Absorption and marginal costing cannot be applied in all manufacturing environments. Both methods require identification of discrete cost units that can be followed through the production process. Flow-based production methods, such as food processing and oil refining, do not facilitate this. It is not possible, for instance, to follow the same litre of crude oil through the refining processes as it constantly being intermixed.
To overcome this, process costing has been developed. In this method a unit of raw material input is taken as a cost unit and all other costs are added to the unit of raw material as processing occurs.
At the heart of this technique is the process account, a form of work in progress account, for a specific process.
There are three things worth noting about the process account:
- Units of raw material are shown in the account as well as costs.
- Only raw materials have units – remember the unit of raw material is being treated as a unit of finished output.
- The units of raw materials, as with costs, must balance i.e. if a million units of material are input then a million units of output must be accounted for.
In reality, process accounts are more complex as they have to account for:
- Losses in processing
- Opening and closing working in progress
- Any scrap revenue gained form the disposal of losses
- Apportionment of costs between outputs if more than one product is produced by the process
Most processes experience some form of input loss. For example, as food is processed weight loss will occur. During oil refining, evaporation and spillage will lead to volume loss.
How these losses are accounted for depends on whether a loss was expected or unexpected.
If a loss was expected it is known as a normal loss. In process costing, normal losses do not have a cost, as they are built into the budgeted cost of expected output.
An abnormal loss is an unexpected loss. As it is unexpected, it cannot be built into the budgeted unit cost of output and has to be costed differently to normal loss. Each unit of abnormal loss is usually costed at the same rate per unit as units of finished goods.
On occasion, processes can record abnormal gains. These occur when a company loses fewer units that expected i.e. there is a gain on budget. Due to the fact these are extra units of good product, these cost are recorded at the same rate as good units.
However, as they are a gain they appear on the debit, rather than the credit, side of the process account.
The characteristic of many processes is the existence of large amounts of work in progress at the end of an accounting period i.e. processes are not shut down at the end of a period but are run continually.
Because it is not fair to cost work in progress at the same unit cost as finished output, work in progress is recorded according to the degree of completion. The number of physical units of work in progress can be converted to the number of equivalent (finished cost) units it represents.
A unit of finished goods normally contains at least three cost inputs – materials, direct labour and production overheads. It is often the case that closing work in progress is not complete to the same degree for each of these inputs. In many processes, all the materials are added at the start so closing work in progress is complete according to materials. However, labour and overheads normally accumulate as units move through the production process.
This problem can be overcome by calculating separate equivalent units for each of the inputs.
This involves producing:
- A statement of equivalent units
- A statement of unit cost
- A statement of valuation
If at the end of an accounting period there is closing work in progress, it follows that at the start of the next accounting period, this will become opening work in progress. Any output finished during the period will have two sources:
- Units that represent finished off opening work in progress
- Units that were started and finished in the period
There are two ways of accounting for opening work in progress:
- Weighted Average. In this method a distinction is not made between the two sources of finished output, and an average unit cost is calculated.
- First in First Out. In this method units finished off and units started and finished are accounted for separately and then added together to get a total value for finished output.
The difference between the two methods is normally small (Except in cases where there is a significant inflation between accounting periods).
In the case of weighted average, units of opening work in progress are treated as another process input. Their cost is split into its constituent parts (materials, labour and overheads) and added into the costs of input in the statement of unit cost. Finished goods are then treated as a single item in the statement of valuation