Unit 5: Process Costing

Process Costing

Process Costing is a method of costing used in industries where the production is continuous, and the product is undifferentiated. Instead of assigning a cost to each individual unit, the cost is assigned to the whole process or production department. Example: In a paper mill, the cost of producing paper is calculated for a batch of paper rather than for each sheet of paper.

Concepts of Process Costing

1. Normal Loss : Normal Loss is the expected or inherent loss that occurs during the production process due to natural factors (e.g., evaporation, spoilage, shrinkage). These losses are acceptable and pre-planned in the costing system.

Characteristics

• Expected Loss: These losses are anticipated and part of the production process.
• Costs Allocated: The cost of normal loss is absorbed by the good units produced.
• No Extra Charge: The loss is not charged separately to the production cost.

Example: In a textile industry, if 1000 meters of cloth are produced and 100 meters are lost during the dyeing process (normal loss), the loss is considered normal and is factored into the total cost.

2. Abnormal Loss: Abnormal Loss refers to losses that exceed the normal loss and occur due to unforeseen or avoidable circumstances (e.g., accidents, errors, machine breakdowns). These losses are not expected and must be treated separately in cost accounting.

Characteristics

• Unexpected Loss: Occurs due to mishaps, inefficiencies, or failures.
• Not Included in Normal Costing: The cost of abnormal loss is charged to a separate account and not absorbed by good units.
• Costs Allocated: The loss is accounted for separately, often as a special loss in financial statements.

Example: In a chemical plant, if 1000 liters of chemicals are processed and 50 liters are lost due to a leak (beyond normal evaporation), it would be recorded as abnormal loss.

3. Abnormal Effectiveness: Abnormal Effectiveness refers to the unexpected gain in the production process where the actual output exceeds the expected output. This happens due to some unexpected improvement in efficiency, such as better raw material usage or machine performance.

Characteristics

• Unexpected Gain: The production exceeds the normal yield due to favorable factors.
• Separate Accounting: The abnormal gain is recorded separately, and the excess output is treated as a profit or reduction in cost.
• Offsetting Losses: Sometimes, abnormal effectiveness can offset the losses due to normal or abnormal loss.

Example: If a company planned to produce 1000 units of a product, but due to improved efficiency or raw materials, they produce 1100 units, the 100 extra units are treated as abnormal effectiveness.

Process Costing Flow with Losses and Effectiveness:

• Calculate Normal Cost: Material, labor, and overheads are assigned to the normal units produced.
• Account for Normal Loss: Normal loss is accounted for as part of the process and included in the cost per unit.
• Account for Abnormal Loss: If actual loss exceeds normal loss, the difference is recorded as abnormal loss and charged separately.
• Account for Abnormal Effectiveness: If actual output exceeds the normal output, the difference is treated as abnormal effectiveness.

Example

• Normal Loss: 100 units (10% expected)
• Abnormal Loss: 50 units (unexpected)
• Abnormal Effectiveness: 150 extra units (unexpected gain)

Summary

Process Accounts

Process accounts are used to record the costs incurred in the production process. It tracks costs for raw materials, labor, overheads, normal losses, abnormal losses, and abnormal gains.

Structure of Process Account

Normal Loss Account

Normal loss is the expected loss during production. The cost of normal loss is absorbed by the good units produced.

Structure of Normal Loss Account

Note: The normal loss does not affect the cost of the finished goods, as its cost is absorbed by the good units produced.

Abnormal Loss Account

Abnormal loss is any loss that exceeds the expected (normal) loss. It is treated separately and charged to an Abnormal Loss Account.

Structure of Abnormal Loss Account

Note: The abnormal loss is charged to the Profit and Loss Account since it is not part of the normal cost of production.

Abnormal Gain Account

Abnormal gain occurs when the actual output exceeds the expected (normal) output. The extra units are treated as an abnormal gain.

