Management Accounting-Process Costing

PROCESS COSTING

Process costing is a method of applying costing systems to goods or services that are produced in a series of processes. 

Every unit is assumed to have involved the same amount of work and therefore the costs for a period are charged to processes or operations, and unit costs are calculated by dividing process costs by the quantity of units produced.

Process costing is a form of operation costing used when cost units are passed through a series of clearly defined process before the final product is completed.

It is the form of unit costing used when units pass through processes cost. The main feature of this method is that the finished output of one process becomes the input of the next process.  In this case all, costs direct and indirect are charged to each process

•   Process costing applies when standardized goods are produced from a series of inter-connected operations e.g. oil refining, breweries, canned or process food, chemicals manufacture, soap, spirits, paper, paint, biscuits, textiles etc

•   Process costing is used by the industries having a continuous flow of identical products, where it is not possible to distinguish one unit from another.

Elements of process cost

ü  Material

ü  Labour

ü  Direct Expenses

ü  Production overheads

Simple process accounts

Opening w.i.p Material introduced Material added Labour Overheads Abnormal gain

C.p.u * * * * * *

Value * * * * * * *

Normal loss Abnormal loss Process a/c Finished goods a/c Closing W.I.P

Units * * * * *

Cpu * * * * *

Value * * * * *

Calculation of cost per unit

Calculate the total of all costs incurred in the process during a period

•   If using absorption costing then include all over heads.

•   If using marginal costing then only include variable overheads

Divide the total cost by the number of units produced to arrive at a cost per unit.

Unit costing involves the division of all costs incurred during a period by the number of cost units.  The cost per unit is therefore:

CPU = Cost incurred during period

            Number of units produced

Illustration 1

During February the following costs were incurred in a process:

Materials                      Sh20, 000

Labour                         Sh 10,000

Overheads                   Sh 8,000

2,000 units were produced

Calculate the cost per unit:

Solution

Total process cost

Materials                     Sh 20,000

Labour                                    Sh 10,000

Overheads                  Sh 8,000

                                    Sh 38,000

Cost per unit Sh 38,000/2000 units

                        = Sh $ 19

The cost relating to a process for a period are collected and divided by the number of units produced during the period.

This costing process can be done in four steps:

1. Have a separate process account for each process.  The account is used to build up the cost of the process and work out the value of items produced from the process.
2. Charge the process account with the direct costs incurred. (Debit the account with the direct costs)
3. If absorption costing is being used, charge the process account with absorbed production overheads.  If marginal costing is being used, charged with variable production overheads only.
4. Divide the total costs by the number of units produced to calculate the cost per unit and so value the output of the process.  The cost of output is credited to the process account.

PROCESS LOSSES, SPOILAGE, WASTE AND DEFECTIVE UNITS

These terms are used frequently in process costing.  Mostly the quantity or weight of output of a process is less than input of that process.  The loss of weight or volume arises in the course of manufacture.  This loss mainly arises where distillation or disintegration by heat or chemical action is involves the reason of this loss are evaporation, residuals, ash, spoilage etc.

Spoilage:

Materials which have been damaged in the course of manufacture & it's not possible to economically rectify the damage & hence has to be taken out of the process so that the same can be disposed of in some way without being further processed, such damage is known as spoilage.
Accounting Treatment of Spoilage:

1. Spoilage may be normal or abnormal. Due to causes inherent in operation, normal spoilage occurs whereas due to causes not inherent in operation, abnormal spoilage occurs.
2. Production cost includes costs of normal spoilage. This can be done in 2 alternate ways: - (i) by charging the loss to production order, or (ii) by charging the loss to overhead.
3. If any value is realized from the spoilage, then such value is credited to the production order or overhead as the case may be.
4. Production cost excludes the cost of abnormal spoilage, which is transferred to costing profit & loss A/c.
5. Sometimes the specifications of the customer's are so rigid that any production not satisfying the specification is liable to be regarded as spoilage. In such cases, the cost of spoilage should be borne by the good units.

Spoilage should be controlled through compulsory preparation of spoilage report, setting standards for spoilage, & comparing the actual with standards.

Defective units

Defectives are those products which are not up to the standard & which are not meeting dimensional specification. Due to any one or more of the causes like, improper material, faulty supervision, bad workmanship, improper work planning, improper inspection etc., defectives may arise By incurring additional cost, defectives may be reconditioned or re-worked & can be brought to standard or little below standard.
Accounting Treatment of defectives:

When responsibility for defectives, cannot be located to any department, then in that case, the rectification cost should be treated as general overhead.

