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Cost and Management Accounting

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Cost & Management Accounting (MGT-402)
VU
LESSON# 19
PROCESS COSTING SYSTEM
(An introduction)
Definition
Process costing system applies when standardised goods are produced tom a series of inter-
connected operations.
In some industries, the output produced emerges from a continuous process. An example might be
an oil refinery; Oil in a raw state is input and subjected to a process of purification. Refined oil
emerges at the end of the process.
Problems that arise in such situations include the attribution of materials costs and conversion
costs to units of finished output and the occurrence of losses during the process (spoilt or lost
production).
The characteristics and application of process costing
Continuous production
In the job order costing, costs were directly allocated to a particular job. When standardised goods
or services result from a sequence of repetitive and continuous operations, it is useful to work out
the cost of each operation. Then because every unit produced may be assumed to have involved
the same amount of work, costs for a period are charged to processes or operations, and unit costs
are ascertained by dividing process costs by the quantity of output units produced This is know n
as process costing.
Series of interconnected operations
Process costing applies when standardised goods are produced from a series of interconnected
operations. Process costing system is employed by industries possessing following characteristics:
1. There is mass production of a single product or two or more products in successive runs
of scheduled duration e.g., vegetable canning or fruit juice bottling.
2. All units of output are exactly similar and are produced by the same manufacturing
process.
3. Entire manufacturing process is divided into departments or processes, each performing a
specific set of operations.
4. Completed output of each department, except the last one, is the raw materials for the next
department.
5. Manufacturing operations may result in production of joint products or by products.
6. Production is not in response to customers' orders but in anticipation of demand.
Examples of industries using Process Costing include:
Bottling, Pharmaceuticals, Cement, Paint, Coal, Distilleries Electricity, Ice, Soap, Sugar, Canning,
Chemicals, Cooking oil, Electric appliances, Flour, Natural gas, Petroleum Products, Rubber, Steel,
Textile. Under process costing, for the purpose of cost control, each department involved in
manufacturing process is regarded as a cost centre and product costs are accumulated separately
for each department. Cost Centre means a division or segment for which an individual is made responsible
.for the incurrence of cost
Departmental costs are passed through department work in process accounts and not through a
single work in process control account as in job costing. As all units are produced from the same
raw materials and by same manufacturing operations, therefore, it is assumed that same cost is
chargeable to each unit. Instead of accumulating cost of individual units, an average unit cost is
computed by dividing total cost by total output of the period. Cost is associated only with
departments and not with jobs. It reduces clerical efforts for accumulation and analysis of cost. In
this way process costing is less expensive, as compared with job costing.
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Cost & Management Accounting (MGT-402)
VU
The Process Cost Sheet also called Cost of Production Report is the basic document in process
costing. This document is prepared for each department and shows the quantities processed, total
and unit cost, and cost of work transferred out, and still in process. .
Following table is meant to make the difference between the two costing systems more clear.
Job order costing system
Process costing system
Where different products
Application
Where single standard
having peculiar
product is produced or
specifications are produced
two or more standard
against customers' orders
products are produced in
successive runs.
Production is for stock
and in anticipation of
demand.
In order to determine cost
Accumulation of Cost
of each job, costs are
Costs are associated only
compiled job wise. At the
same time, to evaluate
with departments
efficiency of departmental
management cost are also
compiled department wise
Unit cost is computed on
completion of job. The job
may itself be a single cost
Cost per unit
unit e.g. a machine or it may
An average unit cost is
be a multi unit
computed at the end of
costing period by dividing
total cost by units of output
Only one work in process
of the period.
control account is
maintained
A separate work in process
control
account
is
More clerical efforts are
Work in process a/c
maintained
for
each
needed to accumulate costs
producing department
by jobs and by departments,-
therefore, the system is more
Cost accumulation is simple
expensive
as costs are accumulated only
Cost of operating the system
by departments; therefore,
the system is comparatively
less expensive.
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Cost & Management Accounting (MGT-402)
VU
Process costing procedures
In process costing industries standard products are produced in accordance with production
budget. Therefore, it becomes unnecessary to issue a production order. Production Planning and
Control Department communicates production targets to departmental heads by means of written
letters. Data of quantities produced by each department are collected and compared with budgeted
quantities for control purposes. These information are collected by departmental supervisors or
quality inspectors may recording these data. Each producing department is a cost centre because
for the purpose of cost control management is interested in ascertaining departmental costs.
In process costing, generally, a separate work in process account is maintained for each producing
department.
Data Collection
Collection of departmental cost figures of direct materials, direct labor and factory overhead is
based on similar procedure as for, job order costing. However, the source documents used for the
data collection are comparatively simple. These documents identify costs only with departments
and not with jobs as well.
Direct Materials:
Production people secure materials by issuing properly authorised Materials Requisitions. At the
end of each month, these requisitions are sorted and a Materials Requisition Summary indicating
cost of direct and indirect materials issued to each department is prepared. Monthly totals of
direct and indirect materials issued are debited to departmental work in process control accounts
and factory overhead control account respectively and credited to materials control account.
