APPLICATION AND GENERAL PRINCIPLES
Application
Until now we have been considering organisations with a cost unit which can be segregated, and have direct expenses wholly attributed to it. Other types of organisation produce output in which a unit cannot be easily separated, so that the output requires to be treated in bulk. It is then necessary to use the technique known as process costing.
Process costing is applicable in the chemical, paint, carpet, food processing and textiles industries.
General Method
The method is essentially one of averaging, whereby the total costs of production are accumulated under the headings of processes in the manufacturing routine, and output figures are collected in respect of the various processes. The total process cost is divided by the total output of the process, so that an average unit cost of manufacturing is arrived at for each process.
Where there are several processes involved in the production routine, it is usual to cost each process and to build up the final total average cost, step by step. The output of one process may be the raw material of a subsequent one, thus making it necessary to establish the process cost at each stage of the manufacturing operation.
The way to do this is to regard each process carried out as a cost centre, and to collect information regarding the usage of materials, costs of labour and direct expenses exclusively attributable to individual processes. Each process will be charged with its share of overhead expenses and the procedure of building up cost rates per process or cost centre is carried out in accordance with the rules given previously.
Need to Record Losses and Good Production
We have said that an average cost per unit is obtained for each process. This average cost is arrived at by dividing the cost of each process by the number of “good” units of production obtained from it. Hence it is necessary to set up a recording scheme to find the number of units produced by each process. Since it is unlikely that all material entering a process will emerge in the form of good production, the recording scheme should provide records of losses from each process in addition to records of good production achieved.
BUILDING UP PROCESS COSTS
Material
The method of charging material usage will depend on the factory layout and organisation. If there is only one input of raw material at the stage of the initial process, the problem is simplified and material usage can be computed from the stores requisitions. In a case such as this, the output of the first process becomes the raw material of the second, and so on.
If further raw material is required at a subsequent process, it may be convenient to establish raw material stores adjacent to the point of usage.
In many cases material may be used which is of low value, e.g. nails, and the volume of paperwork required to record each issue would be prohibitive. In such cases the method of charging would be to issue the anticipated usage for a costing period at one time, the issue being held for use at the point of manufacture. A physical stock-taking at the end of the period would establish actual usage of material, which could be compared with the theoretical usage expected for the output achieved. With all such items the requirement is to maintain some degree of physical control rather than accurate cost allocation.
Labour
Accounting for labour where process costing is in operation is normally straightforward because fixed teams of operatives are associated with individual processes, and the interchange of labour between processes is not normal from the point of view of efficiency. It is often as simple as collating names on the pay sheets to establish the wages cost for a process. Where process labour is interchangeable, labour charges per process may be established by issuing job cards to employees to record the time spent on each process.
Direct Expenses
All expenses wholly and exclusively incurred for one particular process will be given the proper process number and attributed to the cost centre on this basis.
Overhead
The indirect material, labour and expenses not chargeable to one particular process must be borne eventually by production. Absorption rates are used as before, and it is necessary that we establish rates in advance for each cost centre. This means that the total overhead expenses of the business must be estimated and apportioned to the processes in terms of the rules which we have already explained. As we have seen, it is necessary to assess the output expected at each cost centre. Then the absorption rates for the cost centres can be calculated by dividing the costs associated with them by the estimated output per cost centre.
In this way we establish a relationship between overhead cost and activity. At the close of each period the actual activity achieved by the cost centre is multiplied by the predetermined rate to give the charge for overheads. However, where marginal costing techniques are being followed (see later study units), overhead costs are not included but are dealt with in total as is fundamental to marginal costing.
Conversion Costs
These are the costs of converting material input into semi-finished or finished products, i.e. additional direct materials, direct wages, direct expenses and absorbed production overhead. They do not include the costs of original new material inputs. The term “conversion costs” is often referred to in examination questions on process costing and you should understand what the term means.
EXAMPLES OF PROCESS COSTING
- Value of opening and closing WIP
- Equivalent units
- FIFO method
- Average method
The techniques used in process costing can be demonstrated with the aid of a series of examples. You should follow them through carefully, making sure that you understand each stage and can follow the double entries in the accounts.
Example 1: Demonstration of Process Accounts and Stock Accounts When the Value of Opening and Closing Work-in-Progress is Given
In this example an organisation produces an item which requires two processes, and it is normal for stocks of goods completed by Process I to be held for some time before being used in Process II. It is therefore necessary to open process stock accounts.
Essential Differences Using FIFO and Average Methods
It is important to understand the essential differences between the FIFO and average methods, and when each may be used. Although the average method may appear somewhat easier, in examinations you are recommended to use FIFO whenever possible, i.e. when the percentage completion is given for both opening and closing WIP.
In practice FIFO is used when the costs do not fluctuate significantly from month to month, and the average method is used where there are larger fluctuations.
The essential differences you will see between the two methods are:
- The equivalent units calculation under FIFO shows percentage of work required to complete opening WIP, whereas under the average method, opening WIP and units fully processed (started and finished) this period are grouped together.
- Under FIFO only one cost (the cost incurred this period) is used to work out the cost per equivalent unit. The value of opening WIP is not brought in until later. In the average method the value of opening WIP is added to the cost incurred this period.
- In Example 3, we were looking at Process 2 and consequently had a cost brought forward from Process 1. By leaving this element until the very end of the calculations, no difficulties were encountered. This element is slightly more difficult to introduce in the average method. The best way is to have a four-column instead of a three-column layout for the calculation of equivalent units, treating the units transferred from the previous process as “Material 1” and the material introduced in the present process as “Material 2”. All units, whether fully complete at the end of the period or closing WIP, are of course 100% complete in respect of “Material 1”.
This technique can also be applied to the FIFO method, and is illustrated by the following alternative solution to Example 3 (using the FIFO method).
LOSSES IN PROCESS COSTING – NORMAL LOSSES AND ABNORMAL LOSSES
Losses – The Terminology
You should familiarise yourself with the following CIMA terminology. Make sure you understand the difference between scrap and waste.
Scrap
Discarded material which has some recovery value and which is usually either disposed of without further treatment (other than reclamation and handling), or re-introduced into the production process in place of raw material.
Waste
Discarded substances having no value.
Normal Loss
All loss, theoretically, is avoidable, and it can be said that inefficiency exists wherever waste occurs. However, no factory ever completes its manufacturing programme without producing some loss, so loss up to a certain level must be expected and regarded as normal. Every effort must be made to reduce it to an absolute minimum by the proper use of materials, machines, methods and effective controls.
The normal loss in processes is usually readily recognisable, and can be expressed as a percentage of the total input of material. The cost of normal loss is borne by the process, less any incoming credit in respect of the sale of loss. Where there is no sale value of the normal loss, then of course in the examples which follow, normal loss value would be nil.
Abnormal Loss or Gain
If losses are greater than normal, there is said to be an abnormal loss, while if losses are less than normal there is an abnormal gain. Normal loss is treated in exactly the same manner as above, i.e. its scrap value is credited to the process account and the cost per unit of normal output is found. Abnormal losses or gains are valued at the same value as good production and transferred to abnormal loss or gain account and thence to profit and loss account, after making any adjustments for the income from the sale of abnormal loss. This procedure highlights any abnormalities so that any necessary explanations may be incorporated in the periodic management accounts, thus facilitating the taking of corrective action.
