Chapter 18 Process Costing

Chapter 18 Process Costing

© 2016 Pearson Education, Inc.
Learning Objectives Describe the flow of costs through a process costing system Calculate equivalent units of production for direct materials and conversion costs Prepare a production cost report using the weighted-average method © 2016 Pearson Education, Inc.

Learning Objectives Prepare journal entries for a process costing system Use a production cost report to make decisions Prepare a production cost report using the first-in, first-out method (Appendix 18A) © 2016 Pearson Education, Inc.

How Do Costs Flow Through a Process Costing System?
Job order costing system Allocates costs by job Used by companies that manufacture a unique product or provide specialized services Process costing system Allocates costs by process Used by companies manufacturing identical units A process is one of the steps in manufacturing production Job order costing is an accounting system that accumulates costs by job. Used by companies that manufacturer unique products or provide specialized services. In contrast, other companies use a series of steps, which are called processes, to make large quantities of similar products. A process is one of a series of steps in manufacturing production; usually associated with making large quantities of similar items. A process costing system is an accounting system that accumulates costs by process. Used by companies that manufacturer identical units through a series of uniform production steps or processes. © 2016 Pearson Education, Inc.

Job Order Costing Versus Process Costing
Both job order and process costing systems track the product costs of direct materials, direct labor, and manufacturing overhead through the three inventory accounts on the balance sheet: Raw Materials Inventory, Work-in-Process Inventory, and Finished Goods Inventory. The primary differences between job costing and process costing are how and when costs are recorded in Work-in-Process Inventory. Job order costing has one Work-in-Process Inventory account, with a subsidiary ledger containing individual job cost records for each job. Costs are transferred to Finished Goods Inventory when the jobs are completed. Process costing has a separate Work-in-Process Inventory account for each process or department. © 2016 Pearson Education, Inc.

Flow of Costs Through a Process Costing System
Companies use process costing to determine the per unit cost in order to: Control costs Set selling prices Calculate account balances for Work-in-Process Inventory Finished Goods Inventory Cost of Goods Sold As we look at how process costing works, we will be using Cheerful Colors, a fictitious crayon manufacturing company. Cheerful Colors divides its manufacturing operations into three processes: mixing, molding, and packaging. The Mixing Department combines direct materials such as paraffin wax and pigments. The heated mixture is pumped to the Molding Department, where it is poured into molds. After the molds cool, the crayons are removed from the molds and transferred to the Packaging Department, where paper wrappers are added to each crayon, and the crayons are boxed. The crayons accumulate production costs during each process. The company then assigns these costs to the crayons passing through that process. Cheerful Colors uses cost per unit information to control costs, set selling prices, and calculate account balances. The company can look for ways to cut the costs when actual process costs are more than planned costs. The company wants the selling price to cover the costs of making the crayons, and it also wants to earn a profit. In addition, the company needs to know the ending balances in Work-in-Process Inventory and Finished Goods Inventory for the balance sheet and the Cost of Goods Sold for the income statement. © 2016 Pearson Education, Inc.

Flow of Costs Through a Process Costing System
Exhibit 18-2 provides a comparison of cost flows in Smart Touch Learning’s job order costing system with the Cheerful Crayons process costing system. Panel A shows that a job order costing system has a single Work-in-Process Inventory control account. Panel B diagrams the flow of costs for the Cheerful Crayons process costing system. Each process is a separate department, and each department has its own Work-in-Process Inventory account. Direct materials, direct labor, and manufacturing overhead are assigned to Work-in-Process Inventory for each process that uses them. The total cost of the crayons includes the costs of mixing, molding, and packaging. The costs incurred in the first process are transferred to the second process. The costs incurred in the first and second processes are then transferred to the third process. Then the entire cost is transferred to Finished Goods Inventory. © 2016 Pearson Education, Inc.

