Process costing is an “accounting method”, that traces and accumulates direct costs, and allocates & distribute indirect costs of a manufacturing process. Costs are assigned & allocated to products, usually in a large batch which might include an entire month's production. Eventually, costs have to be allocated to individual units of production. It allocates average costs to each unit, and is the opposite of Job costing which does attempt to measure individual costs of production of each unit. Process costing is a significant chapter.
Process costing, is a type of operation costing which, is used to ascertain the cost of a product at each process or, stage of manufacture. CIMA defines process costing as "The costing method applicable where, goods or services result from a sequence of continuous or repetitive operations or processes. Costs are averaged over the units produced during the period". Process costing is suitable for industries which produce homogeneous products and where production is a continuous flow. A process can be defined as the sub-unit of an organization specifically defined for cost collection purpose.
The importance of process costing:-
Costing is a main process that many companies engage in to keep track of where their money is being spent in the production and distribution processes. The first step is understanding these costs in being able to control them. It is very important that a company chooses the appropriate & suitable type of costing system for their product type and industry. One type of costing system that is used in certain industries is “ process costing”that varies from other types of costing (such as job costing) in some ways. In Process costing unit costs are more like averages, the process-costing system needs less bookkeeping than a job-order costing system. Thus, a lot of companies prefer to use process-costing system.
When process costing is applied?:-
Process costing is appropriate for organizations that produce a continuous mass of like units through series of operations or process. Also, when one order does not affect the production process and a standardization of the process. However, if there are significant differences among the costs of various products & items, a process costing system would not provide adequate & suitable product-cost information. Costing is generally used in such industries like chemicals, paper ,petroleum, coal mining, textiles, plastic, glass, and food.
Reasons for use
Companies need to allocate total product costs to units of product for the following reasons:
- Products are manufactured in large quantities, but products may be sold in small quantities, sometimes one at a time (automobiles, loaves of bread), a dozen or 2 at a time (eggs, cookies), etc.
- A company may manufacture thousands or millions of units of product in a given period of time.
- Materials part, way through a process (e.g. chemicals) might need to be given a value, process costing allows for this. By determining what cost the part processed material has incurred such, as labor or overhead an equivalent unitrelative to the value of a finished process can be calculated.
- A fraction-of-a-cent cost change can represent, a large dollar change in overall profitability, when selling millions of units of product a month. Managers, must carefully see per unit costs on a daily basis through the production process, while at the same time dealing with materials and output in huge quantities.
- Product costs, must be transferred from Finished Goods to Cost of Goods Sold as sales are made. This needs a “correct and accurate accounting” of product costs per unit, to have a proper matching of product costs against related sales revenue.
- Managers require to maintain cost control over the manufacturing process. Process costing provides managers with feedback that can be used to compare similar product costs from one month to the next, keeping costs in line, with projected manufacturing budgets.