Process costing and operation costing Chapter 5 Process costing and operation costing

Product costing systems Job costing and process costing are two extremes of the continuum of conventional product costing systems Job costing systems accumulate the costs of each job Process costing systems accumulate the cost of each process, then average these costs across all units produced Many businesses use a combination of job and process costing—hybrid costing Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Process costing Used by businesses that mass-produce one product or a small range of almost identical products Involves a number of processes that are performed repetitively Used by oil refineries, food processors, manufactures of tobacco, chemicals and paper Also used by producers of repetitive services— routine processing of cheques in banks and delivery of standard letters in Australia Post continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Process costing Two main steps Estimate the cost of the production process Calculate the average cost per unit by dividing the cost of the process by the number of units produced Process costing can be used in situations where there is no opening or closing WIP inventory (see Chapter 4) More complex process costing takes place where there is WIP inventory Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing with WIP WIP inventory Product is not complete at the beginning or end of the month Production costs will relate to Units started in the previous period and completed in current period (beginning WIP) Units started and completed in the period Units that are incomplete at the end of the period (ending WIP) continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing with WIP Partially-completed goods at the beginning or end of the period change the way we allocate production costs Equivalent units The amount of production inputs that have been applied to the physical units in production Physical units are all units currently in production whether complete or incomplete WIP inventory needs to be converted to equivalent units continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing with WIP Labour and overhead are incurred at different stages of the production process Units in ending WIP are generally at different stages of completion in respect to material and labour Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Calculation of equivalent units for ending WIP If WIP is 50% complete for 10,000 litres on hand at the end of the month: 100% complete for direct materials, which are added at the start of the process  10,000 equivalent units of material 50% complete for conversion costs, assuming that conversion costs occur uniformly across the production process  5,000 equivalent units of conversion cost Equivalent units are used to calculated unit costs when there is WIP Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

The effect of beginning and ending WIP Four steps in process costing 1. Analyse the physical flow of units 2. Calculate the equivalent units 3. Calculate the unit costs 4. Analyse the total costs Product are costed using either Weighted average method First in first out (FIFO) method Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing using the weighted average method Step one: analyse the physical flow of units Physical units in beginning WIP Physical units started Physical units completed and transferred out Physical units in ending WIP = - + continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing using the weighted average method Step two: calculate the equivalent units The equivalent units in beginning WIP are not identified separately, a key feature of weighted average cost method Equivalent units completed and transferred out Equivalent units in ending WIP Total equivalent units + = continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing using the weighted average method Step three: calculate the unit costs The cost per equivalent unit for direct material is the total direct material (conversion costs) costs divided by the total equivalent units Under the weighted average method the cost per equivalent unit is based on the total costs incurred, including the cost of beginning WIP Step four: analyse the costs Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing using the FIFO method It is assumed that the oldest inventory is completed before new production commences Step one: analyse the physical flow of units Identical to the weighted average method Step two: calculate the equivalent units Under FIFO, equivalent units in opening WIP are subtracted from total equivalent units to give new units of production continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing using the FIFO method Step three: calculate the unit costs Cost per equivalent unit is calculated for direct material (or conversion cost) by dividing the direct material cost incurred during the current month only by the new equivalent units added during the current month only. Step four: analyse total costs Assumes that the units in beginning inventory are completed and transferred out first Cost of the beginning WIP are not mixed with those incurred during current month Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Comparison of weighted average vs. FIFO Key difference is the treatment of the beginning WIP Under weighted average costs, cost of beginning WIP and equivalent units of work done on it are included in the calculation of the cost per equivalent unit Under FIFO, cost per equivalent unit is based only on costs incurred in the current month Weighted average is more commonly used Simpler and WIP inventory may be negligible Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing and spoilage Spoilage cost: the cost of defective product and wasted resources that cannot be recovered by rework or recycling When spoilage occurred there are three forms of output Units completed and transferred out Spoiled units, and Unfinished units remaining in WIP Spoiled units are costed using cost per equivalent unit along with other two outputs continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Process costing and spoilage Spoilage is accounted for depending on whether it is normal or abnormal Normal spoilage: inherent in the production process and occurs even under efficient operating conditions Included as part of the cost of good units completed Abnormal spoilage: should not occur under efficient operating conditions Cost of abnormal spoilage are expensed Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Operation costing Some businesses have repetitive production processes, but produce a narrow range of products that differ in some significant aspects In batch manufacturing processes, individual product lines are produced in large batches and require specific combinations of direct materials and a specific sequence of production processes continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Slides prepared by Kim Langfield-Smith Operation costing Hybrid costing has features of both job costing and process costing Operation costing is used to estimate product costs in a batch manufacturing environment Direct costs are assigned to individual batches —a job costing approach Conversion costs are accumulated by department—a process costing approach Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Other issues in process costing Standard costs are more likely to be used that actual costs Process costing and operation costs are consistent with concepts of responsibility accounting Processes or operations are usually performance in different departments, and Departmental managers may be held responsible for the department’s costs and output produced continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Other issues in process costing A pre-determined overhead rate may be used in process costing and a pre-determined conversion cost rate in operation costing Production units are usually used as the cost driver in process costing and operation costing Inputs may be used as cost drivers in operation costing continued Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith

Other issues in process costing The percentage of completion is difficult to determine and is often only a rough estimate In service firms, some routine repetitive or similar services can be costing using process or operation costing Copyright  2003 McGraw-Hill Australia Pty Ltd, PPTs t/a Management Accounting: An Australian Perspective 3/e by Langfield-Smith, Thorne & Hilton Slides prepared by Kim Langfield-Smith