What Are Equivalent Units of Production, and How Are They Calculated?
Exhibit 18-3 illustrates the point that all costs must be accounted for. They must either remain in the department or be transferred to the next department. Because the production process takes time, companies may have products that are not completed and are still in process at the end of the accounting period. In process costing, production costs are accumulated by process. Then, at the end of the period, the total production costs incurred must be split between the following: units that have been completed in that process and transferred to the next process (or to Finished Goods Inventory, if it is the last process) and units not completed and remaining in Work-in-Process Inventory for that department. When the production costs have to be split, we cannot just divide the total cost by the number of units started to get a unit cost because some units are not complete and, therefore, have not incurred the same amount of costs. The unit cost of the completed units is more than the unit cost of the incomplete units. So how are the costs divided? We use the concept of equivalent units of production. © 2016 Pearson Education, Inc.

Equivalent Units of Production
Equivalent units of production (EUP) Measures the amount of materials added to or work done on partially completed units during a period Expressed in terms of fully complete units of output Equivalent units of production (EUP) is used to measure the amount of materials added to or work done on partially completed units and is expressed in terms of fully complete units. © 2016 Pearson Education, Inc.

Conversion Costs Direct labor is a small part of manufacturing costs for highly automated manufacturers. To simplify accounting, direct labor is combined with manufacturing overhead and called conversion costs. Conversions costs are the costs to convert raw materials into finished goods. Many manufacturing companies that use process costing are highly automated, so direct labor is a small part of total manufacturing costs. Conversion costs are the costs to covert raw materials into finished goods: direct labor plus manufacturing overhead. © 2016 Pearson Education, Inc.

How Is a Production Cost Report Prepared?
For a comprehensive example of a process costing system, let’s look at Puzzle Me, a fictitious company that manufactures jigsaw puzzles. Exhibit 18-4 illustrates the two major production processes. In the first process, the Assembly Department applies glue to the cardboard and then presses a picture onto the cardboard. Then the Cutting Department cuts the board into puzzle pieces and packages the puzzles in a box. The box is then moved to finished goods storage. The production process uses materials, machines, and labor in both departments, and there are two work-in-process inventory accounts: one for the Assembly Department and one for the Cutting Department. We are going to complete a lot of calculations in this chapter. As you work through the computations, keep the picture in Exhibit 18-4 in mind so you don’t confuse inputs with outputs. The inputs are the materials, labor, and overhead. The outputs are the completed puzzles. © 2016 Pearson Education, Inc.

Production Cost Report—First Process—Assembly Department
A production cost report show the calculations for the physical flows and the cost flows of the products. Summarize the flow of physical units. Compute output in terms of equivalent units of production. Compute the cost per equivalent unit of production. Assign costs to units completed and units in process. A production cost report must be completed for each department. The production cost reports show the calculations for the physical flows and the cost flows of the products. There are four steps in preparing a production cost report. The first step is to summarize the flow of physical units. The next step is to compute output in terms of equivalent units of production. The third step is to compute the cost per equivalent unit of production. The last step is to assign costs to units completed and units in process. © 2016 Pearson Education, Inc.

Two unique terms are used on the production cost report: To account for includes the amount in process at the beginning of the period plus the amount started or added during the period. Accounted for shows what happened to the amounts to account for. They are either still in process or completed and transferred out. There are two unique terms used on a production cost report. To account for includes the amount in process at the beginning of the period plus the amount started or added during the period. Accounted for shows what happened to the amounts to account for. They are either still in process or completed and transferred out. These terms are used for both units and costs. To account for and accounted for must always be equal. © 2016 Pearson Education, Inc.

Exhibit 18-6 shows the updated production cost report with information on the equivalent units. Notice that there are no entries in the Transferred In column. The Assembly Department is the first department in the manufacturing process, so there are no units transferred in from a previous department. We will use this column when we complete the production cost report for the Cutting Department. Notice there is a difference in equivalent units between direct material and conversion costs units in the ending work-in-process. Since direct materials are added at the beginning of the process, the puzzles include all of the material. However, the units are only 25% complete with regard to conversion costs. Now that we have completed the units section of the report, it is time to complete the costs section. © 2016 Pearson Education, Inc.

Exhibit 18-7 shows how we use the information from step 3 to complete the costs to account for section of the production cost report. The per equivalent unit is different for direct materials and conversion costs. The total cost to account for is divided by the total equivalent units of production for each category. In this example, the cost per equivalent unit for direct materials is $2.80 and $1.60 for conversion costs. © 2016 Pearson Education, Inc.

