Your artisanal baking company is doing great and growing rapidly, selling gourmet crackers online as fast as it can make them. But to know exactly how great you’re doing, you need to know your production costs. Doing this for each cracker, or even each box, can be tricky. After all, you’re buying and mixing ingredients in bulk, and the ovens and mixers are running continuously. So after a chat with your accountant, you adopt a cost-tracking method categorizing expenses by their stage of production. This is a technique known as process costing, and it can help you accurately track your production expenses.
What is process costing?
Process costing is a way of tracking product costs in mass-production industries where output is continuous, the units are uniform, and it would be difficult to monitor costs for each individual item. Industries like oil refining, chemical manufacturing, and food processing tend to use process costing. This accounting method is called process costing because you track all direct costs for labor, raw materials, and overhead through the various stages of manufacturing. Continuing with the bakery example, you’d track all the costs of the mixing, baking, and packaging stages of cracker production.
Although many small businesses are retailers and distributors, not manufacturers, they can adopt a process-costing approach by tracking costs through the stages of customer acquisition and order fulfillment. Various accounting software providers offer process-costing tools to help you organize this process. Process costing helps businesses control inventory, track profit margins, identify inefficiencies, and set competitive prices. The data generated by process costing is also used to prepare financial statements.
Process costing vs. job costing
Process costing and job costing are two different methods for tracking production costs. Process costing is suitable for the continual production of homogeneous products—bags of snacks, rolls of paper towels, or yards of textiles, for instance. Job costing, on the other hand, tracks costs for individual and unique products, such as custom furniture, or one-off projects such as office building construction or shipbuilding. Plumbing, electrical, and other contracting businesses also use the job costing system, because each job is different.
How to calculate process costing
The first step is adding up the costs of all the process stages at the end of an accounting period, such as a quarter or year, and then dividing the total cost by the number of units produced. This determines the per-unit cost.
Let’s say the artisanal baking company has $200,000 in total production costs in a quarter and produced 50,000 boxes of crackers. With process costing, it calculates the cost to produce a box of crackers as follows:
$200,000 / 50,000 = $4 per box
But process costing also accounts for unfinished goods. To account for this in-process inventory, include the partial cost of the unfinished production units, based on the percentage of completion.
For example, let’s say your cracker business has another 10,000 boxes in the pipeline, estimated to be half completed at the end of the quarter. This means you’d include 10,000 units as 50% completed, or equivalent to 5,000 boxes of finished crackers. You then add this to the 50,000 finished boxes, calculating per-unit production cost as:
$200,000 / (50,000 + 5,000) = $3.64 per box
This calculation gives you a more accurate look at where your production costs are netting out at any point in the process.
Types of process costing
You can use one of three methods to calculate process costs:
Weighted average costs
The weighted average method is the simplest and most frequently used. Companies add all actual production costs for the period and divide by the number of units completed, plus the equivalent units of work in progress based on their percentage of completion.
Standard costs
This method uses an estimated standard cost for each process stage instead of the actual costs used in weighted average costing. Companies typically use this method when it’s too difficult or time-consuming to collect all real-time cost information.
For example, a big soda bottler would set a standard cost for manufacturing a one-liter bottle, based on the expected amount of labor and ingredients needed. The standard cost totals are then compared to actual costs for a production period. The difference is recorded and charged to another account, usually called a variance account. You can then analyze the variance account to either find ways to lower costs or adjust the standard costs for future production periods.
First in, first out (FIFO)
First in, first out (FIFO) is the most complicated process costing approach because it creates different costs. One cost is for units started in the previous period but not completed, and another for any production started in the current period. FIFO costing assumes the first units in—work in progress at the beginning of the current period—are completed and shipped out first. When calculating costs for the current period, you exclude costs incurred during the previous period for partly completed equivalents.
Companies such as oil refiners tend to use FIFO when costs can fluctuate significantly from one period to the next. FIFO costing is also often used in industries selling perishables or products with expiration dates, such as food processors, grocery chains, and pharmaceutical makers.
How to do process costing step-by-step
- Analyze inventory
- Calculate equivalent units
- Tally total applicable costs
- Calculate per-unit cost
- Allocate costs to finished and unfinished goods
Businesses using the process costing system typically take the following five steps to arrive at a per-unit cost:
1. Analyze inventory
Analyze the flow of products during the period. The first step is determining the amount of starting inventory—incomplete items. Then assess how many were finished and moved out, and how many remain incomplete. This reflects the ending inventory.
2. Calculate equivalent units
Next, convert any ending inventory that is a work in progress to an equivalent number of finished units. Equivalent units account for the work done so far on the incomplete items and help you accurately allocate costs.
3. Tally total applicable costs
Add up the costs of the various production stages that accumulate during the manufacturing process. Companies often break down production costs into direct material costs and conversion costs. Conversion costs include the direct labor and manufacturing overhead for each production process. The total is known as the cost of goods manufactured (COGM). This amount is proportionately applied, or weighted, between the inventory that is completed and the work in progress.
4. Calculate per-unit cost
The per-unit calculation includes the costs for completed units and partly finished equivalents at the end of the period. Costs for unfinished goods are usually expressed as a percentage of the total cost, reflecting processing expenses incurred so far.
5. Allocate total costs to finished and unfinished goods
Finally, split up the total costs by allocating the appropriate amounts to the number of products completed, as well as to the inventory that was considered in-process at the end of the period. For example:
This leaves you with a total of $200,000 in production costs. This can help a business know how much money is committed to work-in-process inventory.
Process costing FAQ
What is meant by process costing?
Process costing accounts for production costs during a sequence of processes. Process costing is practical for businesses mass-producing identical goods, such as gallons of gasoline or bags of potato chips, rather than trying to track the individual costs for each gallon or bag.
What are the 5 steps in process costing?
The five steps of process costing are:
1. Analyze inventory at the beginning and end of the period.
2. Calculate the number of units produced, both completed units and the portion of partly completed units.
3. Add up all production costs, including those associated with direct materials and manufacturing.
4. Compute the per-unit production cost by dividing total production costs by the number of units.
5. Allocate the costs proportionately to completed units and equivalent, or unfinished, units.
What is an example of process costing?
Imagine a cardboard box maker produced 50,000 boxes in one quarter, with another 20,000 boxes half completed, equivalent to 10,000 finished boxes. The total number of boxes, completed and equivalent, is 60,000. If production costs were $120,000, the per-unit cost is found by dividing $120,000 by 60,000, or $2 per box. Costs are allocated as follows: 50,000 x $2 = $100,000 for completed boxes and 10,000 x $2 = $20,000 for partly completed, or equivalent, boxes.