1. When responsibility for defectives, can be located to any department, then in that case, the rectification cost should be treated as overhead of that department.
2. When defectives have normal value & when defectives, subsequently rectified, is of normal quantity, the good units absorb the loss, i.e. the process account is credited with the proceeds of defectives.
3. When defectives are of abnormal quantity & arises out of uncontrollable causes, the rectification cost should be written off to costing profit & loss account.
4. The rectification cost of defectives which can be traced with a particular job should be charged to that job.
   Control should be exercised on (i) production, & (ii) rectification of defectives. For defectives & rectification costs of defectives, standards should be set & comparison of actual should be made with the corresponding standards. For the purpose of control, reports on defectives should be prepared. 

Wastage:

When basic raw materials are lost in the course of manufacture, rendering no realizable value, such are known as wastage. Wastage may be visible (e.g. waste in the form of smokes, dusts etc.) & invisible (e.g. due to evaporation, shrinkage etc.). Sometimes very nominal value may be realized from visible wastes.

Accounting Treatment of wastes:

1. Good units should absorb the Normal wastes whereas cost of abnormal wastes should be written off to costing profit & loss account.
2. When wastes fetch some sales value, such value should be credited to process account.
3. When such value is insignificant, then it may be treated as miscellaneous income.

Exercise of control should be on purchase, production, storage, inspection etc. Waste reports should be prepared & such preparation should be made compulsory. On the basis of past experience, estimation of wastes should be made before production & comparison of actual wastes should be made with the estimated wastes.

Normal wastage is inevitable and is bound to occur due to nature of materials. It arises out of breakage, evaporation, deterioration, shrinkage; it cannot be avoided even if by exercising strict control over materials.

Accounting Treatment of Wastages:

Normal wastage is unavoidable and uncontrollable and is therefore, treated part of the product. Abnormal wastage is unanticipated and is valued as if the out is good. This cost is transferred to Costing Profit and Loss A/C.

Process Loss

The loss of weight or volume of material during a process is known as process loss.  It may be of two types

•   Normal Process Loss

•   Abnormal Process Loss

Normal Process Loss (Expected Loss)

Is the amount of loss expected from the operation of a process.  This expectation is based on past experience and this loss is considered to be unavoidable in view of the nature of the production process.  This loss is caused by such factors as evaporation and this is calculated in advance on the basis of past experience.

The cost of normal loss is absorbed in the cost of production for goods production.  If defective units in respect of normal loss can be sold for a reduced value than the proceeds of these units are subtracted from total cost of good products in this case, the following formulas are used.

(i) Cost per unit            =          Total Process Cost

                                                Expected production

(ii) Cost per unit           =          Total Process Cost – Scrap Value of normal loss

                                                                 Expected production

Illustration 2

The following data relates to Process one during March

Input materials 1,000 kg costing                      sh.9,000

Labour cost                                                      sh.18,000

Overhead cost                                                  sh.13,500

A normal loss equal to 10% of input was expected.  Actual output was 900 kg, so that actual loss was equal to expected normal loss

Solution

Calculation of the number of normal loss unit

Normal loss = 10% of 1000 kg = 100 kg

Calculating the expected number of output units:

Expected output units              = 1000 kg – 100kg       = 900kg

Total process costs                   = Direct material            sh.9, 000

                                                    Direct labour                        sh.18, 000       

                                                  Overheads                 sh.13, 500                                                                                                                                            sh.40, 500

Cost per Unit                     =    Total Cost

                                                Output Units

                                          =    sh.40,500/900kg          = sh.45 per kg   

Process Account

	Kg	Value		Kg	P.U	Value
Material Labour Overheads	1000 1000	9,000 18,000 13,500 40,500	Normal loss output	100 900	45	40,500       40,500

The process account contains columns to record both quantities and value which are both balanced off.

No value is attributed to the normal loss units in this example

Example 1

During March the following costs were incurred in a process:

Materials (1000kg)                sh.12000

Labour                                    sh. 7000

Overheads                               sh.8000

A normal loss of 10%was expected. The actual output was 900kg.

Calculate cost per kg, and prepare a process Account.

Normal losses having a scrap sale value

When losses have a scrap value, reduce the cost of the process by the income anticipated from the normal loss.