Direct Labor:
Instead of using Job Time Tickets, labor cost data are accumulated on Clock Cards and Daily
Time Sheets. These documents show labor time utilized by each department and classification of
labor cost as direct and indirect. At the end of each month, labor cost data accumulated on these
source documents are summarised in Labor Cost Analysis Sheet indicating direct and indirect
labor cost for each department. Monthly totals of direct labor are debited to departmental work in
process accounts and indirect labor is debited to factory overhead control account.
Factory Overhead:
Factory overhead costs, other than indirect materials and indirect labor discussed earlier, are
accumulated in Voucher Register and in General Journal by means of adjusting entries for
depreciation, expired insurance etc, Monthly total, are debited to factory overhead control
account.
Factory overhead is charged to production through predetermined departmental factory overhead
applied rates. Some industries using process costing charge actual factory overhead to
departments. This method gives satisfactory results if production is stable from month to month,
But if there are fluctuations in production volume, charge of actual factory overhead is
unsatisfactory especially when considerable portion of factory overhead is a fixed cost,
Cost of Completed Output:
Cost of completed output of each production department is calculated in Cost of Production
Report. Cost of units completed and transferred out is credited to work in process control account
of the respective department and debited to work in process control account of the department
receiving the units. Cost transferred out by the last department is, however, debited to finished
goods control account
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Cost & Management Accounting (MGT-402)
VU
Cost of Production Report
In process costing Cost of Production Report also called Process Cost Sheet is the key
document. At the end of costing period, generally a month, a Cost of Production Report is
prepared. It summarizes the data of quantity produced and cost incurred by each producing
department. It also serves as a source document for passing accounting entries at the end of
costing period.
Cost of production report is divided into five sections. Each section is meant to provide specific
information. A brief description of these sections is presented below:
1.
Quantity schedule.
2.
Cost accumulated in the department/process.
3.
Calculation of equivalent units produced.
4.
Calculation of cost per unit.
5.
Accounting treatment / apportionment of the accumulated cost
Quantity Schedule:
The first section Quantity Schedule contains input and output data in terms of quantities. The
information is presented in the following order.
(i)
Units in process at the beginning of costing period.
(ii)
Units started in process or received from preceding department during the period.
(Total of (i) and (ii) constitutes total units to be accounted for)
(iii)
Units completed and transferred to next department or to finished goods.
(iv)
Units completed but still in the department.
(v)
Units in process at the end of the period and their degree of completion.
(vi)
Units lost in process during the period indicating whether normal loss or abnormal loss.
The stage of completion at which the loss occurs is also specified.
(Total of (iii) , (iv) , (v) and (vi) is again the total units to be accounted for)
The quantity schedule assists management to look at a glance production performance of
departments as well as it provides necessary data for preparing remaining sections of the report.
Cost accumulated in the department/process.
The second section Cost Accumulated to Departments shows total cost for which the
departments are accountable. Total costs include cost of beginning work in process inventory,
cost transferred in from the preceding department and cost of direct materials, direct labor and
factory overhead added by the department. If there is normal loss of units, unit cost received
from preceding department requires adjustment. This adjustment for lost units is also shown in
this section. This section provides data for debiting work in process control accounts of the
departments.
Calculation of equivalent units produced.
In order to arrive at cost per unit of output, total of each cost element is divided by the number of
units produced, For this purpose, where at the end of costing period, there are some partially
completed units in process, these units must be stated in terms of equivalent completed units, For
example, if 4,000 units. are in process at the end of month estimated as 50% complete, these will
be equivalent to 2,000 completed units. These equivalent units are added to units completed by
the department to arrive at equivalent production. Then total cost is divided by this equivalent
production figure to calculate unit cost.
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Cost & Management Accounting (MGT-402)
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Calculation of cost per unit
In process costing, costs are averaged over the units produced. The costs accumulated to a process
for a period are collected and divided by the number of units equally produced during the period.
Accounting treatment / apportionment of the accumulated cost
The last section presents a summary to the explaining the accounting treatments of the costs
incurred in the department. This includes
(i)
Adjustment for lost units for normal loss, if any.
(ii)
Cost transferred out.
(iii)
Cost of abnormal loss, if any.
(iv)
Cost of work in process ending inventory and
(v)
Any other accounting adjustment, if necessary to present.
Cost of production report is generally presented to management with supplementary reports of
usage of materials, labor and factory overhead.
Standard format of a simple
Cost of Production Report
I- Quantity Schedule:
Units put into the process
***
Units completed in this process & transferred
to next department.
***
Units not yet completed at the end of the
Period.
***
***
II- Cost Accumulated In The Department / Process:
Direct Material Cost
***
Direct Labor
***
Factory Overhead (Applied)
***
***
III- Calculation of Equivalent Units Produced
100% of completed units + % completed of the in process units
IV- Calculation Of Per Unit Cost
=
Total Cost
.
