PROCESS COSTING

Structure

1.0 Learning Objectives1.1 Introduction1.2 Meaning of process costing1.3 Distinction between job costing and process costing1.4 Costing Procedure1.6 Valuation of Work-in-progress

LEARNING OBJECTIVES

After studying this chapter you should able to understand• the meaning of Process Costing and its importance• the distinction between job costing and process costing• the accounting procedure of process costing including normalloss abnormal loss (or) gain• the valuation of work-in-progress, using FIFO, LIFO averageand weighted average methods• the steps involved in inter process transfer

INTRODUCTION:

Process costing is a form of operations costing which is usedwhere standardized homogeneous goods are produced. Thiscosting method is used in industries like chemicals, textiles, steel,rubber, sugar, shoes, petrol etc. Process costing is also used in theassembly type of industries also. It is assumed in process costingthat the average cost presents the cost per unit. Cost of productionduring a particular period is divided by the number of unitsproduced during that period to arrive at the cost per unit.

MEANING OF PROCESS COSTINGProcess costing is a method of costing under which all costsare accumulated for each stage of production or process, and the2cost per unit of product is ascertained at each stage of productionby dividing the cost of each process by the normal output of thatprocess.

Definition:CIMA London defines process costing as “that form ofoperation costing which applies where standardize goods areproduced”

Features of Process Costing:(a) The production is continuous(b) The product is homogeneous(c) The process is standardized(d) Output of one process become raw material of another process(e) The output of the last process is transferred to finished stock(f) Costs are collected process-wise(g) Both direct and indirect costs are accumulated in each process(h) If there is a stock of semi-finished goods, it is expressed interms of equalent units(i) The total cost of each process is divided by the normal output ofthat process to find out cost per unit of that process.

Advantages of process costing:1. Costs are be computed periodically at the end of a particularperiod2. It is simple and involves less clerical work that job costing3. It is easy to allocate the expenses to processes in order to haveaccurate costs.4. Use of standard costing systems in very effective in processcosting situations.5. Process costing helps in preparation of tender, quotations6. Since cost data is available for each process, operation anddepartment, good managerial control is possible.

Limitations:1. Cost obtained at each process is only historical cost and are notvery useful for effective control.2. Process costing is based on average cost method, which is notthat suitable for performance analysis, evaluation andmanagerial control.3. Work-in-progress is generally done on estimated basis whichleads to inaccuracy in total cost calculations.4. The computation of average cost is more difficult in those cases

where more than one type of products is manufactured and adivision of the cost element is necessary.5. Where different products arise in the same process andcommon costs are prorated to various costs units. Suchindividual products costs may be taken as only approximationand hence not reliable.3

DISTINCTION BETWEEN JOB COSTING ANDPROCESS COSTINGJob order costing and process costing are two differentsystems. Both the systems are used for cost calculation andattachment of cost to each unit completed, but both the systemsare suitable in different situations. The basic difference between jobcosting and process costing areBasis ofDistinctionJob order costing Process costing1. Specific order Performed againstspecific ordersProduction iscontentious2. Nature Each job many bedifferent.Product ishomogeneous andstandardized.3. Cost determination Cost is determined for

each job separately.Costs are complied foreach process fordepartment on timebasis i.e. for a givenaccounting period.4. Cost calculations Cost is complied whena job is completed.Cost is calculated atthe end of the costperiod.5. Control Proper control iscomparatively difficultas each product unit isdifferent and theproduction is notcontinuous.Proper control iscomparatively easieras the production isstandardized and ismore suitable.6. Transfer There is usually nottransfer from one jobto another unlessthere is some surpluswork.The output of oneprocess is transferredto another process asinput.7. Work-in-Progress There may or may notbe work-in-progress.There is always some

work-in-progressbecause of continuousproduction.8. Suitability Suitable to industrieswhere production isintermittent andcustomer orders canbe identified in thevalue of production.Suitable, where goodsare made for stock andproductions iscontinuous.

COSTING PROCEDURE

For each process an individual process account is prepared.Each process of production is treated as a distinct cost centre.