Structure of Abnormal Gain Account:

Note: The abnormal gain is credited to the Profit and Loss Account because it represents an unexpected positive outcome.

Example: Let's assume the following data for a production process:

• Opening Work in Progress (WIP): 100 units at ₹10 per unit
• Raw Materials: ₹2000
• Labor: ₹1000
• Overheads: ₹500
• Normal Loss: 10% of the total output
• Abnormal Loss: 50 units
• Abnormal Gain: 20 units
• Actual Output: 900 units

Process Account

Normal Loss Account

Abnormal Loss Account

 Abnormal Gain Account

Summary

Process Costing with Opening and Closing Work-in-Progress (WIP)

In process costing, the cost of production is assigned to units in each stage of production. The process involves handling Opening WIP, Closing WIP, and calculating Equivalent Units. The FIFO (First In, First Out) method is often used to calculate Equivalent Units and assign costs.

Key Concepts

• Opening Work in Progress (WIP): Units that are partially completed at the beginning of the period.
• Closing Work in Progress (WIP): Units that are still in progress at the end of the period.
• Equivalent Units: The number of units that could have been completed given the amount of effort applied to the WIP.

FIFO Method

The FIFO method assumes that the units in Opening WIP are completed first, followed by the new units started during the period. The cost of the Opening WIP is separated from the cost of newly started units.

Steps for Process Costing Using FIFO

1. Calculate the Total Costs for the Period

This includes:

• Direct Material Costs
• Direct Labor Costs
• Manufacturing Overhead Costs

2. Identify Equivalent Units (using FIFO)

The number of equivalent units is calculated separately for Opening WIP and the units started and completed during the period.

Formula for Equivalent Units

• For completed units: Units completed during the period (both from Opening WIP and newly started units).
• For Closing WIP: The work done on incomplete units, calculated based on their stage of completion.

FIFO Method:

• Opening WIP equivalent units = Percentage of completion × units in Opening WIP.
• Units started and completed during the period = Units completed – Opening WIP units completed.
• Closing WIP equivalent units = Percentage of completion × units in Closing WIP.

3. Calculate the Cost per Equivalent Unit

This is done for Materials, Labor, and Overhead separately:

4. Cost Allocation

• Costs transferred out (completed units) = Cost per Equivalent Unit × Equivalent Units completed and transferred out.
• Costs in Closing WIP = Cost per Equivalent Unit × Equivalent Units in Closing WIP.

Example: Consider the following data for a company that manufactures units

• Opening WIP: 200 units (40% complete for materials, 30% complete for labor and overhead)
• Units started during the period: 1000 units
• Closing WIP: 100 units (50% complete for materials, 40% complete for labor and overhead)

Costs

• Direct Material Cost: ₹15,000
• Direct Labor Cost: ₹10,000
• Overhead Cost: ₹5,000
• Total Costs: ₹30,000

Step-by-Step Calculation Using FIFO:

1. Equivalent Units Calculation:

Let’s break it down for materials, labor, and overheads:

For Materials

• Opening WIP: 200 units × 60% (remaining work to complete) = 120 equivalent units.
• Started and completed: 1000 units started – 200 units (Opening WIP) = 800 units completed.
• Closing WIP: 100 units × 50% (remaining work to complete) = 50 equivalent units.

Total Equivalent Units for Materials: 120 (Opening WIP)+800 (Started and Completed)+50 (Closing WIP)=970 units

For Labor and Overheads

• Opening WIP: 200 units × 70% (remaining work to complete) = 140 equivalent units.
• Started and completed: 1000 units started – 200 units (Opening WIP) = 800 units completed.
• Closing WIP: 100 units × 60% (remaining work to complete) = 60 equivalent units.

