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Chapter 5 Process Costing and Operation Costing

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MONASH

BUSINESS

SCHOOL

Week 5 and 6 are going to be tough!! Try and keep on top of your work – don’t fall behind

It will get easier I PROMISE

For this topic you should be able to:

Understand how a process costing system operates where work in process (WIP) inventories are involved

Assign total production costs to completed units and WIP inventory using the Weighted Average method

Assign total production costs to completed units and WIP inventory using First-in-First-out

Process costing and spoilage

Understand in what contexts operation or hybrid costing would be appropriate and explain how it could work in these particular contexts

Job costing and process costing are two extremes of the continuum of conventional product costing systems

Job costing systems accumulate the costs of each job

Process costing systems accumulate the cost of each process then average these costs across all units produced

Many businesses use a combination of job and process costing; this is called hybrid costing

Job Costing vs. Process Costing

Copyright © 2012 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Management Accounting: Information for managing and creating value 6e

Slides prepared by

Two main steps:

Estimate the cost of the production process

Calculate the average cost per unit by dividing the cost of the process by the number of units produced

Process costing can occur where there is no opening or closing WIP inventory (remember the simple example from last week?)

More complex process costing accounts for WIP inventory

Process Costing

Simple Process Costing: Packaged Cereal

Cleaning & Mixing cost / unit… $250,000 / 80,000 = $3.125 /unit

Packaging cost / unit .…………$150,000 / 80,000 = $1.875 /unit

Total product cost……………… $ 5.00 /unit

Note also: The value of completed units =80,000 x $5= $400,000

4-7

RM  Cleaning & mixing dept  packaging dept  FG inventory

No WIP at end of each work shift since health regulations require the machines to be cleaned each day.

# units produced (i.e. number of boxes of cereal): 80,000

Required: Calculate the product cost for June.

June period Cleaning & mixing Packaging
Direct materials $ 130,000 $ 20,000
Direct labour $ 40,000 $ 30,000
Mfg Overhead $ 80,000 $ 100,000
Total $ 250,000 $ 150,000

FROM LAST WEEK’S LECTURE!

7

To Think About…

What if there was work-in-process inventory? For example, some units are 20% finished, some 70% finished

What would the product cost for June be given that not all manufacturing processes (and therefore costs) have been completed?

Remember this question from last week??

8

Now Imagine….

The health regulations did not apply in the packaging department, so within it there may be partially completed units at the start and end of each month.

Now the cost of packaging per unit no longer = total cost for the department ÷ the number of units worked on. Why?

Previously, Packaging cost / unit

= $150,000 / 80,000 = $1.875 /unit

But now, what should the denominator be?

Now we have two inventories:

(1) completed units, and

(2) partially completed units

9

WIP inventory

Not all products are complete at the beginning or end of the accounting period (usually a month)

Sometimes production costs differ from month to month

So …. when WIP exists, production costs should be calculated by taking into account:

Units started in the previous month (beginning WIP) and completed in the current month … maybe at a different cost

Units started and completed during the current month

Units that are incomplete at the end of the month (ending WIP) …. and therefore, haven’t consumed all their costs yet

Process Costing with WIP

Materials costs are an input into production at various stages

for example, 50% of materials are applied to production at the beginning of the production process, the remainder (50%) when the product is 70% completed or converted

Remember conversion costs from Week 2?!

The cost of converting material into a product

Conversion cost = direct labour + manufacturing overhead

We usually assume that conversion costs are applied uniformly throughout the production process (rather than applied at distinct points in the production process as above in relation to material costs)

Process Costing with WIP

Partially completed goods at the beginning or end of the accounting period are converted to equivalent units for costing purposes

Equivalent units:

The amount of production inputs that have been applied to the physical units in production

Physical units are all units currently in production whether complete or incomplete

Conversion of WIP inventory into equivalent units provides the basis for calculating product cost

Process Costing with WIP

5 Physical Units

2.5 Equivalent Units

Equivalent Units

Calculation of equivalent units:

For WIP of 10,000 litres of a carbonated beverage:

100% complete for direct materials, which were all added at the start of the process  10,000 equivalent units of material

50% complete for conversion costs, assuming that conversion costs occur uniformly across the production process  5,000 equivalent units of conversion

Process Cost Report

Uses of the Process Costing Report

Enables managers to estimate and value the cost of inventories

Inventory values become an input into the Cost of Goods Manufactured, Cost of Goods Sold and Income Statement remember from Week 2?

