Illustrating Process Costing

Learning Objective 1 Identify the situations in which process-costing systems are appropriate

Before examining process costing in detail, let’s briefly review the distinction between job costing and process costing explained in Chapter 4. Job-costing and process-costing systems are best viewed as ends of a continuum:

A figure shows a continuum with job-costing system at the left and process-costing system at the right.

A figure shows a continuum with job-costing system at the left, characterized by distinct, identifiable units of a product or service, for example, custom-made machines and houses. At the right of the continuum is process-costing system, characterized by masses of identical or similar units of a product or service, for example, food or chemicals.

In a process-costing system, the unit cost of a product or service is obtained by assigning total costs to many identical or similar units of output. Unit cost equals total costs divided by the number of units of output from the production process. In a manufacturing process-costing setting, each unit receives the same or similar amounts of direct material costs, direct manufacturing labor costs, and indirect manufacturing costs (manufacturing overhead).

The main difference between process costing and job costing is the extent of averaging used to compute unit costs. In job-costing, individual jobs use different quantities of resources, so it is incorrect to cost each job at the same average production cost. In contrast, when identical or similar units of products or services are mass-produced, process costing calculates an average production cost for all units produced. Some processes, such as clothes manufacturing, have aspects of both process costing (the cost per unit of each operation, such as cutting or sewing, is identical) and job costing (different materials are used in different batches of clothing, say, wool versus cotton). The final section in this chapter describes “hybrid” costing systems that combine elements of both job and process costing.

Consider the following example: Pacific Electronics manufactures a cell phone, model SG-40. The phones are assembled in the assembly department. Upon completion, units are transferred to the testing department. All units of SG-40 are identical. The process-costing system for SG-40 in the assembly department has a single direct-cost category—direct materials—and a single indirect-cost category—conversion costs. Conversion costs are all manufacturing costs other than direct material costs, including manufacturing labor, energy, plant depreciation, and so on. Direct materials, such as a phone’s processor, image sensors, and microphone, are added at the beginning of the assembly process. Conversion costs are added evenly during assembly.

The following graphic represents these facts:

Flow diagram shows the two costing systems: Job-costing system and Process-costing system.

The details are as follows:

Process-costing systems separate costs into cost categories according to when costs are introduced into the process. Often, as in our Pacific Electronics example, only two cost classifications—direct materials and conversion costs—are necessary to assign costs to products. Why only two? Because all direct materials are added to the process at one time and all conversion costs generally are added to the process evenly through time. Sometimes the situation is different.

  1. If two different direct materials—such as the processor and digital camera—are added to the process at different times, two different direct materials categories would be needed to assign these costs to products.
  2. If manufacturing labor costs are added to the process at a different time compared to other conversion costs, an additional cost category—direct manufacturing labor costs—would be needed to assign these costs to products.

We illustrate process costing using three cases of increasing complexity: