UNIT 5

Process Costing
Process costing is the technique of assigning costs to each process or stage of production and
determining the cost per unit of output.

Features of Process Costing

 Production is continuous and mass-scale

 Units are homogeneous (identical)
 Output of one process becomes input of next
 Costs are collected process-wise
 Cost is calculated per unit of output
 Suitable for industries like cement, sugar, chemicals, oil, textiles

Objectives of Process Costing

 To determine cost per unit at each stage

 To control wastage and losses
 To measure efficiency of each process
 To facilitate cost comparison between processes

Advantages of Process Costing

 Simple and easy to apply

 Helps in cost control
 Suitable for large-scale production
 Provides accurate cost per unit
 Enables standardization

Disadvantages of Process Costing

 Not suitable for customized production

 Difficulty in valuation of work-in-progress
 Assumptions may reduce accuracy
 Does not show individual job cost

Types of Losses in Process Costing

1. Normal Loss

 Expected loss due to the nature of the process

 Unavoidable
 Scrap value is credited
 Cost borne by good units
2. Abnormal Loss

 Unexpected and avoidable

 Due to inefficiency or accident
 Valued at cost per unit
 Transferred to Costing Profit & Loss A/c

3. Abnormal Gain

 When actual loss is less than normal loss

 Indicates efficiency
 Credited to Costing Profit & Loss A/c

Work-in-Progress (WIP) in Process Costing

Work-in-Progress (WIP) refers to units that are partially completed at the end of an
accounting period. These units have incurred some cost but are not yet fully finished.

 WIP exists due to continuous production

 Units are valued based on degree of completion (%)
 Different elements (material, labour, overhead) may have different completion levels
 Requires calculation of Equivalent Units of Production (EUP)

Equivalent Units of Production

Equivalent units convert incomplete units into fully completed units.

Formula:

Equivalent Units=Actual Units×Percentage of Completion

Example

Given Data:

 Units introduced: 1,000

 Units completed: 800
 Closing WIP: 200 units
 Degree of completion:
o Materials: 100%
o Labour & Overheads: 50%

Step 1: Calculate Equivalent Units

Materials

 Completed units = 800 × 100% = 800

 Closing WIP = 200 × 100% = 200

Total Equivalent Units (Materials) = 1000 units

Labour & Overheads

 Completed units = 800 × 100% = 800

 Closing WIP = 200 × 50% = 100
 Total Equivalent Units (Labour & OH) = 900 units

Step 2: Assume Costs

 Material Cost = ₹10,000

 Labour & Overheads = ₹9,000

Step 3: Cost per Equivalent Unit

 Material per unit = 10,000 ÷ 1000 = ₹10

 Labour & OH per unit = 9,000 ÷ 900 = ₹10

Step 4: Cost Allocation

Completed Units (800 units)

 Material = 800 × 10 = ₹8,000

 Labour & OH = 800 × 10 = ₹8,000
 Total = ₹16,000

Closing WIP (200 units)

 Material = 200 × 10 = ₹2,000

 Labour & OH = 100 × 10 = ₹1,000
Total = ₹3,000

 Cost of Completed Units = ₹16,000

 Cost of Closing WIP = ₹3,000

Equivalent Units of Production (EUP)

Equivalent Units convert partially completed units into fully completed units for cost
calculation.

Methods of EUP
 1. FIFO Method
2. Weighted Average Method

FIFO Method

 Considers only current period work

 Opening WIP cost is kept separate
 More accurate method
 Separates:
o Work done last period
o Work done this period

Steps in FIFO Method

1. Calculate Units Completed

2. Compute Equivalent Units
3. Calculate Cost per Equivalent Unit
4. Allocate Cost to:
o Completed Units
o Closing WIP

Example 1: FIFO Method

Given Data:

 Opening WIP = 200 units (60% complete)

 Units introduced = 800 units
 Units completed = 900 units
 Closing WIP = 100 units

Degree of Completion:

 Materials = 100%
 Labour & OH = 50%

Step 1: Units Analysis

Particulars Units
Opening WIP 200
Units Started 800
Total 1000
Completed 900
Closing WIP 100

Step 2: Equivalent Units (FIFO)

Work needed to complete Opening WIP:

