This is crucial to generate job estimates that are as close to your actual cost as possible. Process costing is used when the products or services you offer are nearly identical or close to it. Changing from the traditional allocation method to ABC costing is not as simple as having management dictate that employees follow the new system.
- The diagram also shows the departments that report to the production unit director and gives an indication as to the flow of goods through production.
- You’ll also learn the concepts of conversion costs and equivalent units of production and how to use these for calculating the unit and total cost of items produced using a process costing system.
- This video on how drumsticks are made shows the production process for drumsticks at one company, starting with the raw wood and ending with packaging.
- Overhead costs are the most difficult to assign to products, and many businesses struggle to analyze these costs.
- This results in the costing system selected being the one that best matches the manufacturing process.
The majority of companies produce more than one product, and they use process costing by making batches of identical products, or at least highly similar products. Batch 1 might be 1,000 solid black masks, while batch 2 is 1,500 red and white striped masks. Work in process begins with the first stage of production(mixing and blending), continues with the second stage (bottling),and ends with the third stage (inspecting, labeling, andpackaging).
The difference between process costing and job order costing relates to how the costs are assigned to the products. In either costing system, the ability to obtain and analyze cost data is needed. This results in the costing system selected being the one that best matches the manufacturing process. In contrast, period costs are not directly related to the production process and are expensed during the period in which they are incurred. This approach matches administrative and other expenses shown on the income statement in the same period in which the company earns income.
Basic Managerial Accounting Terms Used in Job Order Costing and Process Costing
Figure 5.2 shows a partial organizational chart for Rock City Percussion, a drumstick manufacturer. In this example, two groups—administrative and manufacturing—report directly to the chief financial officer (CFO). The organizational chart also shows the departments that report to the production department, illustrating the production arrangement.
The equivalent unit is determined separately for direct materials and for conversion costs as part of the computation of the per-unit cost for both material and conversion costs. Understanding the company’s organization is an important first step in any costing system. The sticks are dried, and then sent to the packaging department, where the sticks are embossed with the Rock City Percussion logo, inspected, paired, packaged, and shipped to retail outlets such as Guitar Center.
Equivalent Units
For example, some items that are classified as overhead, such as plant insurance, are period costs but are classified as overhead and are attached to the items produced as product costs. As shown with Musicality’s products, not only are there different costs for each product when comparing traditional allocation with an activity-based costing, but ABC showed that the Solo product creates a loss for the company. Activity-based costing is a more accurate method, because it assigns overhead based on the activities that drive the overhead costs. It can be concluded, then, that the cost and subsequent gross loss for each unit’s sales provide a more accurate picture than the overall cost and gross profit under the traditional method. The image below compares the cost per unit using the different cost systems and shows how different the costs can be depending on the method used.
If Jennifer finds that job A required more labor hours than job B, it makes sense to assign more overhead costs to job a because it took more effort and therefore should be assigned more costs. Though it’s not a perfect allocation, it’s an accepted approach many companies use. Overhead costs are the most difficult to assign to products, and many businesses struggle to analyze these costs. Overhead costs cannot be directly traced to products or services, which makes them harder to track and manage. The batches are a little different, and the manufacturer makes slight adjustments to switch between products. The cost to change machine settings and to move in different materials – such as a different type of fabric – is factored into the overhead cost for each product.
For example, it would not be cost-effective for a restaurant to make each cup of iced tea separately or to track the direct material and direct labor used to make each eight-ounce glass of iced tea served to a customer. There are two methods used to compute the values in the work in process and finished goods inventories. The first method is the weighted-average method, which includes all costs (costs incurred during the current period and costs incurred during the prior period and carried over to the current period). This method is often favored, because in the process cost production method there often is little product left at the end of the period and most has been transferred out. The second method is the first-in, first-out (FIFO) method, which calculates the unit costs based on the assumption that the first units sold come from the prior period’s work in process that was carried over into the current period and completed. The theory is similar to the FIFO inventory valuation process that you learned about in an earlier chapter.
Accounting for Managers
Assigning these productcosts to individual products remains an important goal for processcosting, just as with job costing. However, instead of assigningproduct costs to individual jobs (shown on a job cost sheet),process costing assigns these costs to departments (shown on adepartmental production cost report). Job order costing tracks prime costs to assign direct material and direct labor to individual products (jobs). Process costing also tracks prime costs to assign direct material and direct labor to each production department (batch).
Manufacturing overhead is another cost of production, and it is applied to products (job order) or departments (process) based on an appropriate activity base. One factor that can complicate the choice between job order costing and process costing is the growth of automation in the production process, which typically is accompanied by a reduction in direct labor. The cost of the increase in equipment (typically reflected as a depreciation expense) is allocated to overhead, while the decreased need for labor usually reduces the direct labor cost. Because of these issues, some companies choose a hybrid system, using process costing to account for mass producing a part and using job order costing to account for assembling some of those individual parts into a custom product. Companies that mass produce a product allocate the costs to each department and use process costing.
Because the frames have already been through each department, the additional work is typically minor and often entails simply adding an additional fastener to keep the back of the frame intact. For example, assume a not-for-profit pet adoption organization has an annual budget of \(\$180,000\) and typically matches 900 shelter animals with new owners each year. To accurately track these process costs, an information system that allows your staff to easily record this activity is crucial. Hannah also has to keep her staff accountable for using these systems every day because if they don’t, the company can’t track product costs.
The diagram in Figure 8.1 shows a partial organizational chart for sign manufacturer Dinosaur Vinyl. The CEO has several direct reporting units—Financing, Production, Information Technology, Marketing, Human Resources, and Maintenance—each with a director responsible for several departments. Technology makes it easy to track costs as small as one fastener or ounce of glue. However, if compare and contrast job order and process costing systems. each fastener had to be requisitioned and each ounce of glue recorded, the product would take longer to make and the direct labor cost would be higher. So, while it is possible to track the cost of each individual product, the additional information may not be worth the additional expense. Manufacturing departments are often organized by the various stages of the production process.