Process costing is an accounting method typically used by companies that mass produce very similar or identical products or units of output. It’s common in manufacturing industries where the costs of producing each unit of output are very similar, and it doesn’t make sense to try to track costs for each individual unit throughout the production process. For example, process costing is used by oil companies that produce millions of gallons of fuel and by processed food companies that make millions of identical packages of snacks. Show
What Is Process Costing?With process costing, companies determine item cost by tracking the cost of each stage in the production process, instead of tracking costs for each individual item. After adding up the cost of all the steps in the process, they divide the total cost by the number of items. This is called the cost per unit. For example, a paper company might track the cost of each stage in the process of turning wood pulp into reams of paper, then divide the total cost by the number of reams to get the cost per ream. Key Takeaways
Process Costing ExplainedHomogeneous items are products that cannot be distinguished from one another — for example, a bin of screws of the same size and type. These similar products all generally flow through a number of stages during the production process. To use the process costing approach to accounting, companies determine the direct costs and manufacturing overhead for each of those stages. These stages include direct and indirect costs. Direct costs are those directly incurred for production, such as raw materials and machine operators’ wages. Overhead often includes indirect costs such as equipment maintenance and facility rent, as well as the wages of administrative staff who aren’t directly involved in making the products. Companies often break down these costs into direct materials and conversion costs. Direct materials are the materials consumed at each stage; conversion costs are process-related costs such as payroll and manufacturing overhead. At many companies, a different department handles each stage in the production process. Each department prepares a report that details its direct materials, direct labor and manufacturing overhead costs. The company then aggregates these reports to analyze total product cost. Process vs. Job CostingTwo of the primary methods of determining the cost of each product are process costing and job costing. Process costing doesn’t rely on tracing the costs of each individual item throughout the production process, so it’s particularly useful for industries that mass produce identical items and cannot easily trace each item’s costs. Job costing, in contrast, tracks all direct and indirect costs for each item or project. This is more commonly used by companies that offer custom products or services and price each one individually. For example, a construction company that makes custom homes needs to know exactly how much it costs to build each house so it can charge an appropriate amount and track whether each home-building project is profitable. Importance of Process CostingProcess costing is particularly important in the oil, chemical, lumber, textile and food processing industries. Getting a handle on production costs enables these companies to set the right prices for their products and determine whether costs are tracking in line with projections. They can use process costing to analyze the costs of each step of the production and distribution process and use the information to identify areas where they can reduce costs. Why Use Process Costing?Process costing is the logical choice for keeping tabs on product costs in industries where the individual units of output are uniform and individually not worth a great deal — such as reams of paper or bottles of soda — and where it’s impossible or difficult to trace production costs for each individual unit. Instead, the cost of goods manufactured (COGM) is produced using process costing. This usually appears on your income statement.
Using the Process Costing MethodProcess costing involves tracking the number of units passing through the production process during a given period, collecting cost information for each stage and then using the collected information to calculate per-unit cost. Having accurate per-unit-costing helps with pricing products appropriately, which can lead to improved revenue and better profit margins. 5 Steps in Process CostingTo accurately estimate the cost of producing each unit, process costing takes into account work in progress — items that have entered but not completed the production process — at the start and end of each period. Here are five primary steps in process costing.
In process costing there are three different ways to calculate costs: weighted average, standard costing and first-in first-out (FIFO). Carefully selecting the method that best meets your business needs is a best accounting practice.
Examples of Process Cost AccountingProcess cost accounting is used in circumstances where the units of product are homogenous. Take a look at a few examples of how it works in these fictional companies. (The companies are not real.)
Pros and Cons of Process CostingFor certain types of manufacturers, process costing is the most practical and efficient accounting method for determining product costs. Still, this method has both advantages and disadvantages. It can be difficult to accurately assign costs to work in progress, for example. Consider the following pros and cons. Pros of process costing:Process costing can be easier to use than other costing methods, and it can help companies zero in on areas for potential cost cutting.
Cons of process costing:Potential disadvantages of process costing include inaccuracy.