Total Equivalent Units for Labor and Overheads: 140 (Opening WIP)+800 (Started and Completed)+60 (Closing WIP)=1000 units

2. Cost per Equivalent Unit:

Now, calculate the cost per equivalent unit for Materials, Labor, and Overhead:

3. Cost Allocation

Costs Transferred Out (Completed Units):

• For Materials:  800 units×₹15.46=₹12,368
• For Labor:  800 units×₹10=₹8,000
• For Overhead:  800 units×₹5=₹4,000
• Total Costs Transferred Out: ₹12,368 (Materials)+₹8,000 (Labor)+₹4,000 (Overhead)=₹24,368

Costs in Closing WIP:

• For Materials:  50 units×₹15.46=₹773
• For Labor:  60 units×₹10=₹600
• For Overhead: 60 units×₹5=₹300
• Total Costs in Closing WIP: ₹773 (Materials)+₹600 (Labor)+₹300 (Overhead)=₹1,673

Joint Products and By-Products

These are two or more products produced simultaneously from a common process and raw material, each having significant commercial value. Example: In crude oil refining – petrol, diesel, and kerosene.

By-Products

Products of minor value that are incidentally produced during the manufacture of the main (joint) products. Example: Molasses in sugar manufacturing.

Joint Costs

These are costs incurred before the split-off point, i.e., until the products become separately identifiable. Examples include: Raw materials, Labor, Factory overheads

Allocation of Joint Costs

Since joint products share initial costs, these costs need to be allocated fairly. The three most common methods are:

Physical Units Method

Joint costs are allocated based on the quantity (weight, volume, units) of output at the split-off point. Simple but ignores product value.

Formula:

Sales Value at Split-off Method

Joint costs are allocated based on the sales value of each product at the split-off point. Reflects the economic value of the product.

Formula:

Net Realizable Value (NRV) Method

Used when products require further processing after split-off. Allocates joint costs based on the final sales value – further processing costs.

Formula

Choosing the right method depends on:

• Whether products are processed further,
• Availability of market value,
• Nature and value of the outputs.

1. Target Costing

Target Costing is a cost planning and management technique used primarily during the product design stage. The goal is to reduce the product cost to meet a pre-decided selling price and desired profit.

Formula: 

Target Cost=Target Selling Price−Desired Profit

Key Features

• Customer-focused: Begins with market-driven price
• Cost control starts before production.
• Helps ensure profitability by setting cost limits early.

Example: If customers are only willing to pay ₹500 and the company wants ₹100 profit, then: Target Cost=₹500−₹100=₹400

2. Life Cycle Costing

Life Cycle Costing involves analyzing the total cost of a product throughout its life cycle — from design, development, and production to maintenance and disposal.

📌 Life Cycle Stages

• Development (R&D, design)
• Production (manufacturing, packaging)
• Operation/Use (servicing, maintenance)
• End-of-life (disposal, recycling)

✅ Benefits:

• Helps make long-term cost-effective decisions
• Identifies hidden or future costs
• Useful in capital-intensive industries (e.g., machinery, electronics)

3. Quality Costing

Quality Costing is the process of identifying and measuring the costs associated with ensuring quality and the costs resulting from poor quality.

📌 Types of Quality Costs

• Prevention Costs – cost of activities to avoid defects (e.g., training).
• Appraisal Costs – cost of inspecting/testing products.
• Internal Failure Costs – cost due to defects found before delivery (e.g., rework, scrap).
• External Failure Costs – cost due to defects found after delivery (e.g., warranty, returns).

Goal:To reduce failure costs by investing more in prevention and appraisal.

 Activity-Based Costing (ABC)

ABC is a costing method that allocates overheads based on activities that drive costs, rather than just using volume-based measures (like machine hours).

📌 Steps in ABC

• Identify major activities (e.g., packing, inspection)
• Assign costs to those activities
• Determine cost drivers (e.g., number of orders, setups)
• Allocate costs to products based on usage of activities

✅ Advantages

• More accurate product costing
• Highlights cost-driving activities
• Helps eliminate waste and inefficiencies

📊 Comparison Table: