Process Costing Systems
A. Cost Management Challenges — There are three questions addressed in this chapter.
1. How should costing systems measure costs of products, services, and operations
when outputs are numerous and indistinguishable?
2. How should organizations recognize and measure the costs of spoilage and
3. What is the advantage of first-in first-out (FIFO) process costing over weighted-
average process costing?
B. Learning Objectives — This chapter has nine learning objectives.
1. What organizations should use process costing or job costing?
2. Why is process-costing information useful for decision making?
3. Describe the five-step method to assign process costs to products.
4. Analyze the process costs assigned to products using weighted-average price.
5. Account for costs transferred between processes.
6. Analyze and manage ―normal‖ and ―abnormal‖ spoilage.
7. Assign costs to products using first-in, first-out (FIFO) costing (Appendix A).
8. Compare and contrast the results from weighted-average and FIFO costing
9. Compare and contrast operation costing with job costing and process costing
C. Process costing is a method for assigning product costs to units of product when all units
of product are virtually the same. Products are completed in a short time, and costs for a
single period can be averaged over the number of units produced.
1. With process costing, costs are not traced to units of product. Instead, all
production costs (unit-level and otherwise) are assigned or allocated based on
total production costs and total units produced.
2. Job costing and process costing differ in the way costs are assigned, and they
differ because of differences in product characteristics. With job costing, many
costs are traceable to jobs or can be assigned to specific jobs using cost-driver
rates. For products in a process costing environment, all costs must be assigned
using a cost-driver approach. The key difference is that the only cost-driver is the
actual number of units produced.
D. A very basic model of process costing assumes there are only two cost categories —
materials and conversion costs. Materials costs (also called direct materials) are unit-level
costs, but they are assigned to units of product based on the cost of materials and the
actual number of units produced. Conversion costs include all other costs for resources
used besides materials. These other costs may be batch, product, or facility-level costs.
Resources are recorded as processes rather than activities. Simplifying assumptions in the
basic process costing model presented in Chapter 8 preclude the use of ABC.
E. The simplest case for assigning costs using a process costing approach assumes all
production is started and completed within a single accounting period. This simplifying
assumption makes it easier to see how materials and conversion costs are used and
applied to units of product. If all units of product are completed in one month, there is no
work-on-process inventory. It is the presence of WIP inventory that makes process
1. There are only two cost categories to consider in a simple process costing model.
They are direct material and conversion costs. Each of these resources is assigned
to units of product separately. That is because, except in the simplest case, these
two resources are added and used in production in differing amounts and points
2. There is only one cost-driver. The cost-driver in process costing is the actual
number of units produced. Calculation of a rate for direct materials is calculated
as total direct materials cost divided by total number of (equivalent) units = direct
materials cost per unit of product. The rate for conversion costs is total
conversion cost divided by total (equivalent) units = conversion cost per unit of
product. The process costing system described is an actual costing system.
3. Calculation of the cost per unit for conversion costs includes higher-level
resources. For decision-making purposes, the cost per unit information can be
misleading. Managers should separate higher-level costs from unit-level costs
when making cost decisions or when trying to assess profitability.
4. When making decisions, managers should determine whether the decision should
be based on resource spending or resource use. Average costing, as it is used in
process costing, measures resource use.
F. A slightly more complex case for process costing occurs when there is production that is not
completed at the end of an accounting period. In other words, there is no beginning work-in-
process inventory, but there is ending WIP inventory. This case better illustrates the need to
segregate the costs and activities of different resources like materials and conversion
activities. It is useful at his point to explain the five steps used to assign costs to units of
1. First, summarize the flow of physical units. What is the total number of units
being made when all production is complete?
a. The basic cost flow model can be used to depict the flow of physical
units through WIP inventory. Beginning WIP + units transferred in (or
units started) – units transferred out (or completed) = ending WIP.
b. In the simplest case, beginning WIP and ending WIP are zero. In this
simple case, the number of units transferred (started) equals the number
of units transferred out (completed).
c. In the case where there is no beginning WIP but there is ending WIP, the
number of units transferred in (started) does not equal the number of
units transferred out (completed). Transferred in units are greater than
units transferred out because some units are not completed at the end of
an accounting period.
d. This first step expresses the number of units to account for and then
accounts for them. It shows where units of product came from (beginning
WIP and units started) and where they went (transferred out and ending
2. The second step requires that the number of equivalent units (EUs) be computed.
Equivalent units equal the number of whole units that could have been completed
given the amount of resources actually used. For instance, if 5,000 toys had 90%
of the direct materials needed for the toys to be complete, this would be the
equivalent of having 5,000 * 90%, or 4,500 toys being fully completed. Suppose
2,000 physical units were started and 1,500 were fully complete as far as
conversion activity goes, and the remaining 500 were 60% complete as far as
conversion activity goes. This is the equivalent of 1,500 + (60% * 500) = 1,500 +
300 = 1,800 equivalent units.
a. The number of equivalent units must be computed separately for each
different resource. In the simplest case there are just two resources —
direct materials and conversion costs.
b. The equivalent units calculations could be expanded to include as many
different categories as the accounting system needed to improve
information, but the calculations for each resource would be
accomplished the same way.
3. The third step requires that costs to account for be identified, and classified as
direct materials cost or conversion cost. This information comes from the
beginning WIP balance and costs transferred in for the period. In the case where
there is no beginning WIP, just the costs transferred in are the costs to account
for. This cost information can be obtained from the accounting system.
4. Step 4 requires that cost per equivalent unit be calculated. It is simply the cost
obtained in Step 3 divided by the number of equivalent units calculated in Step 2.
Separate costs per equivalent unit must be calculated for direct materials costs
and for conversion costs.
a. The total cost per equivalent unit is the sum of direct materials cost per
equivalent unit plus conversion cost per equivalent unit. This represents
the cost of producing one whole unit.
b. Managers should compare monthly calculations over time to see whether
costs are stable. Costs per equivalent unit should not fluctuate erratically
from month to month, because the corresponding price cannot usually
fluctuate the same way. This would result in erratic profits.
5. The last step shows the assignment of costs to the ending WIP inventory balances
and to units transferred out (to FGI, or the next production department).
a. This step shows how costs to account for in Step 3 are accounted for.
b. The number of equivalent units transferred out * cost per EU = total
dollar amount transferred out. Since the number of equivalent units
transferred out is the same for both materials and conversion costs, it is
not necessary to calculate costs transferred out separately for materials
and conversion costs. This is true when the weighted average method is
used but is not true when the FIFO method is used. The number of
equivalent units in ending WIP * cost per EU = total dollar value of
ending WIP. For ending WIP, calculations must be made separately for
materials and conversion costs because the number of equivalent units
will probably not be the same for these two resources.
6. Steps 1 and 2 divide the cost flow model into two pieces for quantities.
Beginning WIP and units transferred in (started) are used in Step 1 to identify the
number of physical units. These amounts show where the units came from. Units
transferred out and units remaining in ending WIP are converted to equivalent
units, and in Step 2 these units are identified as either completed and transferred
out or as incomplete units in ending WIP.
7. Steps 3 and 5 divide the cost flow model into two pieces also, but, instead of
quantities identified in Steps 1 and 2, Steps 3 and 5 divide costs into two pieces.
Step 3 uses the beginning WIP balance and costs transferred in, indicating the
costs to account for. Step 5 uses costs transferred out and ending WIP, indicating
how the costs were accounted for.
8. When an item is completed in one department, it may be transferred to a second
department as an intermediary product for additional work. In such a case the
―transferred in‖ cost is treated as a separate ingredient to which additional
material and processing costs are added. So we would have at least three cost
items, transferred in, materials, and processing costs for which we need to
G. The third example of process costing and cost assignment adds another layer of complexity to
the process costing approach by including spoilage. Spoilage is the cost of wasted resources
and defective products that cannot be recovered by rework or recycling
1. Spoilage is a normal part of production costs. One way to handle spoilage costs is
to view them as a normal part of production. Spoilage, if material in amount,
should be identified and reported, at least internally, so that managers can assess
spoilage and waste as a cost to be managed and minimized. Calculations for
spoiled units are made the same way as for good units, using the five-step
approach described earlier. However, the number of physical units must be split
between good units and spoiled units. Equivalent units are also split so that costs
can be assigned to the spoiled units. The percentage of completion for spoiled
units depends on when the spoilage is detected and what portion of the work has
been completed for those units.
a. Step 1 of the five-step process is the same as described before —
determine the total number of physical units.
b. Step 2 is different. Now, units must be split three ways instead of two.
Before, units were split between those that were completed and
transferred out and those remaining in ending WIP. With spoiled units
included, there is a third group of units — those that are spoiled. The
number of equivalent units for each of these three groups must be
c. Step 3 is the same as before — it consists of determining what costs are
to be accounted for.
d. Step 4 is the same, except now the number of equivalent units will be
calculated and shown for spoiled units, and therefore the cost per EU will
e. Step 5 is different. Now, costs must be assigned to units completed and
transferred out, ending WIP inventory and spoiled units.
2. Spoilage costs can be reported as a period cost and expensed right away (as part
of cost of goods sold), or they can be treated as part of production costs and flow
through the inventory system until product is sold.
a. Normal spoilage is waste that is considered to be part of the production
process. It is generally counted as a normal cost of good units produced.
b. Abnormal spoilage is waste in excess of normal spoilage. Abnormal
spoilage is usually treated as a period cost, regardless of how normal
spoilage is treated.
c. Spoilage is usually not listed as a separate expense on financial
statements. Regardless of how spoilage is reported on financial
statements though, the amount and associated cost of spoilage is
important information for managers to have.
H. The next layer of complexity in process costing arises when there are units from the prior
period included in the assignment of production costs. There are two methods that can be
used in process costing. These methods are the weighted average (WA) method and the first-
in, first-out (FIFO) method. The only difference between these two methods is the way in
which beginning WIP units and costs are treated.
