1. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-1 Chapter 5 Process costing and operation costing

2. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-2 Process costing Job costing and process costing are two extremes of the continuum of conventional product costing systems Job costing systems accumulate the costs of each job Process costing systems accumulate the cost of each process, then average these costs across all units produced Many businesses use a combination of job and process costing; this is called hybrid costing

3. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-3 Process costing Used by businesses that mass-produce one product or a small range of almost identical products –Involves a number of processes that are performed repetitively –Used by oil refineries, food processors, manufactures of tobacco, chemicals and paper –Also used by producers of repetitive services—routine processing of cheques in banks and delivery of standard letters in Australia Post continued

4. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-4 Process costing Two main steps –Estimate the cost of the production process –Calculate the average cost per unit by dividing the cost of the process by the number of units produced Process costing can occur where there is no opening or closing WIP inventory (see Chapter 4) More complex process costing takes place where there is WIP inventory –Need to calculate equivalent units to apportion cost between production and inventory

5. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-5 Process costing with work in process inventories WIP inventory –Not all products are complete at the beginning or end of the period (usually a month) Production costs will be calculated after taking into account –Units started in the previous period and completed in current period (beginning WIP) –Units started and completed in the period –Units that are incomplete at the end of the period (ending WIP) continued

6. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-6 Process costing with work in process inventories Partially completed goods at the beginning or end of the period change the way we allocate production costs Equivalent units –The production inputs that have been applied to the physical units during production –Physical units are all units currently in production whether complete or incomplete –WIP inventory needs to be converted to equivalent units to provide the basis for calculating product cost continued

7. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-7 Process costing with work in process inventories Materials are input into production at various stages We usually assume that labour and overhead are used uniformly throughout the production process –Use the term ‘conversion costs’ Units in ending WIP are generally at different stages of completion with respect to material and labour

8. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-8 Calculation of equivalent units If WIP is 50% complete for 10 000 litres on hand at the end of the month, it is –100% complete for direct materials, which are added at the start of the process  10 000 equivalent units of material –50% complete for conversion costs, assuming that conversion costs occur uniformly across the production process  5000 equivalent units of conversion cost Equivalent units are used to calculated unit costs when there is WIP

9. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-9 The effects of beginning and ending work in process inventories Four steps in process costing 1. Analyse the physical flow of units 2. Calculate the equivalent units 3. Calculate the unit costs 4. Analyse the total costs Products are costed using one of two assumptions about product flow –Weighted average method –First in, first out (FIFO) method

10. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-10 Process costing using the weighted average method Step one: analyse the physical flow of units Physical units in beginning WIP Physical units started Physical units completed and transferred out Physical units in ending WIP = – + continued

11. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-11 Process costing using the weighted average method Step two: calculate the equivalent units –The equivalent units in beginning WIP are not identified separately; this is a key feature of the weighted average cost method Equivalent units completed and transferred out Equivalent units in ending WIP Total equivalent units + = continued

12. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-12 Process costing using the weighted average method Step three: calculate the unit costs –The cost per equivalent unit for direct material is the total direct material (conversion costs) costs divided by the total equivalent units –Under the weighted average method, the cost per equivalent unit is based on the total costs incurred, including the cost of beginning WIP Step four: analyse the total costs –Cost of units transferred to the next production process, or to finished goods –Cost of production remaining in WIP

13. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-13

14. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-14

15. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-15

16. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-16 Process costing using the FIFO method It is assumed that the oldest inventory is completed before new production commences Step one: analyse the physical flow of units –Identical to the weighted average method Step two: calculate the equivalent units –Under FIFO, equivalent units in opening WIP are subtracted from total equivalent units to give new equivalent units of production continued

17. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-17

18. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-18 Process costing using the FIFO method Step three: calculate the unit costs –Cost per equivalent unit is calculated for direct material (or conversion cost) by dividing the direct material cost incurred during the current month by the new equivalent units added during the current month –Costs of opening inventory are not used in this calculation Step four: analyse the total costs –Assumes that the units in beginning inventory are completed and transferred out first –Cost of the beginning WIP are not mixed with those incurred during current month

19. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-19

20. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-20

21. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-21

22. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-22 Comparison of weighted average and FIFO methods Key difference is the treatment of the beginning WIP –Under weighted average costs, the cost of beginning WIP and equivalent units of work done on it are included in the calculation of the cost per equivalent unit –Under FIFO, cost per equivalent unit is based only on costs incurred in the current month –Weighted average is more commonly used than FIFO  Simpler and WIP inventory may be negligible  Cost of using FIFO may exceed the benefits

23. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-23 Process costing and spoilage Spoilage cost: the cost of defective product and wasted resources that cannot be recovered by rework or recycling When spoilage occurrs there are three forms of output –Units completed and transferred out –Spoiled units –Unfinished units remaining in WIP Spoiled units are costed using cost per equivalent unit along with other two outputs continued

24. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-24 Process costing and spoilage Spoilage is accounted for depending on whether it is normal or abnormal Normal spoilage: inherent in the production process and occurs even under efficient operating conditions –Included as part of the cost of good units completed Abnormal spoilage: should not occur under efficient operating conditions –Costs of abnormal spoilage are expensed

25. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-25 Operation costing Some businesses have repetitive production processes but produce a narrow range of products that differ in some significant aspects –Different material inputs –Different combinations of specific production processes In batch manufacturing processes, individual product lines are produced in large batches and require specific combinations of direct materials and a specific sequence of production processes continued

26. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-26

27. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-27 Operation costing Operation costing is a hybrid costing system –Used in a batch manufacturing environment –Features of both job costing and process costing –Direct material assigned to individual batches –Conversion costs assigned to departments or processes using a predetermined application rate

28. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-28

29. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-29 Other issues in process costing Standard costs are more likely to be used than actual costs Process costing and operation costs are consistent with concepts of responsibility accounting –Processes or operations are usually performed in different departments –Departmental managers may be held responsible for the department’s costs and output produced A predetermined overhead rate may be used in process costing and a predetermined conversion cost rate in operation costing –Underapplied or overapplied costs continued

30. Copyright  2006 McGraw-Hill Australia Pty Ltd PPTs t/a Management Accounting: Information for managing and creating value 4e Slides prepared by Kim Langfield-Smith 5-30 Other issues in process costing Production units are usually used as the cost driver in process costing and operation costing –Inputs may be used as cost drivers in operation costing The percentage of completion is difficult to determine and is often only a rough estimate In service firms, some routine, repetitive or similar services can be costed using process or operation costing