The unit costs for materials, conversion and in total:

Provide key inputs into management decisions relating to product price and product mix

Provide a basis for assessing product profitability

Used for control purposes by comparing unit costs over time or with industry benchmarks

Steps in Process Costing

1. Analyse the physical flow of units

2. Calculate the equivalent units

3. Calculate the unit costs

4. Analyse the total costs

Products are costed using one of two assumptions about product flow:

Weighted average method

First-in, first-out (FIFO) method

FIFO assumes that the WIP inventory is completed before the production of new units commences

The weighted average does not make this assumption; it does not distinguish between opening WIP units and units started during current period

Comparison of Weighted Average and FIFO

Let's say you are a furniture store and you purchase 200 chairs for $10 and then 300 chairs for $20, and at the end of an accounting period you have sold 100 chairs.

Weighted Average Cost: Cost of a chair: $8,000 divided by 500 = $16/chair Cost of Goods Sold: $16 x 100 = $1,600 Remaining Inventory: $16 x 400 = $6,400 FIFO: Cost of Goods Sold: 100 chairs sold x $10 = $1,000 Remaining Inventory: (100 chairs x $10) + (300 chairs x $20) = $7,000

Comparison of Weighted Average and FIFO

The weighted average cost method is most commonly used where inventories are piled or mixed together and cannot be differentiated, such as chemicals, oils, etc.

Chemicals bought two months ago cannot be differentiated from those bought yesterday, as they are all mixed together

When to Use Weighted Average or FIFO

FIFO often used in foodstuffs and other goods that have a limited shelf life, because the oldest goods need to be sold before they pass their sell-by date

June period Cleaning & mixing Packaging
Direct materials $ 130,000 $ 20,000
Direct labour $ 40,000 $ 30,000
Mfg Overhead $ 80,000 $ 100,000
Total $ 250,000 $ 150,000

Lecture Illustration 1 (contd. from cereal example)

Calculate the following using the WA and FIFO methods:

1. What is the value of units completed in June?

2. What is the value of the WIP inventory at end of June?

Finished Goods Work in Process (WIP)

Round all calculations to two decimal places

22

80,000 units were started in June by the Packaging department.

There were 10,000 units in WIP from May. Assume this WIP is 40% complete in relation to consumption of DL and OH, but each unit has 100% of its DM requirement since all packaging materials are made available (or added) at the beginning of the process (This is a common assumption in process costing).

The value of this opening WIP inventory was $12,000; this is made up of $2,000 of DM cost and $10,000 of conversion costs.

At the end of June, there were 4,000 partially completed units and these were 70% converted (but contained 100% of their DM)

Further information…..

23

Weighted Average Method

Step one: analyse the physical flow of units

10,000 + 80,000 = ? + 4,000

86,000

Physical units in beginning WIP

Physical units started

Physical units completed and transferred out

Physical units in ending WIP

+

=

+

Start Preparing the Process Cost Report….

Fill in the physical flow of units

(from last slide)

Fill in the conversion %

?

?

?

?

Next step: calculate the equivalent units here

Calculate equivalent units for units completed and transferred out & ending WIP

The equivalent units in beginning WIP are not identified separately;

This is a key feature of the weighted average method

Step Two: Calculate the Equivalent Units

Not included for WA method

Step three: calculate the unit costs

The cost per equivalent unit for DM is the total direct material costs divided by the total equivalent units for DM

The cost per equivalent unit for conversion cost is the total conversion cost divided by the total equivalent units for conversion

Under the weighted average method the cost per equivalent unit is based on the total costs incurred including the cost of beginning WIP

Weighted Average Method

Weighted Average Method: Step 3

From Step 2 (Slide 26)

Included under WA method but not FIFO

22,000/90,000

etc.....

(Round to 2 decimal places here)

From slides 22 and 23

$0.24 + $1.58

Step four: analyse the total costs

Calculate (as per the question on slide 25) the following:

The cost of units completed in June

The cost (to date) of closing WIP at the end of June

Weighted Average Method

From Step 3

From Step 1

100% complete!

100% complete for direct material!

Only 70% complete so… only 2,800 (4,000 x 70%) equivalent units of conversion costs incurred

Oh no … wait

There’s another method!

