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CHAPTER 4 PROCESS COSTING AND HYBRID PRODUCT COSTING SYSTEMS

Process costing is used in repetitive production environments, where large numbers of identical or very similar products are manufactured in a continuous flow. At the end of the an accounting period, the partially completed goods that remain in process generally are at different stages of completion with respect to direct materials and conversion activity (i.e., DL and MOH). Therefore, we need to calculate how much conversion activity has been applied to these partially completed units. We compute the equivalent units to determine it. 1. KEY CONCEPT: EQUIVALENT UNITS (1) Equivalent units (EU): the equivalent, in terms of completed units, of partially completed units. (EU are the number of completed units one could obtain from the materials and effort contained in partially completed units.) (2) Example a) Suppose there are 1,000 in-process physical units, which are 75% completed with respect to conversion. Then; Equivalent units of conversion activity = 1,000 75% = 750 EU b) Now, suppose DMs are incorporated at the beginning of the production process. Then; Equivalent units of DM = 1000 100% = 1,000 EU (3) The most important characteristic of process costing is that the costs of DM and conversion are assigned to equivalent units rather than to physical units. 2. PROCESS COSTING (1) The key document: Department production report (2) Three steps of preparing a departmental production report: (Step 1) Analysis of physical flow of units (Step 2) Calculation of equivalent units (for material and conversion activity). (Step 3) Computation of total and unit costs (i.e., the cost per equivalent unit for DM and conversion). (Step 4) Analysis of total costs (Determine the cost to be removed from WIP and transferred either to the next production department or to FG). (3) Weighted-average (WA) method (Step 1) Physical Flow (Physical units in beginning WIP) + (Physical units started in this period) - (Physical units completed and transferred out) = Physical units (PU) in ending WIP Equivalent Units (Actual units completed and transferred out in this accounting period) + (Equivalent units in the ending WIP) = Total equivalent units of activity

(Step 2)

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(Step 3)

Costs per EU (DM or Conversion costs in the beginning WIP AND incurred during the current period) x (Total EU of material or conversion) = DM (or Conversion) cost per EU (Cost per EU of DM) + (Cost per EU of conversion) = Total cost per EU

(Step 4)

Analysis of total Cost (a) Cost of goods completed and transferred out: (The number of units transferred out) / (Total cost per EU) = COG completed and transferred out (b) Cost of ending WIP inventory: (EU of DM in ending WIP) x (Cost per EU of DM) = (DM costs remaining in ending WIP) (EU of conversion in ending WIP) x (Cost per EU of conversion) = (Conversion costs remaining in ending WIP) (DM costs remaining in ending WIP) + (Conversion costs remaining in ending WIP) = Total cost of ending WIP inventory (c) Total costs accounted for = COG completed and transferred out + total costs of ending WIP

3. ANOTHER METHOD: FIRST-IN FIRST-OUT (FIFO) METHOD Comparisons

(EU calculation)

WA method Beginning WIP equivalent units PLUS EU completed in this period. Beginning WIP DM or conversion costs PLUS total costs of DM or conversion incurred in this period. Simple calculation (used widely)

FIFO method EU completed in this period only.

(Total costs of DM or conversion used to compute cost per EU) (Advantage)

Total costs of DM or conversion incurred in this period only.

Superior and effective cost control and performance evaluation Complex calculation (Less widely used)

(Disadvantage)

Inferior and ineffective cost control and performance evaluation

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The key feature of the WA method is that the total EU for both DM and conversion activities exceed the activity completed in this period alone because the number of EU of activity is calculated without a distinction as to whether the activity occurred in the current accounting period or the proceeding period. The differences between WA and FIFO methods come from the different treatments of the beginning WIP inventory. Since the WIP inventory is very small or nonexistent under the JIT inventory system, there will be little or no difference between WA and FIFO methods.

4. APPENDIX: SEQUENTIAL PRODUCTION DEPARTMENTS (1) In many cases, goods receive processing in more than one department. As the units exit the initial processing department, their costs are charged to the Work-in-Process account of the second department, not to Finished-Goods Inventory. (2) If a product travels through two or more departments, the costs attached to those products travel with them and are called transferred-in costs on the subsequent departments production report. Such costs, from the receiving departments perspective, are similar to direct materials introdu ced at the start of the process. (3) The subsequent department will add conversion cost (and perhaps materials) to these units, and all costs are summed (including the transferred-in costs) and passed along either to the next processing department, if any, or finished goods.

5. OPERATION COSTING: A HYBRID PRODUCT-COSTING SYSTEM (1) Operation Costing Approach: This product-costing system is used when conversion activities are very similar across product lines, but the DM differ significantly. (a) Conversion costs: They are accumulated by department. Process costing is used to assign these costs to products. (b) DM costs: They are accumulated by job-order or batch. Job-order costing is used to assign these costs to products. DM are traced directly to each batch of goods. (2) Examples: electronic equipment, textiles, clothing, and jewelry production

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Example
(Data)
Physical units Units & costs to be accounted for: WIP (Beginning) Started into prod. Units & costs accounted for: Completed and transferred out WIP (Ending) 4,800 400 ??? ??? 100% 40% ??? ??? 100% 25% 200 5,000 $3,000 $74,000 50% $1,000 $70,000 30% DM Total costs ($) Completion ratio Conversion Total costs ($) Completion ratio

Requirement: Fill in [???].

Direct Material (WA)

Beginning WIP $3000 200 units (50%) 200 units (100%) During the period $74,000 Costs $??????

Started 5,000 units

4,600 units (100%)

400 units (40%)

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Conversion (WA)
Beginning WIP $1000 200 units (30%) During the period $70,000 Costs $??????

200 units (100%)

Started 5,000 units

4,600 units (100%)

400 units (25%)

Analysis of total costs

WA Conversion

DM Cost accounted for: Transferred to next department WIP (Ending)

Total

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(Same Example w/ FIFO) Direct Material (FIFO)

Beginning WIP $3000 200 units (50%) 200 units (100%) During the period $74,000 Costs $??????

Started 5,000 units

4,600 units (100%)

400 units (40%)

Conversion (FIFO)
Beginning WIP $1000 200 units (30%) During the period $70,000 Costs $??????

200 units (100%)

Started 5,000 units

4,600 units (100%)

400 units (25%)

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Cost Reconciliation
FIFO Conversion

DM Cost accounted for: Transferred to next department

Total

WIP (Ending)

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