Lesson 20--Process Costing

Process Costing

In Chapter 19, Job Order Costing, we examined a costing system used for small custom batches of products. In contrast, Lesson 20 is concerned with process costing—a system used for manufacturing situations involving 1) homogeneous (identical) products, that are 2) manufactured in huge volumes, in 3) a sequence of production departments.

Whereas Job Order Costing attempts to determine the cost of products by job, in process costing, the goal is to determine the cost of products by department.

Assigning Costs:  Departments

Similar to job order costing, process costing accumulates costs and then assigns costs. For cost accumulation, we use Raw Materials Inventory, Factory Labor, and Manufacturing Overhead accounts, just as you learned in Chapter 20. However, the focus is on departments, rather than jobs. Each department provides a different process that the product must go through, such as machining and assembly.  Moreover, there is a separate Work in Process account for each department.  Each department can add materials, labor, or manufacturing overhead to the cost of the product.  Direct labor and manufacturing overhead are combined, however, as conversion costs.  So, the two components of cost are direct materials and conversion costs.

To illustrate the journal entries for process costing, the text describes Warner Company, a manufacturer of automatic can openers. In the manufacturing process, the can openers go through two departments—Machining and Assembly. Here is a chart of accounts in T-account form that illustrates typical accounts used in process costing.


Cost Accumulation

The journal entries to accumulate manufacturing costs for Warner Company are as follows.

(1) Purchase of raw materials:

General Journal

Raw Materials Inventory XXXX  
        Accounts Payable   XXXX

(2) Incurrence of labor costs.

General Journal

Factory Labor XXXX  
        Wages Payable   XXXX

(3) Incurrence of actual Manufacturing Overhead costs.

General Journal

Manufacturing Overhead XXXX  
        Accounts Payable, etc.   XXX

These three entries should be familiar to you, as they are identical to the cost accumulation entries for Job Order Costing.

Assignment of Costs

(4) When raw materials are moved into a department, they are debited to Work in Process for the department receiving them:

General Journal

WIP—Machining XXXX  
WIP—Assembly XXXX  
        Raw Materials Inventory   XXXX

(5) Factory Labor is similarly assigned to the departments, as follows:

General Journal

WIP—Machining XXXX  
WIP—Assembly XXXX  
        Factory Labor   XXXX

Manufacturing Overhead is assigned to Work in Process using a cost driver. As you studied in the previous chapter, the manufacturing overhead can be applied using direct labor hours, machine hours or direct labor cost. As an example, a predetermined overhead rate would be calculated by dividing total budgeted Manufacturing Overhead by total budgeted machine hours.

Thus, the number of machine hours consumed would be determined for each department as production progresses.

(6) The entry to apply manufacturing overhead in the two departments would appear as follows:

General Journal

WIP—Machining XXXX  
WIP—Assembly XXXX  
        Manufacturing Overhead   XXXX

If you have posted all six of the journal entries, you will find that direct materials, direct labor, and manufacturing overhead costs have now been assigned to each of the departments. We have focused on costs, not the number of units produced. Our next task is to measure the amount of work accomplished in each of the two departments, measured in equivalent units, so that a cost per unit calculation can be made.

One other complication is that there is a sequence in which the production takes place—units move from the Machining Department to the Assembly Department. This means that both the costs and units must be transferred from one department to the other. Also, as goods get completed in Assembly, the units (and costs) move out of that department and are transferred to Finished Goods Inventory.

Calculating Equivalent Units

In order to fairly calculate the amount of work done in a department, we use a measure called equivalent units.  Equivalent units represent the number of units of work done, expressed as completed units.  For example, if we have 1,000 units in a department that are 75% complete, we would say that this represents 750 equivalent units.   Multiply the number of physical units (1,000) times the percentage complete (75%).   Colleges and various businesses use a similar calculation called "full-time equivalents" or FTE's.  If we have 10,000 students attending the college with 2,000 of them attending full time and the rest attending one-quarter time, we would say that the enrollment is 4,000 FTE (2,000*100% + 8,000*.25) This measure provides a fairer determination of the work being done by the college than would counting the number of students enrolled.

In a factory department, the workers continue working on the units until they get done. Then those completed units are moved to the next department. In the case of Warner Company, there are two departments, Machining and Assembly. The parts are created in the first department. When finished, those machined parts move to the Assembly department. Obviously, if we are measuring productivity, the parts that got done count toward the department's units completed. But--what about the work that got done on the units that are not 100% complete? That work must also be counted. So if the Assembly department got 3,000 units 100% done and another 500 that were 40% done, the productivity should be counted as 3000*100% + 500*40%=3200 equivalent units.