Exhibit 18-8 shows the completed production cost report for the Assembly Department. Notice the total costs to account for completed and transferred out and notice that ending work-in-process is the same as the total costs to account for associated with beginning work-in-process and costs added during the period. © 2016 Pearson Education, Inc.

Production Cost Report—Second Process—Cutting Department
The costs of materials from the Assembly Department are transferred into the Cutting Department. The transferred costs are called transferred in costs. The weighted-average method combines the average cost of equivalent units of production by combining beginning inventory costs with current period costs. Transferred in costs are costs that were incurred in a pervious process and brought into a later process as part of the product’s cost. The weighted-average method (for process costing) determines the average cost of equivalent units of production by combining beginning inventory costs with current period costs. © 2016 Pearson Education, Inc.

Exhibit 18-9 shows information on the production cost report for the Cutting Department. Just as we did with the Assembly Department, we start with the units section of the report. © 2016 Pearson Education, Inc.

In Exhibit 18-10, the units section is now complete. The equivalent units for direct materials and conversion costs have been accounted for. However, the units that are in process do not yet have any direct materials added in the Cutting Department because the box is added at the end of the process. Because they are still in process, the box has not yet been added. © 2016 Pearson Education, Inc.

The Cutting Department has $233,040 of costs to account for, as illustrated in Exhibit The beginning balances and the additional costs incurred were given in the original data. The amount transferred in from the Assembly Department, $176,000, is the amount calculated on the production cost report for the Assembly Department for July as the amount completed and transferred out in the costs accounted for section. © 2016 Pearson Education, Inc.

Exhibit shows the completed production cost report for Puzzle Me’s Cutting Department. We have accomplished our goal of splitting the $233,040 total cost between the completed units and the in process units. The total costs to account for between the total completed units and the in process units equal $233,040, which is the same value as the total costs to account for associated with beginning work-in-process inventory and costs added during the period. © 2016 Pearson Education, Inc.

What Journal Entries Are Required in a Process Costing System?
Costs flow through the process costing system in four steps: Accumulate Assign Allocate Adjust Costs flow from one Work-in-Process Inventory account to the next and eventually to Finished Goods Inventory and Cost of Goods Sold. As costs flow through the process costing system, we go through a four-step process of accumulating, assigning, allocating, and adjusting. This is the same process that was illustrated in the previous chapter for job order costing. Remember, the primary differences between the two costing systems are how costs are accumulated and when costs are assigned. In a process costing system, costs are accumulated in the following accounts: Raw Materials Inventory, the various Work-in-Process Inventory accounts, and Manufacturing Overhead. © 2016 Pearson Education, Inc.

Transaction 1—Raw Materials Purchased
During July, the company purchased materials on account for $175,000. The journal entries for process costing are similar to those for job costing. When inventory is purchased on account, the Raw Materials Inventory account is a debit, and Accounts Payable is a credit. © 2016 Pearson Education, Inc.

Transaction 2—Raw Materials Used in Production
During July, direct materials were assigned to the two production departments: $140,000 to the Assembly Department and $19,000 to the Cutting Department; $2,000 in indirect materials were accumulated in Manufacturing Overhead. Direct materials are used in production in both the Assembly Department and the Cutting Department. In addition, indirect materials are used. The Work-in-Process Inventory accounts for each department are increased with a debit for the direct materials that are used. Manufacturing Overhead is increased with a debit for the indirect materials used. Raw Materials Inventory is decreased for the total of all materials used. © 2016 Pearson Education, Inc.

Transaction 3—Labor Costs Incurred
During the month, Puzzle Me incurred $20,000 in direct labor costs in the Assembly Department; $3,840 in direct labor costs in the Cutting Department; and $1,500 in indirect labor costs accumulated in Manufacturing Overhead. Direct labor is used in production in both the Assembly Department and the Cutting Department. In addition, indirect labor is used. The Work-in-Process Inventory accounts for each department are increased with a debit for the direct labor that is incurred. Manufacturing Overhead is increased with a debit for the indirect labor incurred. Wages Payable is increased for the total of all labor incurred. © 2016 Pearson Education, Inc.

