A process costing system is used when a business is producing a large number of identical products. In this situation, it is most efficient to accumulate costs at an aggregate level for a large batch of products, and then allocate them to the individual units produced. The assumption is that the cost of each unit is the same as that of any other unit, so there is no need to track information at an individual unit level. The classic example of a process costing environment is a petroleum refinery, where it is impossible to track the cost of a specific unit of oil as it moves through the refinery.
A process costing system accumulates costs and assigns them at the end of an accounting period. At a very simplified level, the process is:
- Direct materials. Using either a periodic or perpetual inventory system, we determine the amount of materials used during the period. We then calculate the number of units begun and completed during the period, as well as the number of units begun but not completed (work-in-process units). We generally assume that materials are added at the beginning of the production process, which means that a work-in-process unit is the same as a completed unit from the perspective of assigning material costs. We then assign the amount of direct materials used based on the total of fully and partially produced units.
- Direct labor. Labor is accumulated by units throughout the production process, so it is more difficult to account for than direct materials. In this case, we estimate the average level of completion of all work-in-process units, and assign a standard direct labor cost based on that percentage. We also assign the full standard labor cost to all units that were begun and completed in the period. If there is a difference between the actual direct labor cost and the amount charged to production in the period, the difference can be charged to the cost of goods sold or apportioned among the units produced.
- Overhead. Overhead is assigned in a manner similar to what was just described for direct labor, where we estimate the average level of completion of all work-in-process units, and assign a standard amount of overhead based on that percentage. We then assign the full standard amount of overhead to all units that were begun and completed in the period. As was the case with direct labor, any difference between the actual overhead cost and the amount charged to production in the period is either charged to the cost of goods sold or apportioned among the units produced.
Cost assigned to units produced or in process are recorded in the inventory asset account, where it appears on the balance sheet. When the goods are eventually sold, the cost is shifted to the cost of goods sold account, where it appears on the income statement.
If a process costing system does not mesh well with a company's cost accounting systems, there are two other systems available that may be a better fit. The job costing system is designed to accumulate costs for either individual units or for small production batches. The other option is a hybrid costing system, where process costing is used part of the time and job costing is used the rest of the time; it works best in production environments where some of the manufacturing is in large batches, and other work steps involve labor that is unique to individual units.