Question

In the lecture video I used Lay's Potato Chips and an imaginary company (Smith Co.) as examples to explain Process Costing. Please think about a real life manufacturing company (big or small) that would be a good fit for the Process Costing method. Explain why you feel that your company would be a good candidate for Process Costing (hint: look at the criteria). Also, describe how you believe the units of product move through the processing department(s) and how direct labor, direct material and manufacturing overhead cost are added in each department (keep in mind that direct labor and material in process costing are traced to processing departments rather than units of products). Finally, explain what allocation base you would suggest for the calculation of the predetermined overhead rate(s) in your processing departments and why. (Min. 150 words).

Answer 1

Process costing is used when there is mass production of similar products, where the costs associated with individual units of output cannot be differentiated from each other. In other words, the cost of each product produced is assumed to be the same as the cost of every other product. Under this concept, costs are accumulated over a fixed period of time, summarized, and then allocated to all of the units produced during that period of time on a consistent basis. When products are instead being manufactured on an individual basis, job costing is used to accumulate costs and assign the costs to products. When a production process contains some mass manufacturing and some customized elements, then a hybrid costing system is used.

Examples of the industries where this type of production occurs include oil refining, food production, and chemical processing. For example, how would you determine the precise cost required to create one gallon of aviation fuel, when thousands of gallons of the same fuel are gushing out of a refinery every hour? The cost accounting methodology used for this scenario is process costing.

Process costing is the only reasonable approach to determining product costs in many industries.   It uses most of the same journal entries found in a job costing environment, so there is no need to restructure the chart of accounts to any significant degree. This makes it easy to switch over to a job costing system from a process costing one if the need arises, or to adopt a hybrid approach that uses portions of both systems.

The cost accumulation in a process costing system is simpler than in a job order costing system. Unlike job order costing system in which materials, labor and overhead costs are traced to a large number of individual jobs, the process costing system traces costs to only a few processing departments.

In process costing system, a separate work in process account is maintained for each department. The cost flows in parallel to the flow of physical units. When the processing work in a department is completed, the units along with their cost are transferred to the next department to be undergone for further processing.

Journal entries

Materials costs

In process costing system, a materials requisition form is used to draw materials from storeroom. When the materials are used in a particular department, the following journal entry is made:

Work in process — Department name [Dr.]
Raw materials [Cr.]

In debit part of the above journal entry, the words “department name” refer to the name of the particular department in which the materials (or another cost like labor and manufacturing overhead) has been incurred. For example, if the materials have been used in Department A, the debit part of the journal entry would consist of “Work in process — Department A” and the journal entry would look like the following:

Work in process — Department A [Dr.]
Raw materials [Cr.]

Similarly, if the materials have been used in Department B, the debit part of the entry would consist of “Work in process — Department B”. In that case, the journal entry would look like the following:

Work in process — Department B [Dr.]
Raw materials [Cr.]

In many industries, the materials are added only in the first processing department. In subsequent departments, only the labor and manufacturing overhead costs are added. However, it is not uncommon to find manufacturing processes where materials are added in first as well as in one or more subsequent processing departments.

Labor costs

The labor costs in a process costing system are traced to processing departments rather than individual jobs. The journal entry to record labor costs attributable to a particular processing department is given below:

Work in process — Department name [Dr.]
Salaries and wages payable [Cr.]

Manufacturing overhead costs

Like job order costing, the process costing system usually uses predetermined overhead rate to apply manufacturing overhead costs. A separate predetermined overhead rate is computed for each processing department and applied to production as the units move through the department. The journal entry to record manufacturing overhead cost in a process costing system looks like the following:

Work in process — Department name [Dr.]
Manufacturing overhead [Cr.]

Transfer of cost and completion of cost flow

When partially completed units are transferred to the next department

Upon completion of processing in a department, the units and their cost are transferred to the next department where partially completed units are further processed. For example, if a company has only two processing departments, A and B, the following journal entry would be made to transfer the costs of partially completed units from department A to department B:

Work in process — Department B [Dr.]
Work in process — Department A [Cr.]

When completed units are transferred to the finished goods storeroom

The above journal entry transfers the cost of partially completed units from department A to department B. After processing in department B, the partially completed units would be converted into finished goods and the total cost of completed units would be transferred from department B to Finished Goods Inventory Account. The following journal entry would be made for this purpose:

Finished goods [Dr.]
Work in process — Department B [Cr.]

When goods are sold to a customer

When goods are sold to a customer, the cost of units sold would be transferred from Finished Goods Inventory Account to Cost of Goods Sold Account. The following journal entry would be made for this purpose:

Cost of goods sold [Dr.]
Finished goods [Cr.]

Important points to remember

The students should remember the following important points about the flow of cost and units in a process costing system:

1. The materials, labor and overhead costs can be added in any processing department, not only in the first department.
2. A separate work in process account is maintained for each processing department.
3. Once the processing work in a department is completed, the production cost is transferred to the work in process account of the next department by making a journal entry.
4. In final department, the uncompleted units are converted into completed units or finished goods and the whole production cost accumulated in the final department is transferred to the Finished Goods Inventory Account by making a journal entry.
5. When a customer’s order is fulfilled and the goods are shipped to him, the cost of units sold is transferred from Finished Goods Inventory Account to Cost of Goods Sold Account by making a journal entry.

The whole discussion about the flow of cost and physical units in a process costing system can be summarized by the following T-accounts model:

Raw Materials Wages Payable Manufacturing Overhead Work in Process, Department A Work in Process, Department B xxx Finished Goods xox Cost of Goods Sold XXX

Predetermined overhead rate is used to apply manufacturing overhead to products or job orders and is usually computed at the beginning of each period by dividing the estimated manufacturing overhead cost by an allocation base (also known as activity base or activity driver). Commonly used allocation bases are direct labor hours, direct labor dollars, machine hours, and direct materials.

Formula:

The formula of predetermined overhead rate is written as follows:

Notice that the formula of predetermined overhead rate is entirely based on estimates. The overhead applied to products or job orders would, therefore, be different from the actual overhead incurred by jobs or products. This difference is eliminated at the end of the period. The elimination of difference between applied overhead and actual overhead is known as disposition of over or under applied overhead.