What is Process Costing? Definition, How It Works & When to Use It
Unpack process costing: the essential method for tracking costs in continuous, high-volume production. Learn its mechanics, applications, and distinctions.
Process costing is an accounting method used by businesses to determine the cost of mass-produced, identical products or services. This approach is particularly relevant for organizations engaged in continuous production processes. It helps systematically track and allocate expenses across large volumes of uniform items, allowing businesses to accurately assess production costs for standardized goods.
Understanding the Fundamentals
Process costing is utilized when homogeneous products are manufactured in a continuous flow through a series of departments or processes. This method assumes that each unit produced is identical, making it impractical to track individual unit costs. Instead, costs are accumulated by department over a specific period, typically a month. These accumulated costs are then averaged over the large batches of identical units produced within that period.
The primary characteristic of this system is its focus on the production process itself, rather than individual jobs or orders. Since all units passing through a department receive the same amount of direct materials, direct labor, and manufacturing overhead, their costs can be averaged. This averaging simplifies cost assignment for millions of similar units, providing a clear picture of the overall cost of production for a given period.
Where Process Costing Applies
Process costing is suitable for industries where products are indistinguishable from one another and are produced in a continuous, repetitive manner. These industries often involve a series of sequential operations that transform raw materials into finished goods. The consistent nature of the output makes averaging costs across units an efficient and appropriate method.
Examples of industries that commonly use process costing include chemical processing, such as paints and lubricants, and food and beverage production, like soft drinks or cereals. Petroleum refining, textile manufacturing, and pharmaceuticals also frequently employ this method due to their continuous production of uniform products. Assembly line production, where components are mass-produced, also benefits from process costing.
Tracking Costs in a Process System
Tracking costs in a process system involves accumulating expenses by department rather than by individual units. Direct materials, direct labor, and manufacturing overhead are assigned to each department as products move through various production stages. This departmental accumulation provides insight into the costs incurred at each specific manufacturing phase.
As partially completed products move from one department to the next, the costs incurred in the preceding department are transferred along with them. These are known as “transferred-in costs,” representing the accumulated expenses from prior stages of production. These costs become part of the material costs for the subsequent department, which then adds its own direct materials, labor, and overhead.
A unique aspect of process costing is the concept of “equivalent units of production.” Since some units may be partially completed at the end of an accounting period, equivalent units convert these incomplete units into the number of fully completed units they represent. This allows for a consistent measure of output when calculating per-unit costs, accounting for the work done on both finished and unfinished products. A cost per equivalent unit is calculated by dividing total departmental costs by these equivalent units. These per-unit costs are then used to assign total costs to units that have been completed and transferred out to the next department or finished goods inventory, as well as to units remaining in the ending work-in-process inventory.
Process Costing Compared to Job Order Costing
Process costing and job order costing are two distinct cost accounting methods, each suited for different production environments. The fundamental difference lies in the nature of the products and the production process. Process costing applies to homogeneous products produced continuously, while job order costing is for unique or custom products.
In terms of cost accumulation, process costing gathers costs by department or process, averaging them across all units produced within a period. Conversely, job order costing tracks costs by individual jobs or projects, with each job having its own specific cost sheet. This allows for a detailed breakdown of expenses for customized orders.
The unit of cost differs significantly. Process costing determines an average cost per unit for a period, suitable for mass production where individual units are indistinguishable. Job order costing focuses on the specific cost per unique job, which is necessary for products or services with varying specifications. Documentation also varies, with process costing relying on production reports for departments, while job order costing uses job cost sheets for each unique order.