Process costing (accounting)

Process costing is a method in cost accounting for compiling manufacturing costs and assigning them to the units produced. This system is useful when mass-producing units that are very similar or identical.

Process costing must consider the cost of the direct materials, direct labor, and overhead. It helps managers by analyzing trends in costs, which is useful when considering growth or scale changes. Process costing has distinct advantages and shortcomings. It can be used by itself or in combination with job costing.

Background

Accounting has been in use for thousands of years. Early records of business transactions and inventory were discovered in excavations of ancient Mesopotamia. These accounting records are perhaps ten thousand years old. Eventually, the accountants of this and other ancient civilizations, including the Babylonians, Egyptians, and Sumerians recorded taxation, military expenses, and other debits and credits. They used an early version of the abacus to make their calculations. They recorded inventories and other figures by marking clay tablets with sticks; the dried and hardened tablets were saved as records.

Keeping records of various business expenses and payments is essential to maintaining inventory and ensuring a business can pay its bills and employees. Early accounting was quite basic. It involved tracking units of inventory, such as crops and herd animals, and payments received for the units sold. This allowed accountants to see changes in production—for example, how the crop harvested this season compared to last season’s production, whether a city had a surplus or shortage, and how to plan accordingly for the future. Early economies relied on the bartering system, which required only basic bookkeeping.

Accounting became very important to the vast Roman Empire, and was a significant factor in Rome becoming a global power. The emperor and other powerful individuals had to keep track of large quantities of land, pensions paid to military veterans, costs of building temples, expenses of entertainments, and other concerns. Romans also recorded funds in the treasury, taxes paid, and information about enslaved people and freedmen, among other important issues. Because much of the economy was based on currency, accounting was more complex and involved advanced math, but it was necessary to ensure the Roman Empire remained strong economically.

Over time, accounting became more complicated and detailed. In 1494, Luca Pacioli wrote an influential book about mathematics entitled Summa de Arithmetica, Geometria, Proportioni et Proportionalita, meaning "Summary of arithmetic, geometry, proportions and proportionality," that included a lengthy section on bookkeeping. This is the earliest reference to double-entry accounting, which involves recording all entries in at least two places, as a credit and as a debit. This was in keeping with the changes in the economies of Europe, which had transitioned to monetary economies in the thirteenth century. Merchants and early bookkeepers could look at their accounts, see the state of affairs, and make instant decisions about purchases or investments.

Overview

Companies use process costing to assign product costs to units of output. This system is used when similar products are being manufactured (for example, a bottling company may produce multiple flavors of beverages, using identical processes and nearly identical ingredients and packaging). Some manufacturers produce large quantities of identical units, such as bricks. Process costing is used when product output is of low value, identical or near-identical products are mass produced, and costs cannot be tracked to individual products. Costs are therefore tracked to each department in the production process. Each department tracks these costs individually. The accountants use department figures, dividing costs by the number of units produced in a set period to determine an average production cost.

This standardization of products allows managers to evaluate production. They can assess productivity and cost changes. Managers can then look at individual departments to lower production costs, and thereby increase profitability. Changes could involve the manufacturing process, cost of materials, or other concerns handled by various departments.

Process costing does not consider overhead expenses, which are costs not associated with a department or directly related to a product. Examples include electricity and other utilities, insurance, office supplies, administrative salaries, and legal expenses.

Some businesses use systems that are a combination of process costing and job costing. Job costing is a process of tracking costs of specific jobs, for example, billing hours for legal clients, construction costs of a building project, or medical services tracked to a patient. Some businesses, such as prefabrication contractors, manufacture products in batches. The price point is based on the cost of producing that batch, while labor cost is usually calculated based on the hours worked on a single unit level. Some businesses that provide services may use a process costing system when the result of each job is similar. For example, an advertising agency may devote similar resources to each client, and can average out the cost per client to calculate the cost of completing an ad.

The process costing method has five steps.

• First is an analysis of the inventory, determining how much was available at the start of the period, how much was started, how much was completed, and how much remains as work-in-process at the end of the period.
• Next, an accountant converts the work-in-process inventory at the end into a number of produced equivalent units. For example, if 1,000 units of inventory are half-completed, these are considered equivalent to 500 units produced.
• Third, the total direct and indirect costs of the production process must be calculated. These are assigned to the units completed and in process. This will include the costs related to the beginning inventory and costs that occurred during the production period.
• The fourth step is to calculate the cost connected to the completed and equivalent completed units of output in the ending inventory. If, for example, 2,000 units have been completed, and the aforementioned 1,000 units were 50 percent complete and equivalent to 500 units, the applicable costs are divided by 2,500.
• Finally, the relevant costs are allocated to the units of product completed and units remaining in the work-in-process account.

Bibliography

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