Process Costing

Process Costing is the cost accounting method in which all production overhead is equally allocated to each product due to their similarity and mass production. The company assumes that each product requires the same overhead cost, and it hard to separate the overhead cost base on actual consumption. Moreover, raw material needs to pass through multiple stages of production before turning into finished goods. And it is very complicated to assign the overhead cost individual unit.  

All production costs will be accumulated and allocate equally to all products by assuming that they are consumed the same resource. Accountants will calculate the total overhead cost of each month and separate them to each finished product at the month-end.

Process costing is suitable for some businesses, which produces only one or similar products, such as a footwear manufacturing company. Besides that, It is also applicable to manufacturing that has many processes, and we cannot identify the cost of each production process.

Feature of Process Costing

  • The production has more than two processes.
  • Raw material goes through many processes, the output of one process will become the input of another process.
  • The output of the last process will become finished goods.
  • The final products are similar and hard to separate from each other.
  • The production cycle will operate continuously.
  • The output may result in a joint product or by-product.
  • The wastage also takes into account while calculating the cost.
  • The unfinished product at the end of the month will be estimated by the percentage of completion, which known as Equivalent units (EU = number of unfinished product x percentage of completion).

Process Costing Example 

Company ABC is manufacturing which specializes in shoe production, they mainly focus on the local market. The production needs to go through multiple processes which they called the department.

First, they start from the Designing and Cutting department where shoes are designed to fit with the trending market, and fabric will be cut to fit with each design. In March 2019, the Design and Cutting department incur the cost of direct material USD 100,000, direct labor cost of USD 150,000 and USD 80,000 of overhead cost. During month, this department has finished 10,000 pairs of shoes and passes them to next stage.

Second, Sewing department where all parts of the shoes are attached. In March 2019, this department has incurred a cost of direct labor USD 50,000, overhead cost USD 30,000.  As a result, they have completed 8,000 pairs of shoes and pass the next stage.

Finally, the Packaging department, the place where shoes are matched by size and put into a retail box. They are ready for delivery to customers. The cost of direct labor in this department during March has only USD 30,000 and they complete the work for 12,000 pairs of shoes.

Calculate the process costing in each department.

  Design and Cutting department

  •     Direct material cost per unit: 100,000 /10,000 units = $ 10 per unit
  •     Direct Labor cost per unit: 150,000/10,000 units = $ 15 per units
  •     Overhead cost per unit: 80,000/10,000 units = $ 8 per unit

  Sewing department

  •     Direct labor per unit: 50,000/8,000 units = $ 6.25 per unit
  •     Overhead cost per unit: 30,000/8,000 units = $ 3.75 per unit

  Packaging department

  •     Direct Labor per unit: 30,000/12,000 units = $ 2.5 per unit

Process Costing

What are the Advantages of Process Costing?

Advantages

Easy to use

Process costing follows a simple and easy calculation method; even non-accountant can understand it easily. Although it goes through many assembly lines as it incurs costs such as direct material, direct labor, and overhead, we can just sum up all costs and divide them by the total output of each process line. For the total product cost, we will sum all costs from all processes. It is just the normal average cost of the product.

Flexible

Management can review each cost of the assembly line and make any change if necessary. Assembly lines can be combined or separated based on actual production and resource management. It is much easy for management to spot the weakness of each process by comparing their cost and output.

Less expensive

Process costing is not required a complicated accounting or IT system to collect data and calculate it. When we obtain enough information, only a simple spreadsheet is enough to complete the work. The company does not need to invest in an expensive accounting system just for product costing.

What are the Disadvantages of Process Costing?

Although process costing has several benefits, it still has some disadvantages as included in the table below:

Disadvantages 

Less accuracy

Process Costing will allocate same overhead cost to all product, which will result in less accurate and it will impact to product cost and selling price as well. As a result, our selling price will be much higher or under the market, it will impact to our profit.

No performance measurement for individual department

It is hard to assess each department’s performance as the cost is calculated by total divided by quantity product. There is no proper KPI (key performance indicator) for each department to follow. They will not be punished or motivated for any error or cost-saving. It is hard to identify the star performers and poor performers.

Difficult for more than one type of product

Process costing is more suitable for a similar product. It will be the problem when it comes to different products type, as the accountant still allocates the same cost to all products. It is not make sense when two different products consume a different level of overhead but have the same cost.

Work in process

For manufacturing with great work in progress, there will be a problem as management needs to estimate the equivalent of finished goods. Any error in estimation will impact the entire cost of inventory in that assembly line. It will lead to over or underproduction cost per unit.