1 Items on the Debit side of Process A/c.Each process account is debited with –a) Cost of materials used in that process.b) Cost of labour incurred in that process.c) Direct expenses incurred in that process.d) Overheads charged to that process on some pre determined.e) Cost of ratification of normal defectives.f) Cost of abnormal gain (if any arises in that process)

2 Items on the Credit side:Each process account is credited witha) Scrap value of Normal Loss (if any) occurs in that process.b) Cost of Abnormal Loss (if any occurs in that process)

3 Cost of Process:The cost of the output of the process (Total Cost less Sales valueof scrap) is transferred to the next process. The cost of eachprocess is thus made up to cost brought forward from the previousprocess and net cost of material, labour and overhead added in thatprocess after reducing the sales value of scrap. The net cost of thefinished process is transferred to the finished goods account. Thenet cost is divided by the number of units produced to determinethe average cost per unit in that process. Specimen of ProcessAccount when there are normal loss and abnormal losses.

Dr. Process I A/c. Cr.

Particulars Units Rs. Particulars Units Rs.To Basic Material xxx xx By Normal Loss xx xx

To Direct Material xx By Abnormal Loss xx xxTo Direct Wages xx By Process II A/c. xx xxTo Direct Expenses xx (output transferred toTo Production Overheads xx Next process)ToCost ofRectification ofNormal Defects xx By Process I Stock A/c. xx xxTo Abnormal Gains xx xxx xx xx

4 Process Losses:

In many process, some loss is inevitable. Certain productiontechniques are of such a nature that some loss is inherent to theproduction. Wastages of material, evaporation of material is unavoidable in some process. But sometimes the Losses are alsooccurring due to negligence of Labourer, poor quality raw material,

poor technology etc. These are normally called as avoidablelosses. Basically process losses are classified into two categories(a) Normal Loss (b) Abnormal Loss

1. Normal Loss:Normal loss is an unavoidable loss which occurs due to theinherent nature of the materials and production process undernormal conditions. It is normally estimated on the basis of pastexperience of the industry. It may be in the form of normal wastage,normal scrap, normal spoilage, and normal defectiveness. It mayoccur at any time of the process.No of units of normal loss: Input x Expected percentage ofNormal Loss.The cost of normal loss is a process. If the normal loss unitscan be sold as a crap then the sale value is credited with processaccount. If some rectification is required before the sale of thenormal loss, then debit that cost in the process account. Afteradjusting the normal loss the cost per unit is calculates with thehelp of the following formula:Cost of good unit:Total cost increased – Sale Value of ScrapInput – Normal Loss units

2. Abnormal Loss:Any loss caused by unexpected abnormal conditions suchas plant breakdown, substandard material, carelessness, accidentetc. such losses are in excess of pre-determined normal losses.This loss is basically avoidable. Thus abnormal losses arrive whenactual losses are more than expected losses. The units of abnormallosses in calculated as under:Abnormal Losses = Actual Loss – Normal LossThe value of abnormal loss is done with the help of followingformula:

Value of Abnormal Loss:Total Cost increase – Scrap Value of normal Loss x Units of abnormal lossInput units – Normal Loss Units

Abnormal Process loss should not be allowed to affect thecost of production as it is caused by abnormal (or) unexpectedconditions. Such loss representing the cost of materials, labour andoverhead charges called abnormal loss account. The sales value ofthe abnormal loss is credited to Abnormal Loss Account and thebalance is written off to costing P & L A/c.

Dr. Abnormal Loss A/c. Cr.

Particulars Units Rs. Particulars Units Rs.To Process A/c. xx xx By Bank xx xx By Costing P & L A/c. xx xx xx xx xx xx

3. Abnormal Gains:

The margin allowed for normal loss is an estimate (i.e. onthe basis of expectation in process industries in normal conditions)and slight differences are bound to occur between the actual outputof a process and that anticipates. This difference may be positive ornegative. If it is negative it is called ad abnormal Loss and if it ispositive it is Abnormal gain i.e. if the actual loss is less than thenormal loss then it is called as abnormal gain. The value of theabnormal gain calculated in the similar manner of abnormal loss.The formula used for abnormal gain is:

Abnormal Gain Total Cost incurred – Scrap Value of Normal Loss x Abnormal Gain UnitesInput units – Normal Loss UnitsThe sales values of abnormal gain units are transferred toNormal Loss Account since it arrive out of the savings of NormalLoss. The difference is transferred to Costing P & L A/c. as a RealGain.

Dr. Abnormal Gain A/c. Cr.

Particulars Units Rs. Particulars Units Rs.