1. The weighted average method treats the units in beginning WIP as if they are part
of the current month’s production activity. The amount of work completed on
these units in prior months is assumed to be zero. The costs in beginning WIP are
added to the current month’s costs, and this total cost is used to compute cost per
EU. Steps 1 through 5 of the five-step costing approach are reviewed based on
the WA method.
a. Step 1 is exactly the same as before, except now there are some physical
units that came from beginning WIP
b. Step 2 is different. The beginning WIP units are treated as units that were
started and completed in the current period. The calculation of equivalent
units is based on the assumption that 100% of the work for the beginning
WIP units was completed in the current month. Thus, for units completed
and transferred out, the number of EUs is 100% of the physical number
of units transferred out. Calculation of EUs for ending WIP is the same
as described before.
c. Step 3 is the same as before, except that now there is a dollar amount for
d. Step 4 is the same as before also, except that the number of equivalent
units now includes some from beginning inventory. The calculation is
the same though.
e. Step 5 is also the same. Costs assigned go to units completed and
transferred out, spoiled units, and units in ending WIP.
f. A disadvantage of the WA method is that it combines current period
costs with prior period costs. This makes it difficult to isolate
fluctuations in current period costs.
2. The FIFO method segregates prior period costs and production activity from
current period costs and activity. The FIFO method only considers that portion of
work needed to complete the beginning WIP units in calculating the number of
EUs for beginning WIP units. Spoilage must be segregated in the same fashion.
That is, spoilage must be identified as being from beginning WIP or from current
month’s activity. The units in beginning WIP are assumed to be the first units
completed and transferred out. Units started in the month are either completed
and transferred out or are incomplete and remain in ending WIP.
a. Step 1 of the five-step process is the same under WA and FIFO.
b. Step 2 is different. Spoilage quantities are exactly the same as before,
except they are shown as spoiled units from beginning WIP and spoiled
units from those units started. Calculation of EUs for ending WIP is
exactly the same as for WA. The total number of equivalent units from
the total period are calculated just as they were for the WA method, but
the equivalent units from beginning WIP that were completed in the prior
month are subtracted from the EUs transferred out.
c. Step 3 is the same as the WA method, but the beginning WIP costs are
not used to calculate cost per EU in Step 4.
d. Step 4 is different. Cost per EU is based on current costs divided by EUs.
The balance in beginning WIP is not used to calculate cost per equivalent
e. Step 5 is complicated by the fact that costs for spoiled units come from
beginning WIP and current period costs. It is further complicated by the
fact that, even though beginning WIP costs are not included in the
calculation of cost per EU, those costs must be transferred out in order
for the costs to account for to equal the costs accounted for. The only
straightforward calculation in Step 5 is calculation of the costs in ending
f. The main differences between the WA and FIFO methods are that the
WA method is simple but less accurate, while the FIFO method is more
accurate, more complex, and more costly to maintain. If costs change a
lot from period to period and beginning WIP balances are relatively
large, it is probably better to use the FIFO method. However, if an
organization has many products that are process costed, using FIFO may
be too messy and complex to justify its use.
I. The WA and FIFO methods are compared below, in terms of how the five steps are
STEP 1 WEIGHTED AVERAGE FIFO
1. Summarize flow of Use the basic cost flow Same, except keep track of units
physical units model: from beginning WIP separately from
BI + TI = TO + S + EI units started in the current period
2. Compute EUs for each Multiply physical units by Same, except subtract EUs in
cost category degree of completion beginning WIP to obtain current EUs
3. Summarize total costs Add costs in beginning WIP Same as WA costing
to account for to costs of the current period
4. Compute costs per EU Divide total costs in process Divide current costs in process by
by total EUs in each cost current EUs in each cost category to
category to get average get current cost/EU
5. Assign costs to Multiply EUs by cost Beginning WIP units started in the
products and spoilage category for units period are always transferred out or
completed, units spoiled, assigned to spoiled units. Costs of
units in ending WIP by units completed or spoiled include
cost/EU in each cost costs of beginning WIP, costs to
category finish beginning WIP, and costs
from the current period. Ending WIP
units include costs from the current
J. Many companies that use process costing have more than one production process. Instead
of completing production and transferring finished goods to finished-goods inventory,
some portion of production may be completed, and then partially completed goods are
passed on to the next production department. In this case, there are three types of costs to
be assigned to units of product in a subsequent production department. These costs are
direct materials and conversion cost, as well as transferred-in costs. All units transferred
in are 100% complete in terms of the prior department’s process costs, so cost
computations are simple since the number of EUs equals the number of physical units for
this resource called transferred-in costs.
K. Operation costing is a hybrid of job-order and process costing and is used when
companies produce batches of similar products with significantly different types of
material. An operation is a standardized method of making a product that is repeatedly
performed. Hybrid costing also occurs when the same product is produced in a process
costing environment, and then additional custom features are added to it. Like a
computer made to specifications for its software and operating system or a car that has
many custom features.