As emphasized in the preceding section, job order costing is appropriate when each unit of product, or “batch” of production, is manufactured to different specifications.
Many companies, however, produce a continuous stream of identical units, such as bottles of beer, gallons of gasoline, or kilowatt hours of electricity. When identical products are produced in a continuous stream, there are no distinctobs.ttTherefore, companies engaging in mass production often use process costing rather than job order costing.
Mass’ production usually involves a series of specific steps, or manufacturing processes. Process costing measures separately the cost of performing each process arid then allocates these costs to the units processed during the month.
Process costing serves two related purposes. First, it measures the cost of goods manufactured on both a total and per-unit basis. This infonnation is used in valuing inventories and in’ recording the cost of goods sold. But process costing also provides management with infonnation about the per-unit coa of performing each step in the
production process. This infonnation is useful in evaluating the efficiency of production departments and often draws attention to potential cost savings.
Work In Procoss Accounts-The Key to·Process Costing Process costing uses a separate Work in Process Inventory account to’ measure the costs incurred in each production process. Costs flow through these accounts in sequence, just as the units on an assembly line move from one production process to the next. Only’
when the units complete the final production. process are their costs transferred to the Finished Goods Inventory account. An illustration for a company with three manufacturing process~s appears on the following page. Accounting for Material, Labor, and Applied Overhead Each Work in Process account is charged (debited) for the materials used, direct labor, and overhead that relate to that
specific process. For example, only those materials that require cutting are charged to the Cutting Department.
Component parts sent directly to the Assembly Department are charged to the Assembly Department’s Work in Process account; Direct labor and overhead costs also are applied separately to each Work in Process account.
Coil Flow from One Process to the Next Units in production pass from one process to the next. Process costing parallels this physical flow of units by transferring their cost from one Work in Process account to the next.Assume that during the current month, $200,000 in manufacturing costs were charged to the Cutting Department. Assume also that this department cut enough material to manufacture 10,000 units of product, and that the cut materials were transferred to the Assembly Department.
At month-end, the following Journal entry would be made to summarize the transfer of cut materials during tube month:In essence, the output of the Cutting Department is a form of “direct material”. charged to the Assembly Department’ .
Notice that we transferred ali $200,000 of the Cutting Department’s production costs to the Assembly Department. In effect, we assumed that all of the Cutting Department’s costs are applicable to the units completed and transferred during the month.
Process Costing and Equivalent Units
Companies that have significant ending work in process inventories in their departments must assign product costs to unfinished units. Consider .the Assembly Department in the previous example. Suppose that in addition to the cut materials transferred by the Cutting Department, the Assembly’ Department added direct labor, additional direct materials, and overhead.
Assume the cut materials transferred from the Cutting Department are machined and polished over the first one-third of the assembly production process. In the seconder third of the assembly process, additional trim materials are added to the polished ‘cut materials. Finally, the cut, polished, and trimmed assembled units are dipped in a chemical bath to finish the units.
The following page shows an illustration of the production process in the Assembly Department. If, at the end of the reporting period, the Assembly Department has units that are two thirds, finished (that is, they have not yet had the chemical finishing bath), some cost should be assigned to those units.
To be consistent with the matching principle, any significant costs incurred in creating work in process should be assigned to work in process inventories.
To recognize partially completed work in process units. companies use a technique referred to as equivalent units: An equivalent unit is a measure that represents the percentage of a completed unit’s cost that is present in a partially finished unit. Thus the Assembly Department’s work in process that is two-thirds complete would be considered 100% complete with respect to cutting materials, trim materials,and direct labor.
However, the work in process units are only two-thirds complete (66.6667%) with respect to overhead.Companies compute the equivalent units associated with completed units and with work in process as a way to assign costs to inventories. It is important to remember that equivalent unit amounts are computed separately for each significant input added in the production process. In the Assembly Department, these resources include the cutting material transferred from the Cutting Department, the trim materials, the direct labor, and the overhead.
To illustrate the process more futilely, consider a typical month for the Assembly Department.
During the month of March, 10,000 units of cut materials were transferred from the Cutting Department. At the beginning of the month, 1,000 units that were one third finished were in the Assembly Department’s beginning work in process.
At the end of March. 3,000 units were in ending work in process and they were two-thirds finished. The following costs were recorded in March:The equivalent unit computation shows that for the 1.000 beginning work in process units no cut materials were added in March, The cut materials for the units in beginning work in process were added in February,
However, because those beginning work in process units were only’ one-third finished at the beginning of March, the trim materials had net yet been added,
Thus. for those 1.000 units, 100% of the trim materials were added in March. For direct labor. which is added over the first two-thirds of the process, 50% of the ‘direct labor was added in February and the remaining’ 50% was added in March, Thus 500 equivalent units (50% X 1.000 units) of direct labor were added to the beginning work in process units in March.
Finally. 661% of the overhead was added in March, resulting in 666 equivalent units of overhead (1.000 units X 66.%), The started and completed units are those units from the I Q.OOO units started in March that are also transferred to the Packaging Department in March. However, total finished units transferred to Packaging include both the units in beginning work in process and those that are started and completed in March. In computing started and completed units. always assume a first-in. first-out (FIFO) inventory flow, It is calculated as follows: