Christian has a PhD in Business Management and an MA in Accounting & Financial Management
This lesson introduces the topic of equivalent units and demonstrates how to calculate this number. It also calculates per unit cost of production and illustrates a production cost report and the way in which the corresponding numbers are used by management.
What Is an Equivalent Unit?
Manufacturing companies use a lot of ways to figure out what their operational strategy needs to be when they make their products. The operational strategy is a plan that includes the goals and behaviors used to accomplish the goals of a company. These measurements supply different information depending on the tool used and the intended outcome.
One important tool that companies use is the equivalent unit metric. An equivalent unit is a term used to describe work-in-progress inventory units at the end of a specific time period. It defines the number of completed units of a particular item that the company could have produced, given the amount of costs that were incurred during that time period for all items not yet completed.
For example, if there are 1,000 units in progress, and the company has only expended 40% of the processing costs on these units, then you have 400 equivalent units of production. The concept of equivalent units is used solely in process costing because you are determining the equivalent unit calculation based on a mass quantity of an item.
Equivalent units of production are recorded separately for the three categories of manufacturing costs because direct materials are added to the beginning of the manufacturing process, while labor and manufacturing overhead are added throughout the process. As a result, the equivalent units of direct materials will always be higher than other manufacturing costs. When a company assigns costs to an equivalent unit of production, the simplest method is by using the weighted-average cost of beginning inventory and adding new cost in additional purchases of direct materials.
Calculating Equivalent Units of Production
The formula for calculating equivalent units of production uses the weighted-average method formula because of its simplicity.
Total equivalent units of a cost product = A + B * C
Where: A = units transferred to the next department or finished goods (completed) B = units in work-in-progress at the closing time of time period C = percentage of completion with respect to the product
For example, let's look at a calculated total equivalent units:
Units in opening Work-In-Progress (WIP)
Units transferred out
Units in closing WIP
% of completion of closing WIP (direct materials)
% of completion of closing WIP (conversion costs)
Total equivalent units (direct materials) = 190,000 + 5,000 * 100%
= 195,000 units
Total equivalent units (conversion costs) = 190,000 + 5,000 * 60%
= 193,000 units
As we can see, the direct materials are calculated at 100% because direct materials costs are incurred at the beginning of the time period. Conversion costs are the direct labor and manufacturing overhead that is used during the time period, even though some of the product was not completed during the time period.
Calculating Cost Per Unit of Production
Companies calculate the cost per unit of production to know how to most accurately determine price for the customer. Every penny counts, especially if the product that they're selling is made in the thousands. Accurate calculations and proper application of cost metrics will allow companies to ensure that every cost is accounted for.
The formula for calculating:
Per Unit Cost of Production = Total manufacturing costs / Total number of units produced
For a particular manufacturing run, your total manufacturing costs are $130,000. The batch of product consists of 40,000 units.
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By calculating the per unit cost of production, companies are able to determine the break-even point of the product. This is the minimum amount that the company needs to charge for its product to recoup the cost of production. This number can also be used by management to determine if projected costs were over or under the parameters of the project or manufacturing run.
For example, if management projects that the per unit cost of production should be $3, then the calculation provides them data on how to improve the process to reduce resource usage and bring the per unit cost down to projected amounts. The company is also able to split up the cost of manufacturing among departments' completed units and the remaining work-in-progress units.
The Production Cost Report
Each department in the manufacturing process is required to report equivalent units, both those completed and those in working progress (WIP). The production cost report takes data from production and reports it as total amounts incurred during the associated time period. This report is used by management to analyze production processes and determine if improvements need to be made to maximize efficiency.
There are three sections of the report. First is unit reconciliation. This compares total units in production to total units reconciled (those units completed + those units in WIP). The second illustrates the cost per equivalent unit. The third section illustrates cost allocation between completed units and WIP units. The production cost report is a useful tool to aid management in the planning process of operations. It is very dynamic and adaptable to any type of manufacturing process.
Companies determine the efficiency of their manufacturing processes in various ways. One method is to calculate equivalent units of production. This allows managers to see how much of a product was completed during a specific time period and how much of a product is still in work in progress. It also allows managers to calculate per unit cost of production to help determine unit pricing for customers. A production cost report is a departmental report that illustrates all of the information for quick analysis by management.
Upon completion of this lesson, you might discover a stronger ability to:
Define equivalent units and describe their importance to the operational strategy
Illustrate the steps necessary to calculate for equivalent units
Calculate cost per unit
Determine the significance of the production cost report
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