Strategic Cost Management

ACCT 90009

Process Costing
Lecture 5

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 Learning Objectives (Bhimani et al, ch 5)
• Identify the conditions in which process costing systems are appropriate.

• Calculate inventory values using Weighted Average (WA) process costing.

o Calculate and use equivalent units using Weighted Average process costing.

o Illustrate how different inventory valuing methods (WA and FIFO) affect inventory value.

• Describe Hybrid costing systems and recognize when hybrid costing is appropriate.

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Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Ch 5.
 Study Tasks

Textbook
Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson.

• Read chapters 4.
• Do review questions 4.1, 4.2, 4.4, 4.5, 4.6
• Do exercises 4.11, 4.13, 4.20, 4.24.
Note: Exercise 4.24 can be solved independently but the description of 4.22 can facilitate understanding of 4.24.

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 Job Costing v’s Process Costing

Job Process
Costing In a job costing system, costs
are assigned to a distinct unit,
Costing
batch or lot of a product or In a process costing system,
service. the cost object is masses of
identical or similar units.
A job is a task for which
resources are expended in The cost of a product or
bringing a distinct product or service is obtained by using
service to market. The product broad averages to assign
or service is often custom- costs to masses of identical or
made, such as an audit by an similar units. All customers
accounting firm or a gearbox receive the same product
system for a particular car.

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Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Ch 3, p56.
 Job Costing v’s Process Costing
Cost Flow

Direct Material Work-in-progress

Direct Labour Finished Cost of goods
Job 1 Goods cold
Manufacturing Job 2
Overhead Job 3

Direct Material
Work-in-process Work-in-process
Finished Cost of goods
Direct Labour
Goods cold
Process A Process B
Manufacturing
Overhead

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 Examples of manufacturing processes

How Pencils Are Made – YouTube (3 minutes)

WOODEN MATCHES | How It's Made – YouTube (5 minutes)

 Conversion costs
• Often ‘process’ environments in manufacturing are characterised by technology and automation, with
little labour content
• In these circumstances labour is often not traced to processes/products separately. It is included with
overhead and called “conversion” costs
• Thus typically two cost categories in process costing:
o Direct materials
o Conversion costs – all manufacturing costs other than direct materials.

Direct material

Direct labour
Conversion
Manufacturing overhead costs
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Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Ch 2, p42.
 Process costing
• In a job costing system, individual jobs use different quantities of production resources.
Some resources are traced directly to the job (direct costs)
Some resources are averaged across jobs (manufacturing overheads)
• In a process costing system, the unit cost of a product or service is obtained by assigning total costs to
many similar units.
Costs are accumulated at a process level and averaged over all units that go through that process
• The principal difference between process costing and job costing is the extent of averaging used to
compute unit costs of products or services.

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 Process costing (cont.)
• In a job costing system, individual jobs use different quantities of production resources.
Some resources are traced directly to the job (direct costs)
Some resources are averaged across jobs (manufacturing overheads)
• In a process costing system, the unit cost of a product or service is obtained by assigning total costs to
many similar units.
Costs are accumulated at a process level and averaged over all units that go through that process
• The principal difference between process costing and job costing is the extent of averaging used to
compute unit costs of products or services.

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 Equivalent units
In general, inventory is valued at the cost of producing the inventory – material costs plus conversion cost.
In process costing, the concept of equivalent units is used to value work-in-progress.

“When partially completed physical units exist at the beginning or at the end
of an accounting period, they need to be converted to equivalent units. The
term equivalent units refers to the amount of production inputs that have
been applied to the physical units in production.”
Langfield-Smith, Thorne, Smith, Hilton (2015) Management Accounting. Seventh Edition. Pearson. Ch 5, p 175.

𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛𝑝𝑢𝑡𝑠 𝑎𝑝𝑝𝑙𝑖𝑒𝑑 𝑡𝑜 𝑡ℎ𝑒 𝑢𝑛𝑖𝑡𝑠

𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 as a percentage of
= ×
𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑢𝑛𝑖𝑡𝑠 𝑝ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 amount of inputs required to produce
the same number of complete units
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 Illustration – equivalent units
The cost of production inputs required to produce one complete unit of product is $200.
Physical units Production inputs applied Equivalent units
(direct material plus conversion costs)
$
200 16,000 40%
80
250 30,000 60%
150 Work-in-progress
150 27,000 90%
135
50 10,000 100%
50 Finished goods
415
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 Process costing steps

Analysis of Calculation of
Computation Analysis of
flow of equivalent
of unit costs total costs
physical units units

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 Illustration – Process Costing – Snowden Ltd
Snowden Ltd manufactures skiing accessories.

Physical units
Opening WIP 0
Units started during period 35,000
Units completed during period 30,000
Closing WIP 5,000
100% complete with respect to direct materials
20% complete with respect to conversion
Direct material added at the beginning of the process. 13
 Process costing steps
Step 1 Summarise the flow of physical units.
Step 2 Compute outputs in terms of equivalent units.
Step 3 Compute equivalent unit costs.
Step 4 Summarise total cost that need to be accounted for.
Step 5 Assign these costs to units completed and to units in work-in-progress.

