November 13-16, 2015 Process Costing Chapter 4: Systems Design: Process Costing. Managers need to assign costs to products to facilitate external financial reporting and internal decision making. This chapter illustrates an absorption costing approach to calculating product costs known as process costing.

November 13/16, 2015 System Design – Process Costing Review of Process Costing versus Job-Order Costing When should Process Costing be Used? How is it Used? Journal entries Calculating balances by the Weighted Average Cost method

Product Costing Product Costing is the mapping and allocating of costs to a specific product Its purpose is to provide executives with critical information including: How to minimize costs How to price a product competitively and profitably There are two main methodologies of Product Costing 1. Job-Order Costing – each job is different 2. Process Costing – many of the same products

Job Order Costing Job-Order Costing is the costing methodology applied in companies in the following circumstances: Produce many different products or packages Manufacture to order so each job is different Examples would be: SNC (engineering and construction) Airbus (aircraft) Other? In these cases, a company needs to know, often on an order by order basis, what are the costs associated with fulfilling the order Cost records for each job will be required to support decision making and billing of the customer

Process Costing Process Costing is the costing methodology applied in companies in the following circumstances: Produce many units of a single product Each unit is substantially similar to other units Examples would be: Lenovo (PC manufacturing) Frito lay (Snacks and beverages) Others? That each of these products are substantially the same, managers are able to apply the same average cost to each unit

Similarities & Differences Between Job-Order and Process Costing Both are Product Costing systems assigning material, labour and overhead to products Both systems use the same manufacturing accounts The flow of costs are very similar in both systems Differences Process Costing is used for single products which run continuously (versus differing products/packages) Process Costing tracks cost by department (versus by job) Tracks unit cost by department (versus by job sheet)

Processing Departments Any unit in an organization where materials, labor, or overhead are added to the product. The activities performed in a processing department are performed uniformly on all units of production. Furthermore, the output of a processing department must be homogeneous. Products in a process costing environment typically flow in a sequence from one department to another. A processing department is any unit in an organization where materials, labor, or overhead are added to the product. The output from a processing department is homogeneous, that is, they all appear the same (homogeneous output). Products in a process costing environment typically flow in a sequence from one department to another.

Processing Departments The same three inputs go into Work in Process as in Job-Order Costing In Process Costing, Processing Departments must be identified A Processing department is any department in which the activities and output are uniform: Assembly Department Testing Department Others? Inventories get transferred from one department through to the other Costs are accumulated in each department

Flow of Materials, Labor and Overhead Costs Costs are traced and applied to departments in a process cost system. Direct Materials Processing Department Finished Goods Direct Labor Process costing systems trace and apply manufacturing costs to departments. A separate Work in Process account is maintained for each processing department. Material, labor and overhead costs transferred from one department’s Work in Process account to another department’s Work in Process account are called transferred-in costs. ManufacturingOverhead Cost of Goods Sold

Process Cost Flows: The Flow of Raw Materials (in T-account form) Work in Process Department A Raw Materials Direct Materials Direct Materials Work in Process Department B Direct materials can be requisitioned for use in both Department A and Department B. These direct materials are likely to be different in nature. Direct material costs are debited to the appropriate departmental Work in Process account depending upon where the materials were added to the production process. The Raw Materials Inventory account is credited for the corresponding amounts.

Process Cost Flows: The Flow of Labor Costs (in T-account form) Salaries and Wages Payable Work in Process Department A Direct Materials Direct Labor Direct Labor Work in Process Department B Direct labor is transferred from the Salaries and Wages Payable account into the Work in Process account of Departments A and B depending upon where the individual employee worked. Direct labor costs are debited to the appropriate departmental Work in Process account depending upon where the labor was added to the production process. Salaries and Wages Payable is credited for the corresponding amounts. Direct Materials