To Normal LossA/c. xx xx By Process A/c. xx xxTo Costing P & L xx xxA/c. Xx xx xx xx

INTER PROCESS PROFITS:

Normally the output of one process is transferred to anotherprocess at cost but sometimes at a price showing a profit to thetransfer process. The transfer price may be made at a pricecorresponding to current wholesale market price or at cost plus anagreed percentage. The advantage of the method is to find out

whether the particular process is making profit (or) loss. This willhelp the management whether to process the product or to buy theproduct from the market. If the transfer price is higher than the costprice then the process account will show a profit. The complexitybrought into the accounting arises from the fact that the interprocess profits introduced remain a part of the prices of process

stocks, finished stocks and work-in-progress. The balance cannotshow the stock with profit. To avoid the complication a provisionmust be created to reduce the stock at actual cost prices. Thisproblem arises only in respect of stock on hand at the end of theperiod because goods sold must have realized the internal profits.The unrealized profit in the closing stock is eliminated by creating a stock reserve. The amount of stock reserve is calculated by thefollowing formula.

Stock Reserve = Transfer Value of stock x Profit included in transfer priceTransfer PriceVALUATION OF WORK-IN-PROGRESS

1 Meaning of Work-in-Progress:

Since production is a continuous activity, there may be some incomplete production at the end of an accounting period.Incomplete units mean those units on which percentage ofcompletion with regular to all elements of cost (i.e. material, labourand overhead) is not 100%. Such incomplete production units areknown as Work-in-Progress. Such Work-in-Progress is valued interms of equivalent or effective production units.

2 Meaning of equivalent production units : This represents the production of a process in terms of complete units. In other words, it means converting the incompleteproduction into its equivalent of complete units. The term equivalentunit means a notional quantity of completed units substituted for anactual quantity of incomplete physical units in progress, when theaggregate work content of the incomplete units is deemed to beequivalent to that of the substituted quantity. The principle applieswhen operation costs are apportioned between work in progressand completed units. Equivalent units of work in progress = Actual no. of units in progress xPercentage of work completedEquivalent unit should be calculated separately for each element of cost (viz. material, labour and overheads) because the percentage of completion of the different cost component may be different.3 Accounting Procedure:

The following procedure is followed when there is Work-in- Progress(1) Find out equivalent production after taking into account ofthe process losses, degree of completion of opening and / or

closing stock.(2) Find out net process cost according to elements of costs i.e.material, labour and overheads.(3) Ascertain cost per unit of equivalent production of eachelement of cost separately by dividing each element of costsby respective equivalent production units.(4) Evaluate the cost of output finished and transferred work inprogressThe total cost per unit of equivalent units will be equal to thetotal cost divided by effective units and cost of work-inprogresswill be equal to the equivalent units of work-inprogressmultiply by the cost per unit of effective production.In short the following from steps an involved.Step 1 – prepare statement of Equivalent productionStep 2 – Prepare statement of cost per Equivalent unitStep 3 – Prepare of EvaluationStep 4 – Prepare process accountThe problem on equivalent production may be divided into fourgroups.I. when there is only closing work-in-progress but withoutprocess lossesII. when there is only closing work-in-progress but withprocess lossesIII. when there is only opening as well as closing work-inprogresswithout process losses

IV. when there is opening as well as closing work-inprogresswith process losses Situation I : Only closing work-in-progress without process losses :In this case, the existence of process loss is ignored. Closingwork-in-progress is converted into equivalent units on the basis ofestimates on degree of completion of materials, labour andproduction overhead. Afterwards, the cost pr equivalent unit iscalculated and the same is used to value the finished outputtransferred and the closing work-in-progress

Situation II: When there is closing work-in-progress with process loss orgain.If there are process losses the treatment is same as alreadydiscussed in this chapter. In case of normal loss nothing should beadded to equivalent production. If abnormal loss is there, it shouldbe considered as good units completed during the period. If unitsscrapped (normal loss) have any reliable value, the amount should

be deducted from the cost of materials in the cost statement beforedividing by equivalent production units. Abnormal gain will bededucted to obtain equivalent production.

Situation III: Opening and closing work-in-progress without processlosses.Since the production is a continuous activity there ispossibility of opening as well as closing work-in-progress. Theprocedure of conversion of opening work-in-progress will varydepending on the method of apportionment of cost followed viz,FIFO, Average cost Method and LIFO.Let us discuss the methods of valuation of work-in-progress one byone.

(a) FIFO Method: The FIFO method of costing is based on the

assumption of that the opening work-in-progress units arethe first to be completed. Equivalent production of openingwork-in-progress can be calculated as follows:Equivalent Production = Units of Opening WIP x Percentage of workneeded to finishthe units

(b) Average Cost Method: This method is useful when pricefluctuate from period to period. The closing valuation ofwork-in-progress in the old period is added to the cost ofnew period and an average rate obtained. In calculating theequivalent production opening units will not be shownseparately as units of work-in-progress but included in theunits completed and transferred.

