Amy has a master's degree in secondary education and has taught math at a public charter high school.
Read this lesson to learn how production costs are added to a product as it is being made. You'll also see why it's important for a business to know how cash flow relates to process costing.
In this lesson, we'll take a look at how a business keeps track of its manufacturing costs so it knows just how much to sell its products for. When a business makes its products in bulk, it can use the process costing method of figuring this out.
Using process costing, the production cost of one unit of a product is calculated based on the overall cost to make a large quantity of product. For example, a business that makes organic dog food in bulk will take a look at the total cost to make each batch of dog food. It will then use this number to calculate the cost of each bag it sells. If it costs the dog food company $2,545 to make 4,000 pounds of its dog food, it can take that total production cost of $2,545 and divide it by 4,000 pounds to find the per pound price; in this case, $2,545 / 4,000 = $0.64 per pound.
It's important for businesses to know how much it costs to make a product. If they didn't, they wouldn't know how to price their products so they make a profit. For instance, if the dog food company didn't use process costing and blindly sold its dog food for $0.50 or even $0.60 per pound, it would be losing money and would soon close down. But since the company did its homework and performed the process costing analysis of its product costs, it knows that it needs to price its dog food above $0.64 per pound to make profit.
In this lesson, we'll take a look at how the dog food company calculates its overall cost to manufacture its product. We won't be including any journal entries as this lesson focuses on the process itself.
Calculating your production cost through the process costing method isn't that complicated. But when your product has to go through several different departments or stages, then you'll need to do just a bit of math to find your production cost. The path your product takes as it makes its way from raw materials to finished product is called its product flow.
For the organic dog food company, its product flow might begin with the research team, then move on to the purchasing department. After that, it reaches the kitchen department where it is made. As the dog food moves through these stages, it incurs costs associated with each department. As it relates to process costing, cash flow is how the money adds up during the product manufacturing process.
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Let's follow some dog food in the making to see how each department has its own costs. First, the research team brainstorms what ingredients to use. The research team also tries out various recipes and performs taste tests with its resident dogs to see which recipes are keepers. This team also performs a nutritional analysis on the food to make sure that it is healthy for the dogs. The cost of this team is $589 for the 4,000 pound batch. The per pound cost of this department is $589 / 4,000 = $0.15.
The second department the dog food goes through is the purchasing department. This department purchases all the ingredients needed to make the dog food. The cost for this department for 4,000 pounds of organic dog food is $1,123. Per pound, it is $1,123 / 4,000 = $0.28.
The third and final department the dog food goes through is the kitchen department where the actual dog food is made. This department has a cost of $833 to cook and make 4,000 pounds of the food. Per pound, it is $833 / 4,000 = $0.21.
As the dog food moves through its various departments, the cost to make it increases. It began at $0.15 per pound with the research department. It then incurs an additional $0.28 per pound cost from the purchasing department. Lastly, it incurs a $0.21 per pound cost from the kitchen. Adding these up, we get a production cost of $0.15 + $0.28 + $0.21 = $0.64 per pound. This is the process costing method of calculating your production cost.
Let's review. To manage cash flow and calculate production costs for products made in bulk, companies can use the process costing method. The production cost of each product is calculated from the overall cost to make a bulk batch. As a product moves through the various departments from research to manufacturing, product flow, it incurs costs from each department. To calculate the production cost, add the cost from each department and then divide by the number of units made in the batch.
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