Process costing systems
Learning outcome statements
The learning outcome statements relevant for this section are:
- demonstrate an understanding of process costing and the concept of equivalent units (no calculations required)
Process costing
Common industries that use process costing include:
- Chemical manufacturing
- Oil refining
- Food and beverage production
- Paints and plastics
- Paper and pulp processing
In contrast to job order costing, where costs are traced to specific jobs, process costing averages total departmental costs over all units produced during a period. This makes it efficient and cost-effective for high-volume production with repetitive operations.
Cost flows in a process costing environment
In a typical process costing system, production moves sequentially from one department to another. Costs are accumulated within each department and then transferred to the next stage.
Stages of cost flow:
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Direct materials, direct labor, and applied manufacturing overhead are added to the Work-in-process (WIP) account for each department.
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Once processing is complete, costs and units are transferred to the next department or to finished goods inventory, depending on the stage.
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Upon sale, the costs are finally transferred to cost of goods sold (COGS).
Example: Process costing flow
Let’s consider a company that produces fruit juice and uses two departments: Mixing and Bottling.
Department Input costs (for May) Units completed Mixing $50,000 10,000 liters Bottling $30,000 10,000 liters All units flow from Mixing to Bottling without loss. Total cost per liter:
- Mixing: $50,000 ÷ 10,000 = $5.00
- Bottling: $30,000 ÷ 10,000 = $3.00
- Total cost per liter = $8.00
When the juice is bottled and sent to Finished Goods, the cost per unit reflects the cumulative processing cost. The example is a simple one because we assumed that there are no unfinished units for each department and all 10,000 liters flowed completely in and out of production. When this is not the case, the concept of equivalent units is used to estimate the costs of the WIP, inventories and COGS.
Equivalent units
In continuous production systems, it is common for a department to have units still in process at the end of an accounting period. Because these units are only partially completed, we cannot count them as full units when calculating the average cost per unit. Instead, we use the concept of equivalent units of production, which expresses incomplete units as a fraction of a complete unit, based on their percentage of completion.
This concept allows costs to be fairly divided between:
- Completed units transferred to the next department or finished goods
- Partially completed units still in Work-in-process (WIP) at the end of the period
For the exam, focus on what equivalent units represent and why they matter, not on detailed calculations.
Example 1: Partial completion in a single department
Suppose a chocolate factory’s Mixing Department started 10,000 units in March. There is no beginning inventory. By month-end:
- 8,000 units were fully completed and transferred to the next department
- 2,000 units were still in WIP, but only 40% complete
These 2,000 partially complete units are treated as 800 equivalent units (2,000 × 40%).
Assuming all costs are added evenly throughout processing, the department’s total costs are spread over 8,800 equivalent units, not 10,000 physical units. (If materials are added at a different point than labor and overhead, equivalent units are computed separately for each cost type, as shown later.) These 8,800 units form the basis for dividing total costs incurred in the Mixing Department, ensuring a fair share is retained in WIP for unfinished units.
If a company mistakenly uses full physical units instead of converting them to equivalent units, costs get misallocated: WIP inventory is overstated, cost per unit is understated, and profit margins may be distorted.
Example 2: Two departments – transfer and remaining WIP
In a textile plant, the Weaving Department processes 5,000 meters of fabric. By month-end:
- 4,000 meters are completed and transferred to the Finishing Department
- 1,000 meters are still in process, 60% complete
Total costs for the month (materials, labor, and overhead) will be spread over these 4,600 units (instead of 5,000 units). And then these costs are treated as follows:
- The cost assigned to the 4,000 completed meters is transferred to the Finishing Department
- The cost assigned to the 600 equivalent units remains in the Weaving WIP inventory
How equivalent units affect inventory flow
The concept of equivalent units directly affects how production costs are classified and recorded. Since the costs in these inventories are recorded per type (DM, DL or overhead), the equivalent units are typically computed per type of cost, and costs are then applied using the equivalent units per type, as shown below:
Advantages and limitations of process costing
Advantages
- Simplifies accounting for uniform production processes
- Ideal for large-scale, repetitive manufacturing
- Cost per unit is easy to calculate and track over time
Limitations
- Not suitable for customized or small-batch production
- Less flexible for firms producing varied or irregular items
- May obscure cost inefficiencies without additional analysis (e.g., ABC)
Comparison to job order costing
| Feature | Job order costing | Process costing |
| Product type | Customized, unique jobs | Homogeneous, continuous production |
| Cost tracing | To individual jobs | To departments/processes |
| Unit cost determination | Per job | Average cost per unit |
| Inventory flow | Job-specific | Department to department |
| Cost records | Detailed per job | Summarized by process |