In practice, there are two major ways in which Process Costing can be managed.  These are called FIFO (first-in, first-out) and the Weighted Average method.  The FIFO method is quite complex, and yields marginally better costing results, whereas the Weighted Average method (the one we'll use) provides good results, and is, happily, much simpler!

Determining Units Transferred and Units Left in Ending WIP

Our solution will involve four basic steps: 1) compute the whole units; 2) compute the equivalent units; 3) compute the cost per unit; 4) prepare a cost reconciliation schedule, showing the cost of the units transferred out of the department, and the cost of the units remaining in the department. To begin with, Warner had 100,000 units in beginning work in process, and started work on 800,000 more units.

Whole Units

% Complete

WIP 6/1 100,000      
Units Started 800,000      
Units to Acct. For 900,000  
Equivalent Units
Transferred Out 700,000 100%


WIP 6/30 200,000   60%


Units Accounted For 900,000  


During the month, the company completed and transferred 700,000 units that were 100% complete, and did work on another 200,000 units that were 60% done at the end of the month. Note that we multiply the units times the degree of completeness to determine the equivalent units of production in the department.

The Units Accounted For must always be equal to the Units to Account For.  Occasionally, in the homework problems, you may have to reconcile this units table; rely on the fact that these two figures always match.

Cost Per Unit:  Machining Department

We must sort out the direct materials costs, and the conversion costs.  Here's an easy way to set up a table for this calculation:


DM Costs

Converson Costs

June 1 WIP
Costs in June



Notice that we include the costs in the June 1 work in process, and then add in costs incurred in June. The grand total cost, $655,000 provides an important check figure. Also note that we combine the direct labor and factory overhead and refer to the total of those costs as conversion costs.

Here's how we calculate the cost per unit in the department:

Cost Per Unit = Total Costs Incurred in Department divided by Total Equivalent Units = $655,000/820,000 EU= $.79878 per unit (very close to .80 per unit).

Cost of Goods Transferred and Cost of Goods Left in Ending WIP

Determining the Cost of Goods Transferred is now an easy calculation: We measure the cost of the 700,000 units completed and transferred as 700,000 * $.7988 = $559,146.

Determining the Cost of Goods Left in ending Work in Process in the Machining Department can be calculated as well:

120,000 Equivalent Units * .79878 = $95,854. (It is also acceptable to multiply 200,000 physical units times .6 * $.79878).

Reconciling the Cost Data

If you add the cost of goods transferred to the cost of goods left in ending work in process you get:  $559,146 + $95,854 = $655,000. This is an important final step in ascertaining that all costs were accounted for.

(7) When the inventory is transferred to the Baking department, a journal entry would be made, as follows:

General Journal

WIP—Assembly 559146  
        WIP—Machining   559146

Just In Time Inventory Approach

In the past two decades, many companies have questioned the logic of producing vast quantities of a product for the purpose of having inventory on hand.  The typical strategy of many U.S. producers has been to produce as many units of a product as possible to achieve volume discounts and economies of scale.  The result is that inventory accounts on the balance sheet have had large balances, tying up cash that could have been used for other purposes.

A competing point of view is that inventory should only be manufactured if it has already been ordered by a customer.  If production can be efficient, so the theory goes, the goods can then be manufactured, and the ending inventory balance will be at a minimum.  Such a strategy, called a "pull" approach, starts at the moment of sale.  When units are sold, an order is placed to have the units produced.   The anticipated production may require an order to be placed with suppliers of the raw materials for the product.

For this strategy to work, a just-in-time (JIT) inventory system may be implemented.   Under JIT, contracts are arranged with suppliers to guarantee that raw materials will be available within a few hours of an order being placed.  This allows the producing factory to wait for the sale of the final product to occur prior to manufacturing the product.  There may be other efficiencies as well, such as periodic billing to keep paperwork to a minimum.  A manufacturer might even offer to pay premium prices for raw materials in return for delivery to a specific location within a very short time.

Many companies have adopted this approach, and though it sounds logical, it doesn't always produce good results. Changes in market conditions, for example, may underline the need for having multiple suppliers available for meeting changes in customer demand.