Accounting: The Language of Business - Vol. 1 (Part 118)

"For the needs of many are the sins of a few / And the day is forthcoming when accounting is due / Sing a song for sweet justice with a fire in her eyes / Sing of Stone haven mountain home, Stone haven Sunrise." - John Denver  

Process Cost Systems (Part E)

by

Charles Lamson

Average Cost Method

A manufacturer uses a cost flow assumption in determining the costs flowing into, out of, and remaining in each manufacturing department. In preceding posts, we illustrated the first-in, first-out cost flow assumption for the Melting Department of McDermott Steel Inc. In this post, we illustrate the average cost flow method for Gemini Steel Corporation.

Determining Costs Under the Average Cost Method

Gemini's operations are similar to those of McDermott Steel in that Gemini melts scrap metal and then pours the molten metal into an ingot casting. Like McDermott Steel, Gemini has two manufacturing departments, melting and casting. To illustrate the average cost method, we simplify by using only the Melting Department of Gemini Steel. The manufacturing data for the Melting Department for July 2023 are as follows.

Using the average cost method, our objective is to allocate the total costs of production of $86,400 to the 1,100 tons completed and transferred to the casting department and the costs of the remaining 400 tons in the ending work in process inventory. These costs are represented in the preceding table by two question marks. We determine these amounts by using the following four steps:

1. Determine the units to be assigned costs.

2. Calculate equivalent units of production.

3. Determine the cost per equivalent unit.

4. Allocate costs to transferred and partially completed units.

Step 1: Determine the Units to be Assigned Costs

The first step in our illustration is to determine the units to be assigned costs. A unit can be any measure of completed production, such as tons, gallons, pounds, barrels, or cases. We use tons as the definition for units in Gemini Steel.

Gemini Steel's Melting Department had 1,500 tons of direct materials to account for during July, as shown here:

=

There are two categories of units to be assigned costs for the periods: (1) units completed and transferred out and (2) units in the ending work in process inventory. During July, the Melting Department completed and transferred 1,100 tons to the Casting Department. Of the 1,000 tons started in July, 600 tons were completed and transferred to the Casting Department. Thus, the ending work in process inventory consists of 400 tons.

Note that the total units (tons) to be assigned costs (1,500 tons) equals the total units to account for (1,500 tons).

Step 2: Calculate Equivalent Units of Production

Gemini Steel has 400 tons of whole units in the work in process inventory for the Melting Department on July 31. Since these units are 25% complete, the number of equivalent units in process in the Melting Department on July 31 is 100 tons (400 tons * 0.25). Since the units transferred to the Casting Department have been completed, the whole units (1,100 tons) transferred are the same as the equivalent units transferred.

The total equivalent units of production for the melting department is determined by adding the equivalent units and the ending work in process inventory to the units transferred and completed during the period as shown here:

Step 3: Determine the Cost per Equivalent Unit

Materials and conversion costs are often combined in computing cost per equivalent unit under the average cost method. In doing so, the cost per equivalent unit is determined by dividing the total production costs by the total equivalent units of production as follows:

We use the cost per equivalent unit in Step 4 to allocate the production costs to the completed and partially completed units.

Step 4: Allocate Costs to Transferred and Partially Completed Units

In Step 4, we multiply the cost per equivalent unit by the equivalent units of production to determine the cost of transferred and partially completed units. For the Melting Department, these costs are determined as shown:

The Cost of Production Report

The July cost of production reports for Gemini Steel's Mining Department is shown in Exhibit 11. The cost of production report in Exhibit 11 summarizes the following:

1. The units for which the department is accountable and the disposition of those units.

2.  The production costs incurred by the department and the allocation of those costs between completed and partially completed units. 

EXHIBIT 11 Cost of Production Report for Gemini Steel's Melting Department

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 799-802*

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