Equivalent Units Produced
V-
Accounting Treatment
1- Finished goods
2- Closing Work in process
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Cost & Management Accounting (MGT-402)
VU
Problem Questions
Q. 1
Heera Manufacturing Company manufactures a product. Production made and manufacturing
costs incurred in the first department during the month of October .are given below:
10,000 units were started in process out of which 9,400 units were transferred to next department
and remaining 600 units were 1/2 complete as to materials, labor and overhead. Direct materials
Rs. 19,400, direct labor Rs. 24,250 and factory overhead Rs. 14,550 was charged to production.
Required: Cost of production report for the month.
Q. 2
Production and cost data of first production department of Excellent Manufacturing Company for
the month of March 2006 are as follow:
Units started in process were 5,000. Units completed and transferred to second department were
4,500. Remaining units were in process estimated to be 50%, 40%, 60% completed as to materials,
labor and factory overhead respectively. Costs of materials, labor and overhead were Rs. 50,000,
Rs. 60,000 and Rs. 40,000 respectively.
Required: Cost of production report.
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Table of Contents:
  1. COST CLASSIFICATION AND COST BEHAVIOR INTRODUCTION:COST CLASSIFICATION,
  2. IMPORTANT TERMINOLOGIES:Cost Center, Profit Centre, Differential Cost or Incremental cost
  3. FINANCIAL STATEMENTS:Inventory, Direct Material Consumed, Total Factory Cost
  4. FINANCIAL STATEMENTS:Adjustment in the Entire Production, Adjustment in the Income Statement
  5. PROBLEMS IN PREPARATION OF FINANCIAL STATEMENTS:Gross Profit Margin Rate, Net Profit Ratio
  6. MORE ABOUT PREPARATION OF FINANCIAL STATEMENTS:Conversion Cost
  7. MATERIAL:Inventory, Perpetual Inventory System, Weighted Average Method (W.Avg)
  8. CONTROL OVER MATERIAL:Order Level, Maximum Stock Level, Danger Level
  9. ECONOMIC ORDERING QUANTITY:EOQ Graph, PROBLEMS
  10. ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio
  11. LABOR:Direct Labor Cost, Mechanical Methods, MAKING PAYMENTS TO EMPLOYEES
  12. PAYROLL AND INCENTIVES:Systems of Wages, Premium Plans
  13. PIECE RATE BASE PREMIUM PLANS:Suitability of Piece Rate System, GROUP BONUS SYSTEMS
  14. LABOR TURNOVER AND LABOR EFFICIENCY RATIOS & FACTORY OVERHEAD COST
  15. ALLOCATION AND APPORTIONMENT OF FOH COST
  16. FACTORY OVERHEAD COST:Marketing, Research and development
  17. FACTORY OVERHEAD COST:Spending Variance, Capacity/Volume Variance
  18. JOB ORDER COSTING SYSTEM:Direct Materials, Direct Labor, Factory Overhead
  19. PROCESS COSTING SYSTEM:Data Collection, Cost of Completed Output
  20. PROCESS COSTING SYSTEM:Cost of Production Report, Quantity Schedule
  21. PROCESS COSTING SYSTEM:Normal Loss at the End of Process
  22. PROCESS COSTING SYSTEM:PRACTICE QUESTION
  23. PROCESS COSTING SYSTEM:Partially-processed units, Equivalent units
  24. PROCESS COSTING SYSTEM:Weighted average method, Cost of Production Report
  25. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Accounting for joint products
  26. COSTING/VALUATION OF JOINT AND BY PRODUCTS:Problems of common costs
  27. MARGINAL AND ABSORPTION COSTING:Contribution Margin, Marginal cost per unit
  28. MARGINAL AND ABSORPTION COSTING:Contribution and profit
  29. COST VOLUME PROFIT ANALYSIS:Contribution Margin Approach & CVP Analysis
  30. COST VOLUME PROFIT ANALYSIS:Target Contribution Margin
  31. BREAK EVEN ANALYSIS MARGIN OF SAFETY:Margin of Safety (MOS), Using Budget profit
  32. BREAKEVEN ANALYSIS CHARTS AND GRAPHS:Usefulness of charts
  33. WHAT IS A BUDGET?:Budgetary control, Making a Forecast, Preparing budgets
  34. Production & Sales Budget:Rolling budget, Sales budget
  35. Production & Sales Budget:Illustration 1, Production budget
  36. FLEXIBLE BUDGET:Capacity and volume, Theoretical Capacity
  37. FLEXIBLE BUDGET:ANALYSIS OF COST BEHAVIOR, Fixed Expenses
  38. TYPES OF BUDGET:Format of Cash Budget,
  39. Complex Cash Budget & Flexible Budget:Comparing actual with original budget
  40. FLEXIBLE & ZERO BASE BUDGETING:Efficiency Ratio, Performance budgeting
  41. DECISION MAKING IN MANAGEMENT ACCOUNTING:Spare capacity costs, Sunk cost
  42. DECISION MAKING:Size of fund, Income statement
  43. DECISION MAKING:Avoidable Costs, Non-Relevant Variable Costs, Absorbed Overhead
  44. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS
  45. DECISION MAKING CHOICE OF PRODUCT (PRODUCT MIX) DECISIONS:MAKE OR BUY DECISIONS