Chapter 5 Process costing and operation costing 5-1 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Outline Process costing Process costing with work in process inventory Calculation of equivalent units The effects of beginning and ending work in process inventories Process costing using the weighted average method Process costing using the first-in, first-out (FIFO) method Comparison of weighted average and FIFO Process costing and spoilage Operation costing Other issues in process costing 5-2 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Process costing 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; this is called hybrid costing 5-3 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

Process costing (cont.) 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 and manufacturers of tobacco, chemicals and paper –Also used by producers of repetitive services such as routine processing of cheques in banks and delivery of standard letters in Australia Post 5-4 (cont.) Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Process costing (cont.) 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 occur where there is no opening or closing WIP inventory (see Chapter 4) More complex process costing takes account of WIP inventory –Need to calculate equivalent units to apportion cost between new production and inventory 5-5 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Process costing with work in process inventories WIP inventory –Not all products are complete at the beginning or end of the period (usually a month) Production costs will be calculated after taking into account –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) 5-6 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

Process costing with work in process inventories (cont.) 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 during production –Physical units are all units currently in production whether complete or incomplete –WIP inventory needs to be converted to equivalent units to provide the basis for calculating product cost 5-7 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

Process costing with work in process inventories (cont.) Materials are input into production at various stages We usually assume that labour and overhead are used uniformly throughout the production process –Treat collectively as ‘conversion costs’ Units in ending WIP are generally at different stages of completion with respect to material and conversion cost 5-8 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Equivalent units Equivalent units are used to calculated unit costs when there is WIP If WIP is 50% complete for litres on hand at the end of the month, it is –100% complete for direct materials, which are added at the start of the process  equivalent units of material –50% complete for conversion costs, assuming that conversion costs occur uniformly across the production process  5000 equivalent units of conversion cost 5-9 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

The effects of beginning and ending work in process inventories 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 Products are costed using one of two assumptions about product flow –Weighted average method –First in, first out (FIFO) method 5-10 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Process costing using the weighted average method Step one: analyse the physical flow of units 5-11 Physical units in beginning WIP Physical units started Physical units completed and transferred out Physical units in ending WIP = – + Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

Process costing using the weighted average method (cont.) Step two: calculate the equivalent units –The equivalent units in beginning WIP are not identified separately; this is a key feature of the weighted average cost method 5-12 Equivalent units completed and transferred out Equivalent units in ending WIP Total equivalent units += Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

Process costing using the weighted average method (cont.) Step three: calculate the unit costs –The cost per equivalent unit for direct material is the total direct material costs divided by the total equivalent units –The cost per equivalent unit for conversion cost is the total conversion cost 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 total costs –The production cost of units are transferred to the next production process or to finished goods –Cost of incomplete units remains in WIP 5-13 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

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5-16 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Process costing using the FIFO method Assumes that the WIP inventory is completed before the production of new units commences Step one: analyse the physical flow of units –Identical to the weighted average method Step two: calculate the equivalent units –Under FIFO the equivalent units in opening WIP are subtracted from total equivalent units to give equivalent units of new production for the month 5-17 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

5-18 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Process costing using the FIFO method (cont.) Step three: calculate the unit costs –Cost per equivalent unit is calculated for direct material (or conversion cost) by dividing the direct material cost (or conversion cost) incurred during the current month by the new equivalent units added during the current month –Costs of opening inventory are not used in this calculation Step four: analyse the total costs –Assumes that the units in beginning WIP are completed and transferred out first –Costs of the beginning WIP are not mixed with those new costs incurred during the current month 5-19 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

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5-22 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Comparison of weighted average and FIFO methods Key difference is the treatment of the beginning WIP –Under the weighted average method the cost of beginning WIP and equivalent units of work done on WIP are included in the calculation of the average cost per equivalent unit –Under FIFO the cost per equivalent unit is based only on costs incurred in the current month –Weighted average is more commonly used than FIFO  Less complex and WIP inventory may be negligible  Cost of using FIFO may exceed the benefits 5-23 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Process costing and spoilage Spoilage cost: the cost of defective products and wasted resources that cannot be recovered by rework or recycling When spoilage occurs there are three forms of output –Units completed and transferred out –Spoiled units –Unfinished units remaining in WIP Spoiled units are costed using cost per equivalent unit along with the other two outputs 5-24 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

Process costing and spoilage (cont.) 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 –Costs of abnormal spoilage are expensed 5-25 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith 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 –Different material inputs –Different combinations of specific production processes 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 5-26 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

5-27 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Operation costing (cont.) Operation costing is a hybrid costing system –Used in a batch manufacturing environment –Contains features of both job costing and process costing –Direct material assigned to individual batches, as in job costing –Conversion costs assigned to departments or processes using a predetermined application rate, as in process costing 5-28 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

5-29 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Other issues in process costing Standard costs are more likely to be used than actual costs Process costing and operation costs are consistent with concepts of responsibility accounting –Processes or operations are usually performed in different departments –Departmental managers may be held responsible for the department’s costs and output produced A predetermined overhead rate may be used in process costing and a predetermined conversion cost rate in operation costing –Underapplied or overapplied costs to be accounted for 5-30 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith (cont.)

Other issues in process costing (cont.) Production units are usually used as the cost driver in process costing and operation costing –Inputs such as machine hours or labour hours may be used as cost drivers in operation costing The percentage of completion is difficult to determine and is often only a rough estimate –Sometimes businesses will ignore WIP inventories for simplicity In service firms some routine, repetitive or similar services can be costed using process or operation costing 5-31 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith

Summary Process costing suits businesses that mass- produce a small range of products Weighted average or FIFO methods may be used to assign costs to products and inventory The presence of WIP inventory requires calculation of equivalent units Simple forms of process costing do not entail the costing of WIP inventory Operation costing is a hybrid of job costing and process costing 5-32 Copyright  2009 McGraw-Hill Australia Pty Ltd PowerPoint Slides t/a Management Accounting 5e by Langfield-Smith Prepared by Kim Langfield-Smith