Managerial Accounting Balakrishnan | Sivaramakrishnan | Sprinkle | Carty | Ferraro Chapter 15: Process Costing Prepared by Debbie Musil, Kwantlen Polytechnic University

What is Process Costing? Many production environments have a “continuous” flow −Paper, cereal manufacturing, bottling soft drinks, pharmaceuticals, garment manufacturing, electronics assembly Two main features −Units in the same batch might be at different levels of completion (in different inventory accounts) −Not possible to track costs of individual units in a batch We can only track costs at the level of the batch / department LO1: Explain the mechanics of process costing

Problem How to determine inventory values? −Some units might have been finished and sold −Some units might be finished but not sold −Some might still be in process −Some might not have started into production We allocate costs (for each batch) among COGM and WIP −Divide by number of units in COGM to value the layer of inventory Can then calculate COGS −Using “average values” OK because the items are similar Process costing focuses on the allocation LO1: Explain the mechanics of process costing

Example Begin with basic setting −Continue to add detail as we progress Data −Began with 0 inventory −Started 180,000 units −Completed 155,000 units −Incurred $6,880,000 of cost What is the value of Cost of Goods Manufactured (COGM) and ending WIP inventory? LO1: Explain the mechanics of process costing

Easy Solution We can allocate based on number of units −$6,880,000 × (25,000/180,000) = $955,555 to WIP −$6,880,000 × (155,000/ ) = $5,924,444 to COGM This allocation is probably wrong! −Each unit (whether in WIP or completed) is valued at $6,880,000/180,000 = $15.22 per unit −But, we will work some more (and incur more costs) to finish the units in WIP −The value of the units cannot both be $15.22 currently. LO1: Explain the mechanics of process costing

Equivalent Units Process Costing Systems solve the problem by computing equivalent units Physical units × % completion = Equivalent units −100 physical units × 20% complete = 20 Eq. units −500 physical units × 40% complete = 200 Eq. units We use equivalent units (rather than physical units) as the allocation basis −Convenient to use a 5-step template to organize the allocation process. LO1: Explain the mechanics of process costing

Five-step Template Applied LO1: Explain the mechanics of process costing

Refining the Allocation Split the costs into smaller pools −Different costs might have different completion rates −Materials might be added as a lump amount at the start of process −Labour and overhead (conversion) might be incurred uniformly The same unit in WIP could therefore be −100% complete for materials, 20% complete for conversion In our example, suppose: −We added all materials at start and ending WIP was 20% complete for conversion costs −Let $6,880,000 = $4,320,000 for materials and $2,560,000 for conversion LO2: Apply process costing to settings with many pools and beginning inventory

Refining the Allocation: Solution Do the allocations separately! Create a separate column (in Steps 2-5) for each kind of input −Number of columns = number of cost pools Thus, we will have: −One column for materials −One column for conversion costs We can do allocation separately and then add up LO2: Apply process costing to settings with many pools and beginning inventory

Materials Issued at Different Points Real world systems might have many columns for many cost pools −Raw materials for a belt (e.g., leather strips) can be added in the beginning −Some components (e.g., studs) can be added in the middle −Yet more pieces (e.g., buckles) might be added at the end −We might also separate out different types of overhead The underlying mechanics remain unaltered We also can refine the allocation for the product going through many processes LO2: Apply process costing to settings with many pools and beginning inventory

Opening Inventory We often have to deal with inventory left over from the prior period −This inventory might have different costs −Need inventory cost flow assumption −Weighted Average Method is most sensible and common Weighted average method −Does not distinguish between units in opening inventory and those started this period −Does not distinguish (i.e. add together) the costs from opening inventory and the current period LO2: Apply process costing to settings with many pools and beginning inventory

Example Chen began June with 25,000 units −The ending inventory for May −Valued at $561,250 for materials and $80,000 for labor Added more 175,000 units −Incurred $4,038,750 for materials, $2,830,000 for labor and $323,750 for packing Ended with 15,000 units −90% complete for labor Materials added at beginning, labor incurred uniformly and packing added at end of process What is the value of COGM and Ending WIP? LO2: Apply process costing to settings with many pools and beginning inventory

Standard Process Costing Many firms take advantage of large production volumes to use the same rate each accounting period −Product cost does not change across periods −Permits variance analysis (see Chapter 8) for exercising operational control Method −Same template as before −Use standard rates instead of calculating actual rates as we did before LO3: Perform process costing using standard costs

Can Integrate with Variances Standard process costing lets us calculate variances −We know that Chen spent $4,041,000 on materials in May −The standard cost of the work done was $4,005,000 −Thus, we can calculate the variance as $36,000 U = $4,041,000 - $4,005,000. We can extend the idea to settings with opening inventory −Be careful in considering cost of work done during the period −Compare with actual expenditure for the period LO3: Perform process costing using standard costs Cost of work done this period = Cost of goods completed + Cost of ending inventory - Cost of opening inventory

LO2: Apply process costing to settings with many pools and beginning inventory

Mechanics of process costing, steps 1 and 2 (LO1). Orange Computers began June with zero units of its portable music player in work-in-process inventory. During June, Orange started 250,000 units into production, completing 175,000 units by month’s end. Production personnel estimate that the 75,000 units still in process on June 30 are 100% complete with respect to materials and 40% complete with respect to conversion costs. Required: Complete steps 1 and 2 of Orange’s process-costing report for June. Exercise 15.31

Exercise (Continued) Complete steps 1 and 2 of Orange’s process-costing report for June. Using the information provided, we have: TotalDetail for each cost pool Step 1: Track Physical FlowMaterialsConversion Beginning inventory - June 10 Started during June250,000 Total physical units to account for250,000 Step 2: Compute Equivalent Units Units completed during June175,000 (100% of 175,000) 175,000 (100% of 175,000) Units in process on June 30 75,000 (100% of 75,000) 30,000 (0.40 × 75,000) Total physical units accounted for250, ,000

Notice that the percentage of completion varies between materials and conversion costs. Thus, the number of equivalent units also varies. For materials, each unit in WIP is equivalent to a finished unit as it has consumed all of the requisite materials. In contrast, each unit is only 0.40 of a finished unit in terms of conversion costs, because the unit in WIP is only 40% complete with respect to conversion costs. Exercise (Concluded) Complete steps 1 and 2 of Orange’s process-costing report for June.

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