(c) Weighted Average Cost Method: In this method no distinction is made between completed units from opening inventory and completed units from new production. All units finished during the current accounting period are treated as if they were started and finished during that period. The weighted average cost per unit is determined by dividing the total cost (opening work-in-progress cost + current cost) by equivalent production.

(d) LIFO Method: In LIFO method the assumption is that theunits entering into the process is the last one first to becompleted. The cost of opening work-in-progress is chargedto the closing work-in-progress and thus the closing work-inprogressappears cost of opening work-in-progress. Thecompleted units are at their current cost.

Methods of Costing and Types of Costing

Methods of Costing

As per the nature and peculiarities of the business, different Industries follow different methods to find out the cost of their product. There are different principles and procedure for doing the costing. However the basic principle and procedure of costingremain the same. Some of the methods are mentioned

below:

1. Unit Costing2. Job Costing3. Contract Costing4. Batch Costing5. Operating Costing6. Process Costing.7. Multiple Costing8. Uniform Costing.

Different Methods of Costing

Unit Costing:

 This method also called 'Single output Costing'. This method of costing is used for products which can be expressed in identical quantitative units and is suitable for products which are manufactured by continuous manufacturingactivity. Costs are ascertained for convenient units of output. Examples: Brick making, mining, cement manufacturing, dairy, flour mills etc.

Job Costing:

 Under this method costs are ascertained for each work order separately as each job has its own specifications and scope. Examples: Painting, Car repair, Decoration, Repair of building etc. 

Contract Costing: 

Under this method costing is done for big jobs which involves heavy expenditure and stretches over a long period and often it is undertaken at different sites. Each contract is treated as a separate unit for costing. This is also known as Terminal Costing. Construction of bridges, roads, buildings, etc. comes under contract costing. 

Batch Costing:

 This methods of costing is used where the units produced in a batch are uniform in nature and design. For the purpose of costing each batch is treated as a job or separate unit. Industries like Bakery, Pharmaceuticals etc. usually use batch costing method.

Operating Costing or Service Costing: 

Where the cost of operating a service such as nursing home, Bus, railway or chartered bus etc. this method of costing is used to ascertain the cost of such particular service. Each particular service is treated as separate units in operating costing. In the case of a Nursing Home, a unit is treated as the cost of a bed per day and for buses operating cost for a kilometer is treated as a unit.

Process Costing: 

This kind of costing is used for the products which go through different processes. For example, manufacturing cloths goes through different process. Fist process is spinning. The out put of spinning is yarn. It is a finished product which can be sold in the market to the weavers as well as use as

a raw material for weaving in the same manufacturing unit. For the purpose of finding out the cost of yarn, the cost of spinning process is to be ascertained. The second step is the weaving process. The out put of weaving process is cloth which also can be sold as a finished product in the market. In such case, the cost of cloth needs to be evaluated. The third process is converting cloth in to finished product such as shirt or trouser etc. Each process is to be evaluated separately as the out put of each process can be treated as a finished good as well as consumed as a raw material for the next process. In such industries process costing is used to ascertaining the cost at each stage of production.

Multiple Costing: 

When the output comprises many assembled parts or components such as in television, motor Car or electronics gadgets, costs have to be ascertained or each component as well as the finished product. Such costing may involve different methods of costing for different components. Therefore this type of costing is known as composite costing or multiple costing.

Uniform Costing: This is not a separate method of costing. This is a system of using the same method of costing by a number of firms in the same industry. It is treated as a common system of using agreed principles and standard accounting practices in the identical firms or industry. This helps in fixation of price of the product and inter-firm comparisons.

Types of Costing

There are different types or techniques of costings are used in cost accounting. Different types of costing is used in different industries to analyze and presenting costs for the purposes of control and managerial decisions. The generally used types of costing are as follows:

Marginal Costing: 

In Marginal Costing, it allocates only variable costs i.e. direct materials, direct labour and other direct expenses and variable overheads to the production. It does not take into account the fixed cost of production. This type of costing emphasizes the distinction between fixed and variable costs.

Absorption Costing: 

The technique of absorbing fixed and variable costs to production is called absorption costing. Under absorption costing full costs, i.e. fixed and variable costs are absorbed to the production.

Standard Costing: 

When costs are determined in advance on certain predetermined standards under a given set of operating conditions, it is called standard costing. Standard costing is to be compared with the actual costs periodically to analyze the changes in the cost to revise the standards to avoid any loss due to outdated costing.

