FMA/MA – MANAGEMENT ACCOUNTING

PROCESS COSTING
Process costing is a costing method which is applicable in industries producing homogeneous products in
large quantities. The purpose of process costing is a typical one for example stock valuation. It is also
called continuous order costing.

FEATURES OF PROCESS COSTING

➢ Homogeneous production (Large Quantities) identical products.
➢ Production is continuous (2 or 3 or more processes) like oil refining, paper making and chemical
manufacturing.

Some important terms and concepts related to process costing are as follows:
▪ If finished products are produced by more than one process, then output of first process becomes
the input of the next process.
▪ There might be some incomplete products at the end of the period; they are called work in
progress units.
▪ Work in progress might not be complete with respect to all the cost so equivalent units should be
calculated.
▪ Conversion cost = Direct labour cost + Direct expenses + Production overheads.
▪ During production process, some units might get lost, and if the loss is not more than the expected
loss then it is called as NORMAL Loss (ignored in the calculation).
▪ If the loss is more than the expected loss, then it is called as ABNORMAL Loss of the process. It
should be treated in the calculation.
▪ If the output units are greater than the expected output, then the extra units produced are called
as ABNORMAL GAIN. Abnormal Gain must be treated in calculation.
▪ In some industries, there might be a chance of joint and By-products. By-products should be
treated as NORMAL LOSS.
▪ Loses might have a certain resale value, that value is called the “Scrap Value”.
▪ Losses might have to dispose of at some cost to company, that cost is called “Disposal value”.

STEPS TO SOLVE QUESTION

1. Prepare a process account.
2. Calculate equivalent units.
3. Calculate the cost of an equivalent unit.
4. Find the cost of finished goods.
5. If there is work in progress at the end, calculate the cost of work in progress / abnormal loss /
abnormal gain.

Concept of Equivalent Units: Equivalent unit refers to a notional quantity of completed units substituted
for an actual quantity of incomplete physical units in progress.

A process is continuous in nature and at the end of a period there may be some units, which have been
started but have not been completed. These partially completed units are known as work-in progress.
The existence of work-in-progress gives a problem in computing the average cost per unit as production
units will be at different degree of completions, therefore we cannot simply take total cost divided by total
output.

It becomes more complicated if the degree of completions varies for various cost elements. For example,
materials may be added at the start of the process, and are thus fully complete, whereas labour and

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manufacturing overheads (conversion cost) may be added uniformly throughout the process. Hence, the
ending work in progress may consist of materials that are 100% complete and conversion cost that is only
partially complete.

For this problem, we need to calculate equivalent units.

Please note:
● The equivalent unit for one normal loss output is 0 as the company can predict for the normal loss
when determining the cost per normal output unit.
● The equivalent unit for one abnormal gain or loss output is 1 since the company cannot predict it
when calculating the cost per normal output unit.

LOSSES DURING THE PROCESS

● Normal Loss: Normal Loss is an expected loss of the process and its units are ignored while
calculating equivalent units. If normal loss has a scrap value, the value of this loss is set off against
the cost of production usually material.
● Abnormal Loss: Abnormal Loss arises when actual loss is more than expected loss. Abnormal Loss
is the amount by which actual output from a process less than the expected output. Cost of one unit
of abnormal loss is same as one unit of output. The cost of abnormal loss is charged to profit and loss
account in the period in which it occurs.
If abnormal loss has a scrap value, the amount of scrap value will be set off against the amount to be
written off to profit and loss account and not in the process account. In process account abnormal
loss units are valued at average cost per unit.
● Abnormal Gain: Abnormal Gain is the amount by which actual output from a process exceeds the
expected output. It is the amount by which actual loss is less than the expected loss. So, Abnormal
Gain is exactly opposite to Abnormal Loss. Cost of one unit of abnormal gain is same as one unit
of output. Abnormal Gain is recorded in Process account and in Abnormal Gain account. The
Abnormal Gain is then taken to profit and loss account as an item of income.

Losses with disposal cost

Sometimes loss units have a disposal cost rather than some scrap value; for example, additional cost is
incurred in disposing them off. To deal with such a situation remember the following points (opposite to
scrap value):
● Debit the disposal cost of normal loss units to process costs. The resulting amount would be used to
value good output and abnormal loss/gain
● Normal loss appears in process cost with nil value
● Disposal cost of abnormal loss units is included in abnormal loss account and therefore is transferred
to income statement

Example 1: During a 2-week period, period 1, costs of input to a process were $30,000. Input was 2,000
units, output was 1,700 units and a normal loss is 10%, with a scrap value of $1.5 per unit. During the
next period, period 2, costs of input were again $30,000. Input was again 2,000 units, normal loss is 10%,
with scrap value of $1.5 per unit but output was 1,900 units. There were no units of opening or closing
inventory.

Required: Prepare process account.

