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MANAGERIAL ACCOUNTING
Hilton Chapter 4 Adobe Connect – Process Costing

Overview

Chapter 4 introduces another classic cost accounting system, Process Costing.

Then, combined with knowledge of Job-Order Costing (Chapter 3), the authors
describe a Hybrid method that has aspects of both process costing and job-order
costing.

Process cost accounting systems are useful when a product goes through multiple
processes or departments in the production process. For example, an item may
need to go through three different departments (A, B, and C) before being
transferred to finished goods inventory.

In Chapter 3 (job-order), we assumed a single cost driver and a single plant-wide

overhead rate for applying manufacturing overhead to work-in-process (WIP).
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In a process system, a different cost driver could be used for each department (or
process), e.g., direct labor hours in Department A if it is labor intensive and
machine hours in Department B if direct labor is minor.
 The mechanics of accumulating overhead costs and applying them is the
same, except that we run through multiple departments.
 For our example with three departments, we will have WIP Department A,
WIP Department B, and WIP Department C.
 This means that we will have manufacturing overhead accounts for each
department, and at the end of the year we will zero out the balance in each
account.

In addition, Chapter 4 introduces the topic of EQUIVALENT UNITS.

 Manufacturing costs are assigned to WIP based upon equivalent units of
production.
 Equivalent units usually are computed separately for Conversion Costs
(Direct Labor, Manufacturing OH) and Direct Materials.
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Chapter 4 Process Costing and Hybrid Product-Costing Systems 137

A. Job-Order Costing: Accumulates Costs by Job Order Exhibit 4–2

Comparison of Job-Order and
Work-in-Process Process Costing
Inventory

Job 1
Direct material Finished- Cost of
Direct labor Goods Goods
Manufacturing overhead Inventory Sold
Job 2

Job 3

B. Process Costing: Accumulates Costs by Production Department

Direct material
Work-in-Process Inventory:
Direct labor
Production Department A
Manufacturing overhead

Work-in-Process Inventory:
Production Department B

Finished-Goods Inventory

Cost of Goods Sold

The term equivalent units is used in process costing to refer to the amount of manufac-
turing activity that has been applied to a batch of physical units. The 1,000 physical units
in process represent 750 equivalent units of conversion activity.
The term equivalent units also is used to measure the amount of direct materials rep-
resented by the partially completed goods. Since direct materials are incorporated at the
beginning of the production process, the 1,000 physical units represent 1,000 equivalent
units of direct material (1,000 physical units  3  100% complete with respect to direct
materials).
The most important feature of process costing is that the costs of direct material
and conversion are assigned to equivalent units rather than to physical units. Refer again “Operations [managers]
to Exhibit 4–3. For simplicity, suppose that the only production activity of the current have a keen interest in cost
accounting period was to start work on the 1,000 physical units and complete 75 percent management. To truly man-
of the required conversion activity. Assume that the costs incurred were $1,500 for con- age costs, you must look at
version (direct labor and manufacturing overhead) and $5,000 for direct material. These the processes involved.” (4b)
costs would then be assigned as follows: John Deere
Health Care, Inc.
$1,500 conversion cost
____________________________ $2.00 per equivalent unit
5
750 equivalent units of conversion for conversion

$5,000 direct-material cost

_________________________________ $5.00 per equivalent unit
5
1,000 equivalent units of direct material for direct material

This is a highly simplified example because there is no work-in-process inventory at

the beginning of the accounting period and no goods were completed during the period.
Nevertheless, it illustrates the important concept that under process costing, costs are
assigned to equivalent units rather than physical units.

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These methods have been used for a long time, and they are well-established in
companies. In Chapter 5, we will introduce a third method, Activity Based
Costing (ABC).

INVENTORIES
For manufacturing firms, the following are costs are accumulated:
 Raw materials inventory
 Work-in-process inventory
o Direct materials
o Direct labor
o Manufacturing overhead
 Indirect materials
 Indirect labor
 Other
 Finished-goods inventory
 Cost of goods sold
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With a PROCESS-COSTING SYSTEM, a company works in a repetitive

production environment, manufacturing a large number of like units in a
continuous flow.

IN PROCESS COSTING, COSTS ARE NORMALLY ACCUMULATED BY

DEPARTMENT.

In Job Order Costing, costs are accumulated by job.

Conversion costs: Direct Labor + Manufacturing Overhead Costs

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EQUIVALENT UNITS
In a manufacturing process with continuous production, some units are unfinished
at period-end.

Processing costing uses the concept of equivalent units.

 The term refers to the amount of manufacturing activity that has been
applied to a batch of physical units after adjusting for the stage of
completion.

Equivalent-unit calculations are made for:

 Direct materials
 Conversion cost (direct labor and overhead)

When computing the cost of a unit, we base the related calculations on equivalent
units, not physical units.
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Equivalent units is a key concept in process costing.

 If a batch of goods has been completed, the number of physical units and
equivalent units will be the same.

 Units in the ending Work-in-Process Inventory are only partially completed

and may be in different stages of production.

o For example, 100% of the materials may be present in the product, but
only 50% of the conversion work (labor and overhead) may have been
performed.