Illustration 3

The following data relates to process one during March

Input material 1,000 kg                                    sh.9, 000

Labour cost                                          sh.18, 000

Overheads cost                                                sh.13, 500

A normal loss equals to 10% of input was expected.  Actual output was 900 kg so that actual loss was equal to expected (normal) loss.  The normal loss could be sold as scrap for $9 per kg. 

Prepare Process 1 Account and the normal loss Account

Solution

Calculation of the number of normal loss unit

Normal loss = 10% of 1000 kg = 100 kg

Calculating the expected number of output units:

Expected output units              = 1000 kg – 100kg       = 900kg

Total process costs                   = Direct material            sh.9, 000

                                                    Direct labour                        sh.18, 000       

                                                  Overheads                 sh.13, 500

                                                                                    sh.40, 500

Cost per Unit                     =    Total Cost-scrap value of normal loss

                                                Expected production

                                          =    sh.40,500-(9 x100)/900           = sh.44 per kg                                       

            Process Account

	Kg	Value		Kg	P.U	Value
Material Labour Overheads	1000 1000	9,000 18,000 13,500 40,500	Normal loss output	100 900    1000	9  44	900 39,600       40,500

              Normal loss account

	KG	PER KG	VALUE		KG	VALUE
Process account	100	9	900	Bank/cash	100	900
	100		900
					100	900

Example 2

During April the following costs were incurred in a process:

Materials (3000kg)                sh.30000

Labour                                    sh.12000

Overheads                               sh.10800

A normal loss of 10%was expected. The actual output was 2700kg.

Losses have a scrap value of sh.5 per unit.

Calculate cost per kg, and prepare a process Account and a loss account

Abnormal Process Loss

Even though we may expect a normal loss for example 10%to occur each month, it is unlikely that we will actually lose exactly 10% each month. Some months we will probably lose more than 10%and some months less than 10%.

Any excess loss in any month is known as an abnormal loss or unexpected loss.

We prepare costing as normal, taking into account any normal loss, and spreading the total cost over the units that we expect to produce.

Abnormal process loss represents the loss, which occurs under abnormal conditions.  Abnormal loss cannot be foreseen. 

Any abnormal losses are charged separately at the full cost per unit.

The main causes of abnormal loss are:

ü  plant breakdown,

ü  industrial accidents,

ü  inefficiency of workers

ü  Defective raw materials.

If actual loss is more than the normal loss then this difference is called Abnormal Process Loss.  Abnormal process loss is costed on the same basis as good production

It is treated as under:

Value of abnormal loss

Abnormal loss account          Dr

Process account                      Cr

Scrap value of abnormal loss

Scrap Debtors account          Dr

Abnormal loss account          Cr

The balance in the abnormal loss account is transferred to the profit and loss account at the end of the year

The extent to which the actual loss exceeds the normal loss is referred to as the abnormal loss.

Illustration 4

The following data relates to one process during April.

Input material 1000 kg          sh.9, 000

Labour cost                             sh.18, 000

Overhead cost                                    sh.13, 500

A normal loss equal to 10% of inputs was expected.

Actual output was 850 kg.

Losses are sold as scrap for sh.9 per kg

Prepare the process account, normal loss account and abnormal loss account.

Solution

Calculation of normal and abnormal loss

In put units                                                     1000kg

Less normal loss 10%of 1000                         100kg

Expected output                                             900kg

Actual output                                                 850kg

Abnormal loss                                                            50kg

Actual loss is less than normal loss:

Abnormal gain

The extent to which the actual loss is less than the normal loss is referred to as an abnormal gain.

In the same way that the actual output may be less than that expected, in some months it may be more than expected. If this happens, then we say that we have an abnormal gain.

The treatment of abnormal gains is exactly the same as for abnormal losses.

Illustration 5

The following data relates to one process during May

Input material 1000kg                                   sh.9, 000

Labour cost                                         sh.18, 000

Overhead cost                                                sh.13, 500

A normal loss equal to 10% of input was expected.

Actual output was 920 kg

Losses are sold as scrap for $9 per kg

Prepare the process account, normal loss account and abnormal gain account.

Example 3

During June the following costs were incurred in a process:

Materials (2000kg)                 sh. 18,000

Labour                                       sh.36, 000

Overheads                                sh.27, 000

A normal loss of 10% of input was expected.

Actual output was 1840kg.

Losses are sold as scrap for sh.9 per kg.

Calculate the cost per kg, and prepare a Process Account and abnormal gain Loss Account.