Transaction 4—Additional Manufacturing Costs Incurred
In addition to the indirect materials and indirect labor costs, Puzzle Me incurred $35,000 in machinery depreciation and $20,000 in indirect costs that were paid in cash, which included rent and utilities. Additional manufacturing overhead is incurred for depreciation and rent and utilities. Depreciation is recorded with a debit to Manufacturing Overhead and a credit to Accumulated Depreciation. Rent and utilities are recorded with a debit to Manufacturing Overhead and a credit to cash. © 2016 Pearson Education, Inc.

Transaction 5—Allocation of Manufacturing Overhead
Puzzle Me used a predetermined overhead allocation rate to allocate indirect costs to the departments: $48,000 to the Assembly Department and $11,000 to the Cutting Department. To allocate the manufacturing overhead, Puzzle Me will debit the Work-in-Process Inventory accounts for each department and credit Manufacturing Overhead. © 2016 Pearson Education, Inc.

Transaction 6—Transfer from the Assembly Department to the Cutting Department At the end of July, when the production cost report for the Assembly Department was prepared, Puzzle Me assigned $176,000 to the 40,000 units transferred from the Assembly Department to the Cutting Department. The Cutting Department’s Work-in-Process Inventory account is increased, and the Assembly Department’s Work-in-Process Inventory account is decreased. © 2016 Pearson Education, Inc.

Transaction 7—Transfer from Cutting Department to Finished Goods Inventory At the end of July, when the production cost report for the Cutting Department was prepared, Puzzle Me assigned $201,400 to the 38,000 units transferred from the Cutting Department to Finished Goods Inventory. This is the cost of goods manufactured. At the end of the month, when the production cost report for the Cutting Department was prepared, the cost of the units transferred from the Cutting Department to Finished Goods Inventory was recorded. Finished Goods Inventory is increased, and the Cutting Department’s Work-in-Process Inventory account is decreased. This is the cost of goods manufactured. © 2016 Pearson Education, Inc.

Transaction 8—Puzzles Sold
During July, Puzzle Me sold 35,000 puzzles. We have already determined from the production cost report for the Cutting Department that the cost of goods manufactured is $5.30 per puzzle. Therefore, the cost of 35,000 puzzles is $185,500 (35,000 puzzles × $5.30). The puzzles were sold on account for $8.00 each, which is a total of $280,000 (35,000 puzzles × $8.00). The sale increases Accounts Receivable and Sales Revenue. It also increases Cost of Goods Sold but decreases Finished Goods Inventory. © 2016 Pearson Education, Inc.

Transaction 9—Adjust Manufacturing Overhead
The actual manufacturing overhead costs incurred were $58,500, which includes the indirect materials in Transaction 2, the indirect labor in Transaction 3, and the accumulated depreciation and other indirect costs in Transaction 4. The amount of manufacturing overhead allocated to the two departments was $59,000, as shown in Transaction 5. The T-account for Manufacturing Overhead shows that the amount of manufacturing overhead allocated was $500 more than the actual costs incurred. This means the overhead was overallocated. The adjusting entry for overallocated or underallocated manufacturing overhead is usually prepared at the end of the year. We are showing it here at the end of the month so we can illustrate all journal entries for a process costing system. This means manufacturing overhead was overallocated by $500, requiring an adjustment at the end of the period. © 2016 Pearson Education, Inc.

How Can the Production Cost Report Be Used to Make Decisions?
Controlling costs Evaluating performance Pricing products Identifying the most profitable products Preparing the financial statements Managers use the production reports to make decisions for their companies. Puzzle Me uses product cost data to look for ways to reduce costs. This may include changing suppliers to reduce the cost of raw materials or changing a component in the production process to reduce direct materials costs. To reduce labor costs, a manager may need employees with different skill levels paid at different hourly rates. Perhaps more skilled employees would require a higher pay rate but be more efficient. The increase in cost per labor hour may be more than offset by the increased productivity of the workers. Managers are often rewarded based on how well they meet the budget. Puzzle Me compares the actual direct materials and conversion costs with expected amounts. If actual costs are too high, managers look for ways to cut. If actual costs are less than expected, the managers may receive a bonus. Another use is to set the price for the product. Puzzle Me’s selling price must be high enough to cover the manufacturing cost of each puzzle plus marketing and distribution costs. Selling price and cost data help managers figure out which products are most profitable. They can then promote these products to help increase profits. Finally, the production cost report aids in preparing the financial statements. It provides inventory data for the balance sheet and cost of goods sold for the income statement. © 2016 Pearson Education, Inc.