 Conversion costs are usually assumed to be added continuously

throughout the process in text problems. Thus, if 100 units are 60% of
the way through the process, the company is said to have performed 60
equivalent units of work during the period.
o Make the assumption if information to the contrary is not provided

 Direct materials, in contrast, are usually added at discrete points in text

problems. When considering materials, determine at what point the ending
in-process units are and then evaluate whether the materials have been
added.
o If materials have been added, the units are 100% complete with
respect to materials; if not, the units are 0% complete.
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Chapter 4 Process Costing and Hybrid Product-Costing Systems 141

3. Computation of unit costs (i.e., the cost per equivalent unit for direct material
and conversion).
4. Analysis of total costs (determine the cost to be removed from work in process
and transferred either to the next production department or to finished goods).
The method of process costing that we will focus on in this chapter is called the
weighted-average method. This method is almost always used in practice by companies
using process costing. There is another process-costing method called the first-in, first-
out, or FIFO, method. This method is covered in some cost accounting courses, but it is
rarely used in practice.1

Basic Data for Illustration

The Wisconsin Division of MVP Sports Equipment Company manufactures baseball
gloves in its Milwaukee plant. In the Cutting Department, direct material consisting of
imitation leather is placed into production at the beginning of the process. Direct-labor
and manufacturing overhead costs are incurred uniformly throughout the process. The
material is rolled to make it softer and then cut into the pieces needed to produce baseball
MVP
Sports Equipment Company
gloves. The predetermined overhead rate used in the Cutting Department is 125 percent
of direct-labor cost.
The Excel spreadsheet in Exhibit 4–4 presents a summary of the activity and
costs in the Cutting Department during March. The direct-material and conversion
costs listed in Exhibit 4–4 for the March 1 work in process consist of costs that were

1
The FIFO method of process costing is also covered in a supplement to this text titled Process Costing: The First-
In, First-Out Method. This supplement is available to students on the text Web site at http://www.mhhe.com/
hilton9e and to instructors on the Instructor’s Resource CD-ROM.

Exhibit 4–4
Basic Data for Illustration—
Cutting Department

MVP
Sports Equipment Company

hiL10912_ch04_134-167.indd 141 7/8/10 9:28 AM

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144 Chapter 4 Process Costing and Hybrid Product-Costing Systems

Weights

20,000 30,000
$2.50 $3.00 $2.80
20,000 30,000 20,000 30,000

Direct-material Proportion of total equiv- Direct- Proportion of total Weighted-

cost per alent units of direct material cost equivalent units average cost
equivalent unit material in the beginning per equivalent of direct material per equivalent
in February work-in-process unit in March added during March unit of direct
inventory material

Exhibit 4–9 MVP SPORTS EQUIPMENT COMPANY

March Production Report: March Production Report: Cutting Department
Cutting Department
(weighted-average method) Percentage Equivalent Units
of Completion
Physical with Respect to Direct
Units Conversion Material Conversion

Work in process, March 1 ........................................ 20,000 10%

MVP
Sports Equipment Company
Units started during March ...................................... 30,000
Total units to account for ......................................... 50,000
Units completed and transferred out during March .... 40,000 100% 40,000 40,000
Work in process, March 31 ...................................... 10,000 50% 10,000 5,000
Total units accounted for ......................................... 50,000 _____ _____
Total equivalent units ............................................... 50,000 45,000

Direct Material Conversion Total

Work in process, March 1 (from Exhibit 4–4) ............... $ 50,000 $ 7,200 $ 57,200

Costs incurred during March (from Exhibit 4–4) ........... 90,000 193,500 283,500
Total costs to account for ........................................... $140,000 $200,700 $340,700
Equivalent units (from step 2, Exhibit 4–6) ................... 50,000 45,000
Costs per equivalent unit ............................................ $2.80 $4.46 $7.26

$140,000
________ $200,700
________ $2.80 1 $4.46
50,000 45,000

Cost of goods completed and transferred out of the Cutting Department during March:

transferred out ) (equivalent unit)

(Number of units 3 Total cost per ......................... 40,000 3 $7.26 ............................................... $290,400

Cost remaining in March 31 work-in-process inventory in the Cutting Department:

Direct material:

(units of direct material) (unit of direct material)

Number of equivalent Cost per equivalent $ 28,000
3 ...... 10,000 3 $2.80 ...............................................

Conversion:

units of conversion ) ( unit of conversion )

(Number of equivalent Cost per equivalent 22,300
3 .......... 5,000 3 $4.46 .................................................