Manufacturing Overhead Overhead Applied to Work in Process Process Cost Flows: The Flow of Manufacturing Overhead Costs (in T-account form) Work in Process Department A Direct Materials Manufacturing Overhead Direct Labor Actual Overhead Overhead Applied to Work in Process Applied Overhead Work in Process Department B Manufacturing overhead is applied to each processing department based on a predetermined rate for each department. The predetermined rate does not have to be based on the same cost driver for each processing department. Manufacturing overhead costs are debited to the respective departmental Work in Process accounts. Manufacturing overhead is credited by the corresponding amounts. Direct Materials Direct Labor Applied Overhead

Work in Process Department A Work in Process Department B Process Cost Flows: Transfers from WIP-Dept. A to WIP-Dept. B (in T-account form) Work in Process Department A Work in Process Department B Direct Materials Transferred to Dept. B Transferred from Dept. A Direct Materials Direct Labor Direct Labor Applied Overhead Applied Overhead The cost of units complete as to processing in Department A are transferred into Department B for additional work. Department B has incurred additional costs to work on units that were in process at the beginning of the period. The transferred-in costs from Department A are added to the manufacturing costs incurred in Department B. Department A Department B

Cost of Goods Manufactured Process Cost Flows: Transfers from WIP-Dept. B to Finished Goods (in T-account form) Work in Process Department B Finished Goods Direct Materials Cost of Goods Manufactured Cost of Goods Manufactured Direct Labor Applied Overhead Transferred from Dept. A Here we see the transfer of completed goods from Work in Process—Department B into Finished Goods Inventory. The costs transferred represent the cost of goods manufactured.

Process Cost Flows: Transfers from Finished Goods to COGS (in T-account form) Work in Process Department B Finished Goods Direct Materials Cost of Goods Manufactured Cost of Goods Manufactured Cost of Goods Sold Direct Labor Applied Overhead Transferred from Dept. A Once we sell finished goods, we debit Cost of Goods Sold and credit Finished Goods Inventory. Cost of Goods Sold Cost of Goods Sold

Process Cost Flows & Journal Entries Journal entry examples:

Valuing Inventory in Process Costing System Just as with Job Order Costing, There must be a method for valuing inventory accounts and Cost of Goods Manufactured to get COGS Raw Materials WIP Finished Goods There are two main methodologies Weighted Average method First in First Out method First, look at the Weighted Average method Requires the concept of Equivalent Units of Production Equivalent units are defined as the product of the number of partially completed units and the percentage of completion of those units. Equivalent units need to be calculated because a department usually has some partially completed units in its beginning and ending inventory. These partially completed units complicate the determination of a department’s output for a given period and the unit cost that should be assigned to that output.

Equivalent Units of Production Equivalent units are the product of the number of partially completed units and the percentage completion of those units. Equivalent units are the product of the number of partially completed units and the percentage completion of those units. Equivalent units need to be calculated because a department usually has some partially completed units in its beginning and ending inventory. These partially completed units complicate the determination of a department’s output for a given period and the unit cost that should be assigned to that output. These partially completed units complicate the determination of a department’s output for a given period and the unit cost that should be assigned to that output.

Equivalent Units – The Basic Idea Two half-completed products are equivalent to one complete product. + = 1 The basic idea behind equivalent units is quite easy to understand, but the computation of equivalent can become complex. Here we can say the two half-completed units of production are equal to one complete unit. Using this logic, we can say that 10,000 units that are 70% complete are equivalent, or the same as, 7,000 complete units. So, 10,000 units 70% complete are equivalent to 7,000 complete units.

