What Is Process Costing? Features, Types, Advantages & Limitations, Process

Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. More broadly, costing provides a solid foundation for the efficient and smooth functioning of the enterprise as a whole. With this in mind, a sound system of costing helps to derive various advantages. If any deviation between the actuals and the budget and the standards is identified, corrective measures are taken. Budgets are prepared, standards are established, actuals are ascertained, and then a comparison is made.

The cost per unit is obtained by dividing these costs by equivalent production. When prices are rising, (i.e., during inflation), FIFO indicates a lower cost of units finished and a higher inventory value as current costs are applied to closing inventory. (vii) In process costing system the units produced in each process are also recorded and hence there is a separate column for units introduced and units produced in every process. The normal loss, abnormal loss or abnormal effective are also recorded in units in the process account as the case may be. If a process costing system does not mesh well with a company’s cost accounting systems, there are two other systems available that may be a better fit. The job costing system is designed to accumulate costs for either individual units or for small production batches.

Advantages and Limitations of Process Costing

Each unit’s cost is determined based on the overall cost of each department or stage involved in the manufacturing process. Errors can occur when non-production amortization business costs are also included in the calculation. As raw materials progress through the production cycle, identical packages of paper are produced.

  • This enables an organization’s managers to know not only the total cost but also its constituents.
  • For this reason, the amount standing at the credit of abnormal gain account will not be transferred to profit and loss account as it is.
  • (iii) All the losses which takes place in a process are shown in the credit of that process account.
  • We then assign the amount of direct materials used based on the total of fully and partially produced units.

Opening WIP is the number of incomplete units at the start of a process and closing WIP is the number at the end of the process. This occurs when the actual loss is lower than the normal loss. This could, for example, be due to greater efficiency from newly-purchased machinery. The process is a series of stages that must be followed in order to finish a given task. The method of preserving cost records for each procedure is referred to as costing.

Allocate costs to complete and incomplete products

So equivalent unit may represent the production of a process in terms of completed unit. It also means converting the uncompleted units into equivalent of completed units. In a manufacturing unit generally it is not possible to complete the work on all the units on which work has been started. The account is debited with the cost of materials, labour and overheads relating to the process and the value of byproducts and scrap is credited. The balance of this account, representing the cost of a process, is passed on to the next process and so on until the final product is completed. The opening stock is shown on the debit side of the account prepared for the process concerned while the closing stock is shown on its credit side.

Process Costing – Loss in Weight and Sale of Scrap

Note in the above graphic the familiar inventory categories relating to raw materials, work in process, and finished goods. However, rather than observing work in process as being made up of many individual/discrete jobs, see that it instead consists of individual/discrete processes like melting, skimming, and extruding. Ore is introduced in the melting stage, alloys in the skimming stage, etc. (this is equally true for labor and overhead). This necessitates the employment of a separate Work in Process account for each major manufacturing activity. Examine the graphic below that compares job and process costing, noting in particular the difference in how costs are shifted out of work in process.

Presentation of Process Costs

These costs will then be transferred to second department where its processing costs will be added. 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 appropriate for companies that produce a continuous mass of like units through series of operations or process.

To fulfill the underlying idea behind this norm, it is important to control the cost so as to reduce the cost of a product or service. As such, the norm that everyone attempts to follow is «the lower the cost, the greater to profit.» Obotu has 2+years of professional experience in the business and finance sector. Her expertise lies in marketing, economics, finance, biology, and literature.

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If there is a difference between the actual direct labor cost and the amount charged to production in the period, the difference can be charged to the cost of goods sold or apportioned among the units produced. Let’s assume, a manufacturing business completed 4,000 products and has another 1,000 units halfway through production, the total costs would be divided by 4,500 units [i.e. If the total cost calculated across all departments to produce these units was $16,875, it means that the cost per unit will be determined by simply dividing the total cost of $16,875 by the 4,500 number of units. In process costing, the emphasis is on accumulation of costs for a process during a given period of time and the number of units produced in the process during that period. To determine the unit cost of output of each process, the total production cost of the process is divided by the total quantity of the output of the process during a given period.

The main benefit of Process Costing is that it provides information that can be used to make critical business decisions. For example, managers using this system can assess profit margin by product and isolate problem products before they become major issues. Process Costing also allows companies to set prices according to production costs.