First-in-First-out (FIFO)

Finished – yaaay!!!!

Different assumptions regarding inventory (see slide 21)

So how does the process cost report differ under FIFO?

Step 1: Identical to weighted average method

Step 2: Equivalent units in opening WIP are subtracted from total equivalent units to give equivalent units of new production for the month

Step 3: Costs of opening inventory are not used in the calculation of costs per equivalent unit

Step 4: The cost to finish beginning WIP units, and the cost of units started and finished in the current month are calculated separately

Comparison of Weighted Average and FIFO

Step one: analyse the physical flow of units

Identical to the weighted average method

10,000 + 80,000 = ? + 4,000

86,000

Physical units in beginning WIP

Physical units started

Physical units completed and transferred out

Physical units in ending WIP

+

=

+

First in First Out (FIFO) Method

Start Preparing the Process Cost Report….

Fill in the physical flow of units

(from last slide)

Fill in the conversion %

?

?

?

?

Next step: calculate the equivalent units here

First in First Out (FIFO) Method

Step two: calculate the equivalent units

Under FIFO the equivalent units in opening WIP are subtracted from total equivalent units to give equivalent units of new production for the current month (June)

– key difference

First in First Out (FIFO) Method

Calculate EQU as usual

Subtract opening equivalent units

Key difference is the treatment of the beginning WIP

Under the weighted average method the cost of beginning WIP and equivalent units of work done on WIP are included in the calculation of the average cost per equivalent unit

Under FIFO the cost per equivalent unit is based only on costs incurred in the current month

Comparison of Weighted Average and FIFO

Step three: calculate the unit costs

The cost per equivalent unit for DM is the direct material cost incurred during the current month divided by the new equivalent units added during the current month (June)

The cost per equivalent unit for conversion cost is the conversion cost incurred during the current month divided by the new equivalent units added during the current month (June)

Costs of opening inventory are not used in this calculation – key difference

First in First Out (FIFO) Method

From Step 2

Blank

Blank

From slide 22

130,000/84,800

etc.....

(Round to 2 decimal places here)

$0.25 + $1.53

Step four: analyse the total costs

Assumes that the units in beginning WIP are completed and transferred out first

Therefore, the costs of the beginning WIP are not mixed with the new costs incurred during the current month

…..so we have to calculate three separate costs:

The cost to finish beginning WIP units (inclusive of costs incurred in May) – key difference

The cost of units started and finished in June

The cost (to date) of closing WIP at the end of June

First in First Out (FIFO) Method

From Step 3

From Slide 23

Opening WIP was 40% converted; therefore, in June, to complete these units, 6,000 EQU (10,000 x 60%) of conversion costs were incurred

Refer to slides 35 and 36 – 86,000 units were completed & transferred out in June. However, 10,000 of these came from opening WIP – we have already calculated the cost of these units above. Therefore, 76,000 (86,000 – 10,000) were started and finished in June

100% complete!

Only 70% complete so… only 2,800 (4,000 x 70%) equivalent units of conversion costs incurred

100% complete for direct material!

Process Costing and Spoilage

Spoilage cost: the cost of defective products and wasted resources that cannot be recovered by rework or recycling

Spoiled units are also costed using cost per equivalent unit

Spoilage is accounted for depending on whether it is normal or abnormal:

Normal spoilage: inherent in the production process and occurs even under efficient operating conditions

Included as part of the cost of good units completed

Abnormal spoilage: should not occur under efficient operating conditions

Costs of abnormal spoilage are expensed

Process Costing and Spoilage

Physical flow of units with spoilage

Physical units in beginning WIP

Physical units started

Physical units completed and trans’d out

Physical units in ending WIP

=

+

spoiled units

+

+

Total units to account for

Total units accounted for

43

Process Costing and Spoilage

Hybrid Costing Systems

Some businesses have repetitive production processes but produce a narrow range of products that differ in some significant aspects:

Different material inputs

Different combinations of specific production processes

Hybrid Costing Systems

Click to edit Master text styles

Second level

Third level

Fourth level

Fifth level

46

Operation costing is a hybrid costing system

Used in a batch manufacturing environment

Contains features of both job costing and process costing

A product initially uses different raw materials, and is then finished using a common process that is the same for a group of products; or

A product initially has identical processing for a group of products, and is then finished using more product-specific procedures

