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Process Costing System and Formula

Nathan Mahr, Sarah Bilant
  • Author
    Nathan Mahr

    Nathan has taught English literature, business, social sciences, history, and writing for over five years. He has a B.A. in Comparative History of Ideas from the University of Washington.

  • Instructor
    Sarah Bilant

    Sarah has taught QuickBooks classes, has a Bachelor of Science degree in Accounting, and is a licensed CPA.

Learn about process costing. Study the process costing definition, examine process costing examples, and discover why process costing systems are so important. Updated: 05/12/2022

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What is Process Costing?

Process costing is defined as a system for assigning manufacturing costs to an individual product or groups of products at each stage of production. Process costing is used when a company produces large quantities of homogeneous products, such as chemicals, beverages, and plastics. Examples of companies that typically use a process costing system include oil refiners, food processors, and paint manufacturers. In contrast, job costing systems are used when products are produced in small quantities, when production varies greatly from one period to the next, or for manufacturers of dissimilar products.

There are several terms and concepts that are used in the calculations related to process costing. Direct materials are the raw materials used in the manufacturing process. For example, paint ingredients would be direct materials as they are materials needed to make a company's products. Direct labor is the cost of labor required to produce the product. Conversion costs are the indirect costs incurred in converting direct materials into finished products, such as factory overhead. Cost drivers are the factors that cause changes in the total cost of producing a good or service.

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Importance of Process Costing Systems

Process costing is important for companies because it provides accurate information about the costs associated with producing a product. This information is important for setting prices, monitoring profit margins, and identifying areas to reduce costs. Process costing also provides accurate information for tax and inventory purposes.

Types of Process Costing

There are three main types of process costing systems:

  • Standard cost system: This system uses predetermined costs for direct materials and conversion costs. The actual costs are then compared to the standards to determine variances.
  • First-in, first-out (FIFO): In this system, the costs of the first units produced are assigned to the first units sold. This method assumes that the cost of goods sold represents the cost of the most recent production.
  • Weighted average system: In this system, the costs of all units produced are averaged together. This method assumes that the cost of goods sold represents the cost of all production, regardless of when it was produced.

Process Costing Formula

The following formula is used to calculate the cost per unit of output:

Cost Per Unit of Output = Total Expenses / Total Number of Units Produced

There are a few important steps that must be completed in order to use the process costing formula:

  1. Analyze inventory: The first step is to analyze the inventory to determine the number of units that are complete and the number of units that are incomplete.
  2. Convert inventory costs: The next step is to convert any inventory that was not fully completed by the end of the period to a number of equal units. For example, if there are 100 units that are 50% complete, then these units would be converted to 50 completed units.
  3. Calculate applicable costs: The third step is to calculate the total indirect and direct costs that were applicable to the production of the product. This includes costs such as direct materials, direct labor, and factory overhead.
  4. Calculate cost per unit: The next step is to calculate the cost per unit of output. This can be done by dividing the total expenses by the total number of units produced.
  5. Designate costs for complete and incomplete products: The final step is to designate the costs for the complete and incomplete products. This can be done by allocating the applicable costs between the two types of products.

The above steps are important because they ensure that the correct information is used in the calculation of the cost per unit of output. The cost per unit of output can be used to monitor the profitability of a product. If the cost per unit is too high, it may not be possible to sell the product at a price that will generate a profit. Therefore, it is important to keep track of the cost per unit in order to make sure that the product is profitable.

One way to reduce the cost per unit of output is to increase the efficiency of the production process. This can be done by reducing the amount of waste, increasing the utilization of resources, and improving the quality of the product. By doing this, a company can reduce the total expenses incurred in producing the product, which will in turn reduce the cost per unit of output. Another way to reduce the cost per unit of output is to produce in larger quantities. This will allow a company to spread the fixed costs over a larger number of units, which will reduce the cost per unit of output.

Process Costing Examples

It can be helpful to work through a few theoretical examples of using the process costing formula and its associated steps.

Example 1

Company A is an electronics manufacturer that uses a process costing system. The company recently started production on a new product. The following information is available for the month of January:

Total number of complete units produced: 10,000

Total number of incomplete units produced (50% complete): 5,000

Total direct materials cost: $100,000

Total direct labor cost: $200,000

Total factory overhead cost: $50,000

What is the cost per unit of output?

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Frequently Asked Questions

Who uses process costing?

Companies that produce products that are the same or similar typically use process costing systems. Examples include companies such as food processors, oil refiners, and paint manufacturers.

What are the five steps in process costing?

The five steps in process costing are to analyze inventory, convert incomplete units to completed units equivalent, determine total expenses, calculate cost per unit of output, and allocate costs to completed and incomplete units. Each step is an important part of the process and helps to ensure that an accurate cost per unit of output is calculated.

What is the purpose of process costing systems?

Process costing systems are used to track the costs of production at each stage in order to ensure that products are being produced efficiently. By understanding how much it costs to produce a product at each stage, companies can make changes to their production process in order to save money and become more efficient.

What is process costing in accounting?

Process costing in accounting is a system that is used to track the costs of production at each stage. This information is then used to calculate the cost per unit of output.

How is process cost calculated?

The cost of production for each stage is calculated by adding up the costs for that stage and then dividing by the number of products made. This formula can be expressed as:

Cost Per Unit of Output = Total Expenses / Total Number of Units Produced

How can someone calculate process costing?

Costs for each stage are summed together and then divided by the total number of items produced. It is important to include partially completed items when determining the cost per unit as this will give a more accurate representation of the true cost.

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