product costs using a FIFO process costing system requires the same
five-step procedure as the weighted-average approach.
(1) Measure the physical flow of resources.
(2) Compute the equivalent units of production.
(3) Identify the product costs for which to account.
(4) Compute the costs per equivalent unit.
(5) Assign product cost to batches of work.

• The choice of accounting for production costs does not change the physical
flow of production. But the number of units completed and transferred out can
be separated into two groups: those that came from the beginning work-in-
process inventory and those that were started and completed in the current
period. That is,

Units completed and transferred out = Units from the beginning work-in-
process inventory + Units started and completed in current period.

• The FIFO equivalent unit computation is confined only to what was

produced this period.

• Under FIFO, equivalent units are computed in three parts for each distinct
resource:
(1) Equivalent units to complete the beginning work-in-process inventory.
(2) Equivalent units of goods started and completed during the current
period.
(3) Equivalent units of goods still in ending work-in-process inventory.
 Example 2: There are 200 units in the beginning work-in-process inventory, 40
percent complete with respect to materials, labor, and overhead. In the current
period, additional 4,800 units are started. After transferring out 4,500
completed units, the factory is left with 500 units in the ending work-in-process
inventory, 25 percent complete with respect to materials, labor, and overhead.

If the FIFO method is adopted, it can be determined that 4,300 units (= 4,500
units – 200 units) are started and completed during the current period.

The equivalent units can be calculated as follows:

Equivalent units
Physical Materials, Labor,
units Overhead
To complete beginning inventory 200 120
(1 – 40%) (= 200 × 60%)
Units started and completed 4,300 4,300
(100%) (= 4,300 × 100%)
Work in ending inventory 500 125
(25%) (= 500 × 25%)
Current work 4,545

• The equivalent units under FIFO are less than or equal to those under
weighted-average method because the FIFO computations refer to the current
period’s production only; weighted-average equivalent units consider all units in
the department, whether produced this period or in the previous period.

• If the department has no beginning inventory, then the weighted-average

and FIFO equivalent units are equal.

• The total costs to be accounted for under FIFO costing are the same as in
weighted- average costing, which are the sum of those in beginning inventory
and those incurred during the current period.

• Under FIFO, the costs per equivalent unit are confined to the costs incurred
this period and the equivalent units produced this period.

Cost per equivalent unit = .

• The costs to be accounted for must equal the costs accounted for.

(Continued from Demonstration Problem )

The information pertains to the Mixing Department for the month of July is
reproduced here. All materials are added at the beginning of the process. Labor and
overhead (conversion resources) are added evenly throughout the process.

Physical units Materials Conversion

Beginning work-in-process inventory 1,000 units $8,500 $7,552
(40% complete)
Units started in July 5,000 units
Ending work-in-process inventory 400 units
(30% complete)
Costs added in July 60,500 130,872

Required:
1. Determine the number of units completed and transferred to the Packaging
Department in July.
2. Compute the equivalent units using the FIFO method.
3. Compute the cost per equivalent unit using the FIFO method.
4. Compute the costs of goods transferred out and the ending work-in-process
inventory using the FIFO method.

Solution:
1.
Work-in-process inventory account
Beginning balance 1,000
Plus: Units started 5,000 Less: Units transferred out ?
Ending balance 400

1,000 + 5,000 = Units transferred out (?) + 400.

The number of units completed and transferred to the Packaging Department
in July was 5,600 units.

According to the FIFO method, the beginning work-in-process inventory

(1,000 units) would be completed first. The rest, 4,600 completed units (=
5,600 units – 1,000 units), came from the units started in July.

2. Since materials and conversion (labor and overhead) were added at different
pace during the production process, separate equivalent units have to be
calculated, one for materials and the other for conversion.

Equivalent Units
Physical units Materials Conversion
To complete beginning WIP inventory 1,000 0 600
a

Units started and completed 4,600 4,600 4,600

Work in ending WIP inventory 400 400 120
b

Current work 5,000 5,320

 1,000 units × (1 – 40%).
a

400 units × 30%.

b

3. Under the FIFO method, current period costs are divided by the current
equivalent units of production in July to determine the cost per equivalent unit.

Total costs Materials costs Conversion costs

Current costs $191,372 $60,500 $130,872
Current equivalent units 5,000 5,320
Cost per equivalent unit $12.1 $24.6

4.