How Is a Production Cost Report Prepared Using the FIFO Method?
Equivalent unit of production cost methods: Weighted-average method First-in, first-out The first-in, first-out method determines the cost of equivalent units by accounting for beginning inventory separately. The chapter illustrates how to complete the production cost reports for Puzzle Me using the weighted-average method. In the weighted-average method, the costs from the beginning balance in Work-in-Process Inventory are combined with the current period cost when determining the cost per equivalent units of production. Another method for assigning production costs is the first-in, first-out method. The first-in, first-out method (for Process Costing) determines the cost of equivalent units of production by accounting for beginning inventory costs separately from current period costs. It assumes the first units started are the first units completed and sold. © 2016 Pearson Education, Inc.

Using the FIFO method creates three groups of units to be accounted for: • Units in beginning inventory that were started in June and completed in July. • Units started in July and completed in July. • Units started in July but not completed in July. These units are still in process at the end of July and will be completed in August. Exhibit 18A-1 shows the units accounted for during July in the Cutting Department. The data for the Cutting Department show 5,000 units in beginning inventory and 38,000 units transferred out. Therefore, the 38,000 units that were completed and transferred out include the 5,000 units in beginning inventory plus another 33,000 units that were started in July. The 40,000 units started in the Cutting Department were those transferred in from the Assembly Department. Remember, FIFO stands for first-in, first-out. Therefore, it is assumed that the first units in (those in beginning inventory) are the first units transferred out. © 2016 Pearson Education, Inc.

Having completed the units section of the production cost report, we now move to the costs section. Exhibit 18A-5 shows the costs to account for in Puzzle Me’s Cutting Department. The amount transferred in from the Assembly Department, $176,000, is the amount calculated as completed and transferred out in the costs accounted for section on July’s production cost report for the Assembly Department. © 2016 Pearson Education, Inc.

Exhibit 18A-6 shows the production cost report with the costs to account for section completed. The cost per equivalent units is calculated by dividing the total costs to account for by the equivalent units during the period, for a per equivalent cost of $4 ($198,000 / 40,000 units = $4 per unit). © 2016 Pearson Education, Inc.

The completed product cost report is shown in Exhibit 18A-7. We have accomplished our goal of splitting the $232,540 total cost between the completed units and the in process units Notice that the cost per unit for the units that were in beginning Work-in-Process Inventory is $5.20, which is calculated by dividing $26,000 by 5,000 units. The cost per unit for the units started and completed in July is $5.30, which is calculated by dividing $174,900 by 33,000 units. This indicates that costs varied from June to July. © 2016 Pearson Education, Inc.

How Is a Production Cost Report Prepared Using the Weighted-Average Method? Exhibit 18A-8 shows the Cutting Department’s completed production cost report for July using the weighted-average method. This is a duplicate of Exhibit from the chapter. Take a moment to study the reports, examining the similarities and differences. In our example, there were no significant differences between the two methods, only $0.10 per unit. In a large company with many products, however, small fluctuations can have a significant impact. If a business operates in an industry that experiences significant cost changes, it would be to its benefit to use the FIFO method. The weighted-average method merges costs from the prior period with those from the current period. This creates a smoothing effect. The FIFO method would create better month-to-month cost comparisons. This would be especially evident when there are substantial quantities of units in process at the end of the period. The more detailed cost information obtained from the FIFO method would allow managers to make better pricing and product mix decisions. If a business operates in an industry that does not experience significant cost changes, the weighted-average method would be appropriate. This method is easier to use, and the additional benefit derived from more detailed calculations would not outweigh the cost of obtaining them. © 2016 Pearson Education, Inc.

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