Cost Flow in Process CostingWith process costing, companies track the flow of costs from department to department, rather than tracking costs for each individual item. Each department adds direct labor and manufacturing overhead costs, plus the cost of any raw materials it uses. Companies may use separate work-in-process inventory accounts for each department or stage in the process. Manage Process Costing With NetSuiteProcess costing assigns expenses to different departments in your business, and it accounts for various cost areas including materials and payroll. Those costs are then rolled up to determine an overall dollar figure and used to find the price-per-unit. All departments must use uniform reporting and not double count efforts. Enterprise resource planning (ERP) software can help with this process. It brings data from various business software modules from around your company — such as supply chain management, financial management and payroll management — into one digital space. By storing data from disparate areas of your company in one digital ecosystem, you can more easily track data and costs from throughout the manufacturing process and keep tabs on expenses and profitability. ERP platforms with integrated financial management software also help you more expertly, easily and accurately perform process costing. By working together with the same information across the business, costs can easily be tracked by department and roll up into macro-level process costing reports. NetSuite’s ERP suite helps manufacturers manage every aspect of their business, from supply chain management and procurement to order fulfillment and customer relationship management (CRM). The fully integrated financial management solution helps businesses accelerate their financial close, provides strong expense management and real-time visibility into the company’s financial performance. And it can help you more expertly, easily and accurately perform process costing. By working together with the same information across the business, costs can easily be tracked by department and roll up into macro-level process costing reports. Conclusion Process costing is an important accounting method for manufacturers that make large volumes of identical items, such as companies in the food processing, oil and chemicals industries. For these companies, it can be difficult or impossible to directly allocate costs to each item as it moves through the manufacturing process. Process costing enables companies to estimate item costs by adding up the expenses of each step in the manufacturing process, then dividing by the number of items. To ensure accuracy, companies need to include only product-related costs from each department involved in the process and correctly allocate cost to work-in-progress at each stage. Financial management software, particularly platforms integrated into a larger ERP tool, can help track costs by department, as well as generate overview reports and store historical data to monitor trends over time. Process Costing FAQsWhat is an example of process costing? Using process costing, a seltzer bottling company would assign costs to each stage in the bottling process. It then totals the costs from each stage over an accounting period, dividing the overall process cost by the number of finished bottles to obtain a cost per bottle. What are the steps in process costing? There are five basic steps in process costing:
What are the advantages and disadvantages of process costing? For companies that make large volumes of homogeneous products, process costing is much simpler than job costing. It also enables companies to hone in on the cost of each stage in the manufacturing process and look for ways to reduce cost if necessary. But there are drawbacks, too. Process costing can be time consuming, and it can be difficult to accurately assign product costs to each manufacturing stage and to work-in-progress items. What is a process costing system? A process costing system is a method typically used within certain sectors of the manufacturing industry to determine the total production cost for each unit of product. It accumulates cost from each process or department and allocates them to the individual products produced. Who uses process costing? Process costing is generally used by manufacturers that produce a large volume of identical items, such as companies involved in oil refining, food production, chemical processing, textiles, glass, cement and paint. How is process costing calculated? Product costs are allocated to the departments or processes each item passes through over a set period, instead of tracing costs to individual items produced. The total process cost is divided by the total number of items, resulting in an average cost for each item. What is construction job costing? Job costing is an approach to accounting that assigns each expense to a specific job. It’s generally broken into three areas: labor, materials and overhead. Construction job costing is a common approach to unique projects with different requirements. Actual costs are compared against expected budget. What are the 3 manufacturing costs?Manufacturing costs fall into three broad categories of expenses: materials, labor, and overhead. All are direct costs. That is, the salary of the company accountant or the accountant's office supplies are not included, but the salary and supplies of the foreman are.
What are the 3 costs included in product costs?In general, three types of expenses are included in the cost of products: the cost of direct materials, direct labor costs and manufacturing overhead costs.
What costs are included in work in process?WIP refers to the raw materials, labor, and overhead costs incurred for products that are at various stages of the production process. WIP is a component of the inventory asset account on the balance sheet. These costs are subsequently transferred to the finished goods account and eventually to the cost of sales.
What are the three 3 main costs that that you will need to consider when calculating the expenditure to determine production costs?To calculate total manufacturing cost you add together three different cost categories: the costs of direct materials, direct labour and manufacturing overheads. Expressed as a formula, that's: Total manufacturing cost = Direct materials + Direct labour + Manufacturing overheads.
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