Two Methodologies for Calculating Costed Equivalent Units There are two main methodologies for Calculating Equivalent Units Weighted Average No distinction between work done or costs incurred in prior and current periods Equivalent units of production is the sum of Units transferred out to the next department or finished goods, plus Ending Equivalent Units in WIP First-In-First-Out (FIFO) Distinguishes between work done and costs in different periods

Treatment of Direct Labor Direct Materials Direct labor and manufacturing overhead may be combined into one classification of product cost called conversion costs. Conversion Direct Labor Dollar Amount Direct Labor Manufacturing Overhead As a consequence of the change in volume of direct labor costs, many companies combine labor and overhead costs and refer to the total as conversion costs. That is, these are the costs incurred to convert the direct materials into a finished good. We will make extensive use of the notion of direct materials and conversion costs in the remainder of this chapter. Type of Product Cost

Weighted Average Method Direct Labour and Manufacturing Overhead are often consolidated into a single account called “Conversion” This is a simplifying step taken as DL is often very small relative to DM and Manufacturing Overhead in these types of businesses

Weighted Average Method – Equivalent Units of Production Calculation of Equivalent Units of Production = Units transferred out plus ending Equivalent Units (definitional) Assume: Cost of beginning WIP-Materials was $4,000; WIP-Conversion was $9,000 Cost of additional production –Materials was $200,000, Conversion was $250,000 What was the cost per equivalent unit?

Weighted Average Method Cost per equivalent unit = Cost of beginning work in process inventory Cost added during the period Equivalent units of production + Cost of beginning WIP-Materials was $4,000; WIP-Conversion was $9,000 Cost of additional production –Materials was $200,000, Conversion was $250,000

Weighted Average Method Cost per equivalent unit = Cost of beginning work in process inventory Cost added during the period Equivalent units of production +

Computing the Cost of Units Transferred Out & Ending WIP These totals will be entered into the Balance Sheet accounts

Reconciling Costs The following exercise will provide a reconciliation, a “check” on your calculations

Review System Design – Process Costing Review of Process Costing versus Job-Order Costing When should Process Costing be Used? How is it Used? Journal entries Calculating balances by the Weighted Average Cost method

FIFO Method Appendix 4A: FIFO Method.

November 16, 2015 - Continued Process Costing – FIFO Inventory Method What is FIFO? FIFO versus Average Cost method When should FIFO be used? Journal entries Calculating balances by the FIFO Cost method

FIFO FIFO is a method of calculating inventory balances First in - First out Materials, labour and overhead is drawn into production over time FIFO attributes the earlier costs drawn to the inventory that leaves the department or finished goods first FIFO is generally considered more accurate than the Weighted Average method Better attributes costs in any given period Identifies cost overruns more quickly and distinctly allowing managers to address problems with minimal delay

Equivalent Units – FIFO Method Back to “Department B” from the Weighted Average Example This will help us compare the methodologies side-by-side

FIFO – Equivalent Units of Production Calculation of Equivalent Units of Production Note: Units started & completed = units started less ending WIP units

Equivalent Units of Production - Reconciling WA to FIFO The fundamental difference between Equivalent Units of Production under FIFO is that beginning WIP is subtracted from the WA conclusion

Calculating Unit Cost - FIFO Method Note: Equivalent Units are usually not the same Cost per equivalent unit = Cost added during the period Equivalent units of production

Computing the Cost of Ending WIP - FIFO This total will be entered into the Balance Sheet accounts

Computing the Cost of Units Transferred Out - FIFO This total will be entered into the Balance Sheet accounts

Reconciling Costs As with the Weighted Average Method, the following exercise will provide a reconciliation, a “check” on your calculations for the FIFO Method

A Comparison of Costing Methods In a lean production environment, FIFO and weighted-average methods yield similar unit costs. When considering cost control, FIFO is superior to weighted-average because it does not mix costs of the current period with costs of the prior period. In most situations, the weighted-average and FIFO methods will produce very similar unit costs, particularly in a lean production environment. From a cost control standpoint, the FIFO method is superior to the weighted-average method because it does not mix costs of the current period with costs of the prior period.

Review System Design – Process Costing – FIFO Inventory Method What is FIFO? FIFO versus Average Cost method When should FIFO be used? Journal entries Calculating balances by the FIFO Cost method

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