Cost per unit may differ from period to period.

Opening value of WIP is based on the inventory valuation method used such
as ‘weighted average’ method or ‘First-in-first-out’ (FIFO) method, etc.

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Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Ch 4.
Illustration – Process Costing – Snowden Ltd
Step 1 - Summarise the flow of physical units.

Physical
Units
Opening WIP 0
Units started during period 35,00
Units to account for 35,000

Units completed and transferred our during the period 30,000

Closing WIP (100% wrt material; 20% wrt conversion) 5
Units to account for 35,000
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Illustration – Process Costing – Snowden Ltd
Step 2 - Compute outputs in terms of equivalent units.

Equivalent Units
Materials Conversion
Units completed and transferred out 30,000 30,000
Closing WIP (100%) (20%)
5,000 1000
Units to account for 35,000 31,000

Costs of production will be averaged over the work done in the current period!

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 Illustration – Process Costing – Snowden Ltd
Step 3 - Compute equivalent unit costs.

Calculate the direct material and conversion costs per equivalent unit for the reporting period.
Total cost of material for the period is $84,050. Total conversion costs for the period are $62,000.
Inventory is measured using the weighted average method

𝑐𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛
= =
𝑝𝑒𝑟 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑢𝑛𝑖𝑡 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑢𝑛𝑖𝑡𝑠 𝑤𝑟𝑡 𝑡𝑜 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙 𝑝𝑒𝑟 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑢𝑛𝑖𝑡 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑢𝑛𝑖𝑡𝑠 𝑤𝑟𝑡 𝑡𝑜 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛

Direct material Conversion

Costs added during period ($) 84,050 62,000
Number of equivalent units added 35,000 31,000
Cost ($ per equivalent units) 2.4014 2.0000
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Illustration – Process Costing – Snowden Ltd
Steps 4 - Summarise total cost that need to be
accounted for

Manufacturing costs incurred in the period $

Cost of material 84,050
Conversion costs 62,000
Total cost to be accounted for 146,050
Illustration – Process Costing – Snowden Ltd
Steps 5 - Assign these costs to units completed and to
units in work-in-progress.

Equivalent $ per $ $
units equivalent unit
Units completed and transferred out 30,000 4.4014 132,042
Work-in-progress (no opening WIP)
Direct material 5,000 2.4015 12,008
Conversion 1,000 2.0000 2,000
Total work-in-progress 14,008
146,050
 What happens when beginning WIP exists?

• There are a range of inventory valuation methods in common use: weighted average method, First-In-
First-Out (FIFO) method; Last-in-first-out (LIFO) method, etc.

• Different methods will produce different number for cost of units completed and for work-in-
progress.

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 Weighted Average Method for Process Costing

The weighted average process costing method calculates the average equivalent unit cost of the work
done to date, regardless of the period in which it was done.

• It assigns this cost to equivalent units completed and transferred out, and to equivalent units
in closing work in progress stock.
• The weighted average cost is the total of all costs entering the work in progress account,
divided by total equivalent units of work done to date (regardless of whether units are from
opening work in progress or from work started during the period).
• There is no distinction between work done in the prior periods and work done in the current
period.
• The weighted average method blends together units and costs from the prior period and the
current period.

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 First In, First Out (FIFO) Method for Process
Costing
The FIFO method of Process Costing distinguishes the cost of opening WIP from cost added in the current
period.
• It assigns the cost of the prior accounting period’s equivalent units in opening work-in-progress to
the first units completed and transferred out.
• It assigns the cost of equivalent units worked on during the current period separately and in
sequence –
first to complete opening inventory;
then
to start and complete new units;
and finally
to units in closing work in progress.

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 Illustration – Process Costing
Snowden Ltd with opening WIP & weighted average method.

Weighted average method

Snowden Ltd – Assembly Department

• Opening WIP in the Assembly Process is 1,000 units.
– 100% complete with respect to materials (assume cost from last period $2,350)
– 60% complete with respect to conversion (assume cost from last period $5,200).
• Closing WIP in Assembly Department is 5,000 units.
– 100% complete with respect to materials; and
– 20% complete with respect to conversion.

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 Illustration – Process Costing
Snowden Ltd with opening WIP & weighted average method.

Step 1: Flow of Physical units

Beginning of period Physical units End of period Physical units

Opening WIP 1,000 Units transferred out 31,000
Units started 35,000 Closing WIP 5,000
Units to account for 36,000 Units to account for 36,000

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 Illustration – Process Costing
Snowden Ltd with opening WIP & weighted average method.

Step 2: Compute equivalent units using weighted average method

Partially completed units are converted into equivalent units.
Closing stock is only 20% complete wrt conversion which equals 1,000 equivalent units (5,000 × 20%).

Equivaelnt Units
Materials Conversion
Units completed and transferred out 31,000 31,000
Closing WIP (100%) (20%)
5,000 1000
Units to account for 36,000 32,000

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 Illustration – Process Costing
Snowden Ltd with opening WIP & weighted average method.

Step 3: Compute equivalent unit costs.

Step 4: Summarise total cost that need to be accounted for.