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Solution:
Period 1:
Process Account
units $ units $
Input 2,000 30,000 Finished goods 1,700 28,050
Normal loss 200 300
Abnormal loss 100 1,650
Total 2,000 30,000 Total 2,000 30,000

Equivalent units: 1,700 + 100 = 1,800 units

Cost per unit: 30,000 – 300 = $16.5 per unit
1,800
Cost of output: 1,700 x 16.5 = $28,050
Cost of abnormal loss: 100 x 16.5 = $1,650

Period 2:
Process Account
units $ units $
Input 2,000 30,000 Finished goods 1,900 31,350
Normal loss 200 300
Abnormal gain 100 1,650
Total 2,100 31,650 Total 2,100 31,650

Equivalent units: 1,900 - 100 = 1,800 units

Cost per unit: 30,000 – 300 = $16.5 per unit
1,800
Cost of output: 1,900 x 16.5 = $31,350
Cost of abnormal gain: 100 x 16.5 = $1,650

VALUING WORK IN PROGRESS

➢ Closing work in progress: W here there are units partially completed at the end of the period, it has
to be recorded in the books. To deal with this situation equivalent units are calculated. A value is then
placed to closing work in progress.

Following assumptions are made when calculating equivalent units:

● Material is completely added at the start of the process and therefore a unit is assumed to be
100% complete with respect to material unless stated otherwise.
● Labour and overheads are assumed to be incurred evenly over the production process. So when
a unit is referred to be 50% complete with respect to labour and overhead that means that unit is
half complete with respect to labour and overheads although it might be 100% complete for
material.

➢ Opening work in progress: Units left partially completed at the end of the period are treated as
Opening WIP for the next period. International Accounting Standard (IAS) 2 Inventories allows two
methods for inventory valuation:
● First in first out (FIFO)
● Weighted average method

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Which method to use for valuation of opening inventory?

FIFO inventory valuation technique is normally used and should be used in examination unless
specifically stated otherwise.

Remember the following rule:

● If degree of completion of each cost element is not provided in the question but just the value of
each cost element, use weighted average method.
● If, on the other hand, degree of completion is provided for each cost element but not the value of
each cost element, use FIFO method.

Example 2: BR Ltd makes a product requiring several successive processes. Details of the first
process are as follows:
Opening WIP 400 units
Degree of completion:
Material (valued at $19,880) 100%
Conversion (valued at $3,775) 25%
Units transferred to process 2 1700 units
Closing WIP 300 units
Degree of completion:
Materials 100%
Conversion 50%
Costs incurred in the period :
Material $100,000
Conversion $86,000

There were no process losses.

Required: Prepare the process account for august using:

a) Weighted average method.
b) FIFO method.
Solution:
a) Weighted Average Method
Process Account
units $ units $
Opening WIP 400 23,655 Finished goods 1,700 184,394
Material 1,600 100,000 Closing WIP 300 25,261
Conversion 86,000
Total 2,000 209,655 Total 2,000 209,655
Equivalent units:
Material: 1,700 + (300 x 100%) = 2,000 units
Conversion: 1,700 + (300 x 50%) = 1,850 units
Cost per unit:
Materials: ($19,880 + $100,000) / 2,000 units = $59.94 per unit
Conversion: ($3,775 + $86,000) / 1,850 units = $48.527 per unit
Total cost per unit: $59.94 + $48.527 = $108.467 per unit

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Cost of Finished Goods: 1,700 x $108.467 = $184,394

Cost of Closing WIP:
Materials: (300 x 100%) x $59.94 = $17,982
Conversion: (300 x 50%) x $48.527 = $7,279
$25,261

b) FIFO (First in first out)

Process Account
units $ units $
Opening WIP 400 23,655 Finished goods 1,700 183,534
Material 1,600 100,000 Closing WIP 300 26121
Conversion 86,000
Total 2,000 209,655 Total 2,000 209,655

Equivalent units: (Opening WIP x remaining percentage of completion) + Units input n

transferred to output in the period + (closing WIP x percentage of completion).

Material: (400 x 0%) + 1,300 + (300 x 100%) = 1,600 units

Conversion: (400 x 75%) + 1,300 + (300 x 50%) = 1,750 units

Cost per unit:

Materials: $100,000 / 1,600 units = $62.50 per unit
Conversion: $86,000 / 1,750 units = $49.143 per unit

Total cost per unit: $62.50 + $49.143 = $111.643 per unit

Cost of Finished Goods:
1,300 units x $111.643 = $145,137
1,700 units
400 units $23,655 (incurred in the previous period)

Material: (400 x 0%) x $62.50 = $0

Conversion: (400 x 75%) x $49.143 = $14,742
$14,742

Total cost of finished goods: $145,137 + $23,655 + $14,742 = $183,534

Cost of Closing WIP:
Materials: (300 x 100%) x $62.50 = $18,750
Conversion: (300 x 50%) x $49.143 = $7,371
26,121

JOINT AND BY PRODUCTS

Joint Products: Joint Products are produced from the same process but which have significant sales
value at point of separation.

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By Products: By Products on the other hand are the output of the same process but they have a very
small sales value as compared with the value of main products.

Point of Separation/Split Point

A £ 20
Joint Products
£ 22
Process B

£ 0.5
C By Product

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APPORTIONMENT OF JOINT COST INTO JOINT PRODUCTS

Process account will be as normal. The joint cost of the joint products is distributed according to these
methods:
1. Physical measurement/volume at point of separation
2. Sales value at point of separation
3. Net realizable value at point of separation

ACCOUNTING TREATMENT FOR BY-PRODUCTS

In process costing, By Products are treated as normal losses and the sales value of By Product is treated
as scrap value of normal loss.
1. Income from by product added to sales of main product
2. Income from by product treated as a separate source of income
3. Sales income of by product deducted from the cost of production
4. Net realisable value of by product deducted from the cost of production

Joint product By product

Nature It’s a main product Supplementary product
Realizable value High sales value Low sales value

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