Historical costing:

 When costs are determined in terms of actual costs and not in terms of predetermined standards cost is called Historical costing. In this system of cost accounting, costs are determined only after they have been incurred. Almost all organizations use historical costing system of accounting for costs.

Reconciliation of Cost and Financial Accounts

Cost accounts act as a check on financial accounts. To achieve this, we have to compare the profit/loss ascertained under the cost accounts with the profit/loss arrived under financial accounts. By preparing a reconciliation statement, we can find out the causes of difference in cost accounting and financial accounts.

Double entry system of account is being used by large manufacturing firms and they adopt one of the following two methods:

1. Integral or integrated Accounting: 

When cost and financial transactions are unified, it is called the integral/integrated accounting. In integral or integrated accounting Cost and financial transactions are not kept separate, they are together recorded in one set of books of account.

2. Non-integral or Independent Accounting. 

When the cost and financial transactions are kept separate, the method followed is called "non-integral or Independent Accounting". A separate set of books are maintained under this system.

Need of reconciliation of cost and financial accounts arises only when non-integral accounting method is followed.

Integral Accounting: 

means the maintenance of cost and financial accounts in a single set of books. In other words the merger of financial and cost accounting by using a single set of books of accounts. This serve the purpose of both financial account and cost account. A cost ledger and three subsidiary ledgers i.e. Stores Ledger, Work-in-progress Ledger and Finished Stock Ledger are also maintained in addition to the General Ledger, Sales Bought Ledger and Sales Ledger.

Cost Ledger:

It contains all the nominal accounts and known as principal ledger in cost accounting. Please note when the non-integral account is followed, cost ledger contains control account for each subsidiary ledger. Example: Work-in-progress Ledger Control Account, Finished Stock Ledger Control Account, Stores Ledger Control Account etc. It is also be noted that when the integral account method is followed these control accounts are maintained in the General Ledger.

Work-in-progress ledger:

It is a subsidiary ledger which contains an account for each process, job or operation which is pending on the shop floor. The cost of materials, overheads and labour is debited and the cost of goods transferred to Finished Stock Ledger is credited to the account as and when they are completed.

Finished Stock Ledger:

It is a subsidiary ledger which contains an account for each item of job completed or finished product manufactured. Each such completed job or product account is debited with the cost of production and credited with the cost of goods transferred to Cost of Sales Account.

Stores Ledger:

It is a subsidiary ledger where in all the items of stores and its movements are recorded. Purchase of materials debited to this account and issue of materials to jobs credited to this account.

Under this method, no costing profit and loss account is prepared since only one set of account is maintained. Therefore, There is no need for reconciliation of costing and financial profit or loss.

Non-integral Accounting

The subsidiary ledgers and the cost ledger are inter-locked through control accounts maintained in each ledger when independent cost accounts are maintained. This is practice (maintaining Control Accounts) is followed for the purpose of

cross checking the accuracy of ledgers and also make each ledger self balance so that a separate trial balance may be prepared for each ledger without reference to the other ledgers. A general ledger Adjustment Account is opened in the cost ledger for all items of income and expenditure besides the control accounts. It is also known as "Cost Ledger Control Account". The cost ledger also contains control accounts such as Production Overheads Control Account, Wages Control Account, Administrative Overheads Control Account, Selling and Distribution Overheads Control Account etc. The double entry is completed through control accounts in the Non-integral accounting system. Therefore, it is also known as "Control Accounts System".

Costing Profit and Loss Account:

A separate Costing Profit and Loss Account is prepared for determining the profit or loss of a particular period when cost accounts are maintained independent of financial accounts. This account is debited with the cost of sales and credited with the sales value. It is also debited with items like abnormal losses, under-absorption of overheads, loss or sale of special jobs etc., and credited with items like abnormal gains, over-absorption of overheads, profit on sale of special jobs, etc. The balance of this account will indicate the profit or loss as per cost records which should be reconciled with the profit or loss as per financial records.

Need for reconciliation of Cost and Financial Accounts.

When financial and cost accounts are maintained independently many a times the profit or loss disclosed by the two sets of books

may differ from each other. This difference in profit/loss necessitates the preparation of a reconciliation statement. This statement will show the reason for the difference in figures in the two accounts i.e. cost account and financial account. It not only helps in checking the arithmetical accuracy of operating results shown by the financial accounts but also establish the accuracy of cost accounts.

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