Total Materials Conversion

Transferred out:
Costs from the beginning WIP inventory $16,052 $8,500 $7,552
Current costs to complete beginning WIP 14,760 0 14,760a

inventory
Total costs from beginning WIP inventory $30,812 $8,500 $22,312
Current costs of units started and 168,820 55,660 b
113,160c

completed
Cost assigned $199,632 $64,160 $135,472
Ending WIP inventory:
Cost assigned 7,792 $4,840 d
$2,952
e

Total costs assigned $207,424 $69,000 $138,424

a
$24.6 × 600 EU.
b
$12.1 × 4,600 EU.
c
$24.6 × 4,600 EU.
d
$12.1 × 400 EU.
e
$24.6 × 120 EU.

As a final check, the following T-account summarizes the flow of costs for the
Mixing Department for the month of July.

Work-in-process inventory account

16,052
191,372 199,632
7,792

6 Analyze the accounting choice between FIFO and

weighted-average costing.
♦ Weighted-average costing does not separate beginning inventory from current
period activity. Unit costs are a weighted average of the two, whereas FIFO costing
bases unit costs on current period activity only.

• The difference in the costs from the two methods is larger when either the
number of units in the beginning work-in-process inventory is large relative to the
number of units started during the period, or when price changes from period to
period are large, or both.

• The FIFO method results in unit costs that better reflect current costs. For
this reason, FIFO costing generally offers greater decision-making benefits.

• Although either weighted-average or FIFO costing is acceptable, the

weighted-average method has been criticized for masking current period costs.

• Exhibit 8.15 provides a summary of the steps for assigning costs to units of
production using process costing and assuming either a weighted-average or FIFO
cost flow.

♦ As the product passes from one department to another, its costs must follow.

• Prior department costs (or transferred-in costs) are the manufacturing

costs of units transferred out of one department and into a subsequent one in
the manufacturing process.

• Equivalent whole units are 100 percent complete in terms of prior

department costs.

(Continued from Demonstration Problem )

Process Excellence (PE), Inc. has two production departments: Mixing and
Packaging.

Mixing Department Packaging Department Warehouse

At Packaging Department, all materials are added at the beginning of the process.
Labor and overhead (conversion resources) are added evenly throughout the
process. The following information pertains to the Packaging Department for the
month of July.

Physical Transferred- Materials Conversion

units in
Beginning work-in- 900 units $10,680 $3,888 $5,130
process inventory (60%
complete)
 Units completed 6,000 units
Ending work-in- 500 units
process inventory (50%
complete)
Costs added in July 199,920 a
42,912 54,245

a
This is the cost of goods completed and transferred out of the Mixing Department
in July using the weighted-average method.

Required:
1. Determine the number of units started in July.
2. Compute the equivalent units using the weighted-average method.
3. Compute the cost per equivalent unit using the weighted-average method.
4. Compute the costs of goods transferred out and the ending work-in-process
inventory using the weighted-average method.

Solution:
1.
Work-in-process inventory account
Beginning balance 900
Plus: Units started ? Less: Units transferred out 6,000
Ending balance 500

900 + Units started (?) = 6,000 + 500.

The number of units started in July at the Packaging Department was 5,600
units, which matched the number of units completed and transferred out of the
Mixing Department during the same time period.

2. Since materials and conversion (labor and overhead) were added at different
pace during the production process, separate equivalent units have to be
calculated, one for materials and the other for conversion. Transferred-in is
considered an input added at the beginning of the production process at the
Packaging Department.

Equivalent Units
Physical units
Transferred-in Materials Conversion
Units transferred out 6,000 6,000 6,000 6,000
Ending WIP inventory a
500 500 500 250
Total work 6,500 6,500 6,250

50% complete with respect to conversion.

a

3. Under the weighted-average method, the costs for current work and work in
beginning work-in-process inventory are combined. This total cost is then divided
by the total equivalent units of production for July.
 Total Transferred-in Materials Conversion
costs costs costs costs
Beginning WIP $19,698 $10,680 $3,888 $5,130
inventory
Current costs 297,077 199,920 42,912 54,245
Total costs $316,775 $210,600 $46,800 $59,375
Total equivalent 6,500 6,500 6,250
units
Cost per $32.4 $7.2 $9.5
equivalent unit

4.

