Process Costing and Activity-Based Costing
Oftentimes the production of manufactured products is easily divisible into specific jobs, and the job costing method illustrated in the previous chapter is appropriate. However, the job costing method does not work well when the production cycle involves a continuous flow of raw materials through various processing departments, and the finished output is characterized as homogenous units, each displaying the same basic characteristics. Examples of such "processes" are numerous. Wood pulp is "processed" into giant rolls of paper, refineries "process" crude oil to gasoline, iron ore is "processed" into steel, sand is "processed" into glass, and on and on. The physical nature of these "processes" makes it hard to identify and associate specific units of direct labor and direct material with the final output. For example, do you suppose anyone really knows which barrel of oil was used to produce the last tank of gasoline you purchased for your vehicle? Obviously, the crude oil was pumped from the ground, transported, put through a refinery, transported to a storage tank, etc. The molecules of oil were stirred, cracked, blended, and converted many times so that it is no longer possible to trace your tank of gasoline back to any specific barrel of oil. The gasoline was not produced as a specific job; it was the result of a "process."
Now, if you were in charge of a refinery, how would you associate the cost of the barrels of crude oil with the gallons of finished gasoline? Logic would tell you to develop a mathematical approach that would divide the total cost of all oil and allocate it in some proportion to all the gallons of gasoline. This is the essence of "process costing." Process costing is methodology used to allocate the total costs of production to homogenous units produced via a continuous process that usually involves multiple steps or departments.
If you are comfortable with the cost flow concepts from the prior chapter, you are already well on your way to understanding process costing. The reason is that the same cost flow concepts and accounts will be evident. That is, material, labor, and factory overhead will still occur and still be assigned to work in process. And, amounts assigned to work in process will in turn make their way to finished goods. The debits/credits and financial statement outcomes are going to look the same.
The big difference between job costing and process costing arises in the work in process "units." Remember, under job costing we captured costs for each job (recall the discussion about job cost sheets and subsidiary amounts for each job). Under process costing, we will instead capture the costs for each process or department. Let's think about a steel production factory. The basic processes for producing steel are to (1) melt iron ore (along with perhaps processed coal/coke and limestone), then (2) skim the material while adding alloys to adjust for tensile strength and flexibility, and finally (3) oxygen blast and extrude the material into its finished form (I-Beams, sheet steel, coils, etc.). Below is a representative graphic:
Comparing Job and Process Costing
The first thing you should note in the above graphic are familiar inventory categories relating to raw materials, work in process, and finished goods. However, rather than observing work in process as being made up of many individual/discrete jobs, you now begin to see that it consists of individual/ discrete processes - melt, skim/alloy, mold/extrude. You will also note that material can be introduced into each process - ore in the melt stage, alloys in the skim/alloy stage, etc. (this is equally true for labor and overhead). This necessitates the employment of a separate Work in Process account for each major manufacturing activity. Examine the graphic on the top of the next page that compares job and process costing, noting in particular the difference in how costs are shifted out of work in process. Process costing entails handing off accumulated costs from one department to the next.
Introduction to the Cost of Production Report
With a job costing system, the costs of each job were tabulated on some form of job cost sheet. A similar tabulation of costs is needed for process costing, but with emphasis on costs by department. The cost report that is prepared for each department is termed a cost of production report. The graphic on next page illustrates this important comparative distinction.
The cost of production report provides comprehensive information on the material, labor, and overhead incurred within each department during a period. It is the primary source document for determining how those costs are allocated to actual production. Soon, we will look more closely at the specific content of a production cost report. But, first, it is necessary to introduce a new concept called "equivalent units" of production.
Job Costing Flows
Process Costing Flows
Job Costing Flows on Job Cost Sheets