Materials Conversion Total

Opening WIP ($) - assembly 2,350 5,200 7,550
Total cost incurred this period ($) 84,050 62,000 146,050
$86,400 $32,000 153,600
Closing WIP (equivalent units) 36,000 32,000
Cost per equivalent unit ($) $2.40 $2.10 $4.50
 Illustration – Process Costing
Snowden Ltd with opening WIP & weighted average method.

Step 5: Assign these costs to units completed and to units in work-in-progress.

Assembly Department Equivalent $ per $ $

units equivalent unit
Units completed and transferred out 31,000 4.50 139,500
Closing WIP
Direct material 5,000 2.40 12,000
Conversion 1,000 2.10 2,100
Total closing WIP 14,100
153,600
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 Process Costing System: Complexity
Note that the overhead applied to production could be at a pre determined rate ( i.e. normal costing), thus
giving rise to over or under applied overhead − Same treatment as we used in job costing

Process costing can be more complex

• We can recognize more cost categories
For example, we might recognize individual components of
conversion costs rather than ‘lumping’ them all together
• A process costing system may have many processes in the
production sequence
For example: Snowdon Ltd has two processes assembly and
finishing. We only considered the assembly process. We need
would follow the same procedure for the finishing process
• There are different inventory valuation methods.
The ‘form’ of the analysis stays the same it is just expanded.
Production
sequences can be
more complex

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 Cost flow from one production process to the next
in T –account form

Process A Process B

Direct material Transfer to Direct material Transfer to

Direct labour Process B Direct labour next process
Applied overhead Applied overhead

Transfer from Transfer from

previous process process A

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 Flow of production costs through several
processes in the production sequence.
Production costs are carried forward from production process to production process. The production costs
flow with the production units.
• Transferred-in costs (also called previous department costs) are the costs incurred in a previous
department that are carried forward as the product’s cost when it moves to a subsequent process in the
production cycle.
• Transferred-in costs are treated as if they are a separate type of direct material added at the opening of
the process under the weighted average method.
• Materials, labour and overheads costs could be incurred at different stages in the production sequence.
• Thus, at Snowdon calculation of the Finishing department costs would consist of transferred in costs
(from Assembly) as well as the direct materials (if any) and conversion costs added in Finishing process.

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 The costing system continuum
In some cases it may be useful to blend both job costing and process costing in one hybrid costing system.

Job costing Process costing

Hybrid Costing Systems
system system

The need for a hybrid costing system may arise in manufacturing firms and in service firms.

Hybrid costing systems are useful where there are features of both customised production and mass-
production. For example, firms that manufacture customised products consisting of a range of customised
options - “Mass customisation”.
A example of mass customisation is Renault, the French car manufacturer. Cars may be assembled in a
continuous flow, but individual units may include customised options such as engine-size, gear box, audio
systems, sun roof, or leather seats.
Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Ch 4, p 111.
 Illustration – Levi Straus
In the late 1990s to mid 2000s, Levi Strauss, the inventor of blue jeans over a century ago, offered
individually customised jeans (“Original Spin”). It was able to produce this level of customisation through
computer controlled technology.
The demand stemmed mainly from women - complexity in sizing of jeans - waist size, length, hip size, etc.
The process worked as follows:
• Customer selects fabric.
• Salesperson takes customer’s measurements and enters them into the computer system.
• Data is sent over the internet to the company’s factory in Texas.
• A robot cuts out the needed pieces of fabric.
• An employee sews the pieces together.
• Custom fit jeans cost only about US$10 more than Levi’s jeans bought off the shelf.

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Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Ch 4, p 106.
 Illustration – Levi Straus (cont.)
How did Levi Strauss track the cost of Original Spin jeans? Hybrid costing!
• Job costing
– Fabric
– Pattern layout (size parameters)
• Process costing:
– Conversion costs (cutting, sewing)
– Cost of cutting and sewing is the same regardless of the fabric and shape
– Conversion costs of making each pair of jeans calculated by accumulating all conversion costs in
both operating departments and dividing by the number of jeans made.

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Bhimani, Horngren, Datar, Tajan (2019) Management and Cost Accounting. Seventh Edition. Pearson. Ch 4, p 106.
Service firm
archetypes
 Service Firm Archetypes and Costing
Systems
The appropriate costing
system for a service firm
depends on the nature of
the service and the work-
flow.
Service firms do not
recognise inventory on their
balance sheet.
IAS 2 Inventories does not
apply.

Many professional service firms bill based an hourly rates.

Job costing is used to track and manage WIP and for Telecommunication, utilities,
billing purposes. parking stations, etc.
 Workshop

• Read the case narrative.

• Do the workshop tasks before the Better Way is best known for its
KLN water bottle, which is a BPA-
seminar. free,
dishwasher-safe, bubbly glass
• Make sure you take good notes. bottle in a soft silicone sleeve.
• Be prepared to participate in class-
discussion during the seminar.
• Attend the seminar. Ask questions.
Listen and respond to other people’s
views, try to resolve any difficulties.
• Revisit your work after the seminar.
Reflect and not improvements.
• Outline your insights in writing.
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The End