Total Transferred-in Materials Conversion

Transferred out:
Equivalent units 6,000 6,000 6,000
Cost per equivalent unit $32.4 $7.2 $9.5
Cost assigned $294,600 $194,400 $43,200 $57,000
Ending WIP inventory:
Equivalent units 500 500 250
Cost per equivalent unit $32.4 $7.2 $9.5
Cost assigned 22,175 $16,200 $3,600 $2,375
Total costs assigned $316,775 $210,600 $46,800 $59,375

As a final check, the following T-account summarizes the flow of costs for the
Packaging Department for the month of July.

Work-in-process inventory account

19,698
297,077 294,600
22,175

♦ An important question for performance evaluation is whether a department

manager should be held accountable for all costs charged to the department. The
answer is usually no.

• A department and its people are usually evaluated on the basis of costs the
department added relative to its good output. A prior department’s costs are often
excluded when comparing actual department costs with a standard or budget.

• For inventory valuation purpose, on the other hand, assigning costs to units
requires that a prior department’s costs be included in department product
cost calculations.
7 Know when to use process or job costing.
♦ In job costing, costs are collected for each unit produced. Process costing
accumulates costs in a department for an accounting period and then spreads them
evenly, or on an average basis, over all units produced during the period.

• Process costing assumes that each unit produced is relatively uniform.

• Process costing does not maintain a record of the cost of each unit
produced and therefore has less detailed record-keeping.

• Process costing does not provide as much information as job costing.

• The choice of process versus job costing system involves a comparison of

the costs and benefits of each system. The production process being utilized is
also a major factor in choosing a cost system.

• The difference between job costing and process costing is in the level of
aggregation and detail, not in the basic concepts.

8 Compare and contrast operation costing with job costing

and process costing.
♦ Operation costing is a hybrid of job and process costing that is used in
manufacturing goods that have some common characteristics and some individual
characteristics.

• The costs of resources that are applied to products in a roughly uniform

way are assigned to products using process costing methods.

• The costs of resources that are applied in a unique way to products are
assigned to the individual products as in job order costing.

• An operation is a standardized method of making a product that is

repeatedly performed.

• Operation costing is distinct from job and process costing in that for each
work order or batch passing through a particular operation, direct materials
are different but conversion costs are the same.

Problem
Operations Excellence (OE), Inc. has two production departments: Mixing and
Packaging.
 Mixing Department Packaging Department Warehouse

OE manufactures two products: Compound H and Compound L. Compound H is a

high-end product that requires more expensive materials than Compound L and is
produced at smaller volume. The two products go through the two production
departments in essentially the same conversion processes. There is no work-in-
process inventory for either product.

OE uses an operation costing system that assigns materials cost to the specific
product for which the underlying materials are used and conversion costs to all
products evenly as each product undergoes the same process in each production
department.

The production and cost data are available for July.

Compound H Compound L
Total 2,500 units 4,800 units
Materials:
Mixing $220,000 $100,000 $120,000
Packaging 75,900 37,500 38,400
Total materials cost $295,900 $137,500 $158,400
Conversion:
Mixing $219,000
Packaging 131,400
Total conversion cost $350,400

Required:
Determine the unit cost for Compound H and Compound L.

Solution:
For materials costs, the costing system at OE operates like a job order system.
For conversion, a process costing system is appropriate.

Compound H Compound L
Total 2,500 units 4,800 units
Materials:
Mixing $220,000 $100,000 $120,000
Packaging 75,900 37,500 38,400
Total materials cost $295,900 $137,500 $158,400
Conversion:
Mixing $219,000 $75,000 $144,000
Packaging 131,400 45,000 86,400
Total conversion cost $350,400 $120,000 $230,400
Total product cost $646,300 $257,500 $388,800
Number of units 2,500 4,800
Cost per unit $103 $81
 The conversion cost is assigned to the two products based on total units. For

Mixing, each unit is allocated $30 (= ). Then, for

example, the conversion cost for Compound H in the Mixing Department
becomes $75,000 (= $30 × 2,500 units). For Packaging, each unit is allocated

$18 (= ) of the conversion cost.

♦ In practice, elements of all three production methods (job, process, and

operation) and their corresponding costing methods can easily be found.

• Every company has its own unique costing methods that do not precisely fit
any of these three categories.

• The system that provides managers the best information for the decisions
they make routinely should be chosen.

Reference: Fundamentals of Cost Accounting 2nd Edition

by William Lanen (Author), Shannon Anderson (Author), Michael Maher (Author)