Total cost of March 31 work in process .......................................................................................................... $ 50,300

Check: Cost of goods completed and transferred out ....................................................................................... $290,400
Cost of March 31 work-in-process inventory .......................................................................................... 50,300
Total costs accounted for ...................................................................................................................... $340,700

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Step 1: Flow of Physical Goods
Whole Units Materials* Conversion*
Beginning WIP XXXX XXXX
Units started
Total to account for 0
Units Finished
Ending WIP
Total accounted for 0
Step 2: Computing Equivalent Units
Completed Units 0 0
Eq Units in Ending WIP inventory:
Materials 0
Conversion 0
Eq units produced--Wtd avg method 0 0
Step 3: Costs per Equivalent Unit
Materials Conversion Total
Beginning WIP $ -
Current Costs $ -
TOTAL $ - $ - $ -
Cost per Equiv Unit #DIV/0! #DIV/0! #DIV/0!
Step 4: Cost assigned to inventories
Finished Goods units #DIV/0!
Ending WIP units
Materials #DIV/0!
Conversion #DIV/0! #DIV/0!
Total Costs Accounted For #DIV/0!
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TRACKING COSTS

Departmental production reports are completed to disclose equivalent units and

unit costs, along with the cost of completed production and the cost of the ending
work-in-process inventory.

 The text focuses on the weighted-average method of process costing because of

the method's popularity in practice. Assume Unless Otherwise Indicated.

 All units completed during a period are assumed to be started and

completed during that period.

 Equivalent units are calculated without distinguishing as to whether the

manufacturing activity occurred in current period or the preceding
period.
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OVERHEAD ALLOCATION

Assigning Overhead
 Actual versus normal costing: Either actual overhead or applied overhead
(i.e., actual costing or normal costing) may be used with process costing.
o The use of applied overhead smooths per-unit cost fluctuations
o Uses an appropriate cost driver to apply overhead
o We assume that companies will used applied overhead.

Cost drivers
 As in job costing, cost drivers should be chosen to provide an equitable
allocation of overhead to products.
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HYBRID PRODUCT-COSTING SYSTEMS

Some processes have elements of both the job-cost (Chapter 3) environment and
the process-cost (Chapter 4) environment.

A third (hybrid) system known as operation costing may be used.

Characteristics
 Batch environment
 Conversion costs similar across product lines,
 Direct materials and direct labor significantly different across product lines

Conversion costs are usually applied to products by using a predetermined

application rate.

Direct materials would be tracked by job, but the other cost elements would be
more efficiently tracked by process.
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Chapter 4 Process Costing and Hybrid Product-Costing Systems 149

Exhibit 4–10
Work-in-Process Inventory: Operation Costing
Production Department A

Batch 1 Batch 2

Conversion costs
Accumulated Direct labor
by department Manufacturing
overhead

Accumulated Direct-material
by batch costs Work-in-Process Inventory:
Production Department B

Batch 3 Batch 4

Finished-Goods Inventory

differ significantly. Conversion costs are accumulated by department, and process-

costing methods are used to assign these costs to products. In contrast, direct-material
costs are accumulated by job order or batch, and job-order costing is used to assign
material costs to products.
The main features of operation costing are illustrated in Exhibit 4–10. Notice in the
exhibit that products pass sequentially through production departments A and B. Direct-
material costs are traced directly to each batch of goods, but conversion costs are applied
on a departmental basis. Direct labor and manufacturing overhead are combined in a sin-
gle cost category called conversion costs, rather than separately identifying direct labor.
Moreover, under operation costing, conversion costs are applied to products using a pre-
determined application rate. This predetermined rate is based on budgeted conversion
costs, as follows:4

Budgeted conversion costs

(direct labor and manufacturing overhead)
Predetermined application __________________________________
⫽
rate for conversion costs Budgeted cost driver (or activity base)

As an illustration of operation costing, we will focus on the Minnesota Division of

MVP Sports Equipment Company. This division manufactures two different grades of
basketballs: professional balls, which have genuine leather exteriors, and scholastic balls,
which use imitation leather. The cutting and stitching operations for the two different
products are identical. Scholastic balls are sold without special packaging, but profes-
MVP
Sports Equipment Company
sional balls are packaged in an attractive cardboard box.
During October two batches were entered into production and finished. There was
no beginning or ending inventory of work in process for October. Cost and production
data are given in Exhibit 4–11. Notice in Exhibit 4–11 that the direct-material costs are

4
The budgeted amount for the cost driver is based on the company’s practical capacity for production.

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Equivalent Units Example: Direct Materials & Direct Labor Separated
Assume: Overhead added evenly.
Direct Materials and Direct Labor added at different points in time.
Direct Direct
JUNE Materials Labor Overhead
Beginning Inventory
Number units 1,000 1,000 1,000
Percent Complete 0.8 0.6 0.4
Inventory cost 24,000 10,800 2,400

June Activity
Units started 35,000 35,000 35,000
Units completed 32,000 32,000 32,000
Ending units 4,000 4,000 4,000
Percent Complete 0.65 0.4 0.25

Equivalent Units
Ending inventory (4,000 units) 2,600 1,600 1,000
Completed, 100% (32,000 units) 32,000 32,000 32,000
June Equivalent Units 34,600 33,600 33,000

June costs incurred 1,365,000 682,500 560,000

Beginning inventory 24,000 10,800 2,400
Total Costs 1,389,000 693,300 562,400
(this is the weighted average method)

Cost per equivalent unit 40.145 20.634 17.042

Ending Inventory
Number of units 4,000 4,000 4,000
Percent complete 0.65 0.4 0.25
Ending inventory cost 104,376 33,014 17,042