Hybrid Costing Systems

A company manufactures watches in lots of 1,000

The watch casings and workings for all 1,000 units are identical, so the company simply adds up the cost of the production run and divides by 1,000 units to arrive at the per-unit cost

However, watch straps are custom-made for the wrist size of the customer, and use a variety of unique materials

These costs are compiled for each individual watch

Thus, we have process costing for one portion of the production process (the watch casings and workings) and job costing for another portion (the watch bands)

Hybrid Costing Systems: Watches

A company builds unique, custom-designed race cars

It uses job costing to compile the cost of each car

However, all cars are then run through a paint shop, which is essentially a fixed cost

The cost of the paint booth is allocated equally to all of the cars run through it, which is process costing

Thus, we use job costing for the first part of the production process and process costing for the second part

Hybrid Costing Systems: Race Cars

Hybrid Costing System

Acknowledgement

Some slides contained in this presentation were adapted from:

52

2. Equivalent Units

1. Physical Units# units

% complete

wrt

conversion

Packaging

DM

Packaging

Dept

Conversion

WIP 1st June10,00040%

Units started in June (transferred in from C&M)

80,000

Total units to account for90,000

Units completed & transferred out in June

86,000100%86,00086,000

WIP 30 June4,00070%4,0002,800

Total units accounted for90,00090,00088,800

3. Costs to Account for & Unit CostsTotal

WIP 1st June$2,000$10,000

Costs incurred during June$20,000$130,000

Total costs to account for:$22,000$140,000

Cost / EQU (Weighted Average method)$0.244$1.577$1.821

4. Calculation of Inventory values:

Units completed & transferred out in June

86,000$156,608

(86,000 x $1.821)

WIP 30 June4,000$978$4,414$5,392

(4000 x $0.244)(2,800 x $1.577)

Total costs to account for:$162,000

2. Equivalent Units

1. Physical Units# units

% complete

wrt

conversion

Packaging

DM

Packaging

Dept

Conversion

WIP 1st June10,00040%

Units started in June (transferred in from C&M)

80,000

Total units to account for90,000

Units completed & transferred out in June

86,000100%

WIP 30 June4,00070%

Total units accounted for90,000

2. Equivalent Units

1. Physical Units# units

% complete

wrt

conversion

Packaging

DM

Packaging

Dept

Conversion

WIP 1st June10,00040%

Units started in June (transferred in from C&M)

80,000

Total units to account for90,000

Units completed & transferred out in June

86,000100%86,00086,000

WIP 30 June4,00070%4,0002,800

Total units accounted for90,00090,00088,800

DMConversion

Total units accounted for90,00088,800

3. Costs to Account for & Unit CostsTotal

WIP 1st June$2,000$10,000

Costs incurred during June$20,000$130,000

Total costs to account for:$22,000$140,000

Cost / EQU (Weighted Average method)$0.24$1.58$1.82

DMConversion

$0.24$1.58$1.82

4. Calculation of Inventory values:

Units completed & transferred out in June

86,000$156,520

(86,000 x $1.82)

WIP 30 June4,000$960$4,424$5,384

(4000 x $0.24)(2,800 x $1.58)

2. Equivalent Units

1. Physical Units# units

% complete

wrt conversion

Packaging

DM

Packaging Dept

Conversion

WIP 1st June10,00040%

Units started in June (transferred in from C&M)

80,000

Total units to account for

90,000

Units completed & transferred out in June86,000100%86,00086,000

WIP 30 June4,00070%4,0002,800

Total units to account for

90,00090,00088,800

less EQU in WIP 1st June10,0004,000

EQU in June production only

80,00084,800

DMConversion

EQU in June production only

80,00084,800

3. Costs to Account for & Unit CostsTotal

WIP 1st June

Costs incurred during June$20,000$130,000

Cost / EQU for June$0.25$1.530$1.78

DMConversion

Cost / EQU for June$0.25$1.53$1.78

4. Calculation of Inventory values:

Units completed & transf'd out in June

from WIP 10,000$12,000

cost to finish WIP$9,180$9,180

(6,000 x $1.53)

started & finished in June76,000$135,280

(76,000 x $1.78)

TOTAL transfer out$156,460

WIP 30 June4,000$1,000$4,284$5,284

(4,000 x $0.25)(2,800 x $1.53)