Accounting: The Language of Business - Vol. 1 (Part 114)

"E`en as a toper from the dram-shop reeling, / Sees in his garret`s blackness, dazzling fair, / All that he might have been, and, heart-sick, kneeling, / Sobs in the passion of a vast despair: / So my ideal self haunts me alway--/ When the accounting comes, how shall I pay?" - Robert William Service 

 Process Cost System (Part A)

by

Charles Lamson

If you bake cookies, the ingredients would include flour, sugar, and shortening. These ingredients would all be added at the beginning of the baking process by mixing them in a bowl. After mixing, do you have cookies? No. Why? Because they are not (converted). But are they 100% complete with respect to materials? Yes, all the materials have been added to the baking process. When will they be cookies? When they are 100% complete with respect to materials and baking.

Now, assume that you asked the question, "How much cost have I incurred in baking cookies after 15 minutes (out of 30 minutes) of baking time?" The answer would require that you separate the ingredients and the electricity costs. These two costs are incurred in the baking process at different rates. And so it is convenient to identify them separately. The ingredient costs have all been encouraged, since they were all introduced at the beginning of the process. The electricity costs, however, are a different story. Since the baking is only 50% complete, only 50% of the electricity costs (for the oven) have been incurred in the baking process. Therefore, the answer to the question is that all the materials costs and half the electricity costs have been incurred in the baking process after 15 minutes of baking.

In the next several posts, we apply these concepts to manufacturers that use a process cost system. After introducing process costing, we discuss decision-making with process cost system reports. We conclude these next several posts with a brief discussion of just-in-time cost systems.

Comparing Job Order Costing and Process Costing

As we discussed in a previous post, the job order cost system is best suited to industries that make special orders for customers or manufacture different products in groups. Industries that may use job order cost systems include special order printing, custom-made tailoring, furniture manufacturing, shipbuilding, aircraft building, and construction. Process manufacturing is different from job order manufacturing. Process manufacturers typically use large machines to process a flow of raw materials into a finished state. For example, a petrochemical business processes crude oil through numerous refining steps to produce higher grades of oil until gasoline is produced. The cost accounting system used by process manufacturers is called the process cost system.

In some ways, the process cost and job order cost systems are similar. Both systems accumulate product costs---direct materials, direct labor, and factory overhead---and allocate these costs to the units produced. Both systems maintain perpetual inventory accounts [Perpetual inventory is a method of accounting for inventory that records the sale or purchase of inventory immediately through the use of computerized point-of-sale systems and enterprise asset management software (investopedia.com).] with subsidiary ledgers for materials, work in process, and finished goods. Both systems also provide product cost data [Total product costs can be determined by adding together the total direct materials and labor costs as well as the total manufacturing overhead costs. Data like the cost of production per unit can help a business set an appropriate sales price for the finished item (investopedia.com).] to management for planning, directing, improving, controlling, and decision-making. The main difference between the two systems is the form in which the product costs are accumulated and reported.

Exhibit 1 illustrates the main differences between the job order and process cost system. In a job order cost system, product costs are accumulated by job and are summarized on job cost sheets. The job cost sheets provide unit cost information and can be used by management for product pricing, cost control, and inventory valuation. The process manufacturer does not manufacture according to "jobs." Rather, costs are accumulated by department. Each unit of product that passes through the department is similar. Thus, the production costs reported by each department provide unit cost information that can be used by management for cost control. In a job order cost system, the work in process inventory at the end of the accounting period is the sum of the job cost sheets for partially completed jobs. In a process cost system, the amount of work in process inventory is determined by allocating costs between completed and partially completed units within a department. 

Physical Flows and Cost Flows for a Process Manufacturer

Materials costs are a large portion of the costs for most process manufacturers. Often, the materials costs can be as high as 70% of the total manufacturing costs. Thus, accounting for materials costs is very important for process operations.

Exhibit 2 illustrates the physical flow of materials for a steel processor. Direct materials in the form of scrap metal are placed into a furnace in the Melting Department. The Melting Department uses conversion costs (direct labor and factory overhead) during the melting process. The molten metal is then transferred to the Casting Department, where it is poured into an ingot casting. The Casting Department also uses conversion costs during the casting process. The ingot castings are transferred to the finished goods inventory for shipment to customers.

EXHIBIT 2 Physical Flows for a Process Manufacturer

The cost flows in a process cost system reflect the physical materials flows and are illustrated in Exhibit 3.

EXHIBIT 3 Cost Flows for a Process Manufacturer

The transactions in Exhibit 3 are as follows:

1. Purchased materials [Debit (Dr.) Materials; Credit (Cr.) Accounts Payable (not shown)].

2. Direct materials (scrap metal) used by the Melting Department (Dr. Work in Process---Melting; Cr. Materials).

3. Direct labor used in the Melting Department [Dr. Work in Process---Melting; Cr. Wages Payable (not shown)].

4. Indirect materials and other overhead incurred (Dr. Factory Overhead---Melting and Factory Overhead---Casting; Cr. Materials and other accounts (not shown)].

5. Factory overhead applied in the Melting Department, using a predetermined rate (Dr. Work in Process---Melting; Cr. Factory Overhead---Melting).

6. Cost of completed production transferred from the Melting Department to the Casting Department (Dr. Work in Process---Casting; Cr. Work in Process---Melting).

7. Direct labor used in the casting department [Dr. Work in Process---Casting; Cr. Wages Payable (not showing)]. 

8. Factory overhead applied in the casting department (Dr. Work in Process---Casting; Cr. Work in Process---Casting).

9. Cost of finished ingots transferred out of the Casting Department (Dr. Finished Goods; Cr. Work in Process---Casting).

10. Cost of ingots sold to customers (Dr. Cost of Goods Sold; Cr. Finished Goods).

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 784-785*

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