 Labour & OH = 200 × (100% – 60%) = 80 units

(Material already 100% → No work needed)

Units Started & Completed:

 900 – 200 = 700 units

Fully complete:

 Material = 700
 Labour = 700

Closing WIP:

 Material = 100 × 100% = 100

 Labour = 100 × 50% = 50

Total Equivalent Units

Cost Element Units

Material 700 + 100 = 800
Labour & OH 80 + 700 + 50 = 830

Example 2: Cost Calculation (FIFO)

Given Costs:

 Opening WIP Cost:

o Material = ₹2,000
o Labour = ₹1,000
 Current Period Cost:
o Material = ₹8,000
o Labour = ₹8,300

Step 3: Cost per Equivalent Unit

Only current cost ÷ equivalent units

 Material = 8,000 ÷ 800 = ₹10

 Labour = 8,300 ÷ 830 = ₹10
Step 4: Cost Allocation

(A) Opening WIP Completion Cost

 Labour = 80 × 10 = ₹800

Total Opening WIP Cost:

= 2,000 + 1,000 + 800 = ₹3,800

(B) Units Started & Completed (700 units)

 Material = 700 × 10 = ₹7,000

 Labour = 700 × 10 = ₹7,000
Total = ₹14,000

(C) Closing WIP

 Material = 100 × 10 = ₹1,000

 Labour = 50 × 10 = ₹500
Total = ₹1,500

 Cost of Completed Units = ₹3,800 + ₹14,000 = ₹17,800

 Cost of Closing WIP = ₹1,500

Joint Products

Joint products are two or more products produced simultaneously from the same process and
raw material, each having significant economic value.

Key Features

 Produced from a common process

 Separation occurs at split-off point
 All products have almost equal importance
 Joint cost incurred before split-off

Examples

 Crude oil → Petrol, Diesel, Kerosene

 Milk → Butter, Cheese, Cream
 Sugar industry → Sugar, Molasses

Example

Given:
Total Joint Cost = ₹10,000

Output:

 Product A = 100 units

 Product B = 100 units

Physical Units Method

Cost distributed equally:

 A = 10,000 × (100/200) = ₹5,000

 B = 10,000 × (100/200) = ₹5,000

Methods of Allocation of Joint Costs

1. Physical Units Method

 Based on quantity (units, weight, volume)

 Simple but ignores value

2. Sales Value at Split-Off Method

 Based on market price at the split-off point

Example:

 A: 100 units × ₹50 = ₹5,000

 B: 100 units × ₹30 = ₹3,000

Total = ₹8,000

Cost Allocation:

 A = (5000/8000) × 10000 = ₹6,250

 B = (3000/8000) × 10000 = ₹3,750

3. Net Realizable Value (NRV) Method

 Final selling price – further processing cost

Example:

 A final value = ₹7,000 – ₹1,000 = ₹6,000

 B final value = ₹4,000 – ₹500 = ₹3,500 Total NRV = ₹9,500
Allocation:

 A = (6000/9500) × 10000 = ₹6,316

 B = (3500/9500) × 10000 = ₹3,684

By-Products

By-products are secondary products obtained incidentally during production, having minor
economic value.

Features

 Produced along with the main product

 Low sales value
 Not the primary objective of production
 Helps in reducing overall cost

Examples

 Sugar industry → Molasses

 Petroleum → Bitumen
 Rice milling → Husk

Treatment of By-Products

Method 1: Other Income Method

 Sale value treated as income

 Not deducted from cost

Method 2: Deduction from Cost Method

 Sale value deducted from the main product cost

Example

Given:

 Main product cost = ₹10,000

 By-product sales = ₹1,000

Treatment:

Deduction Method:

 Net Cost = 10,000 – 1,000 = ₹9,000

Difference Between Joint Products & By-Products

Basis Joint Products By-Products

Importance Equal Secondary
Value High Low
Objective Main output Incidental
Cost Allocation Necessary Sometimes ignored

Target Costing

1. Target costing is a proactive cost management technique in which the selling price is
determined first based on market conditions, and then the allowable cost is derived by
deducting the desired profit.
2. It follows a market-driven approach, meaning the company has little control over price,
as it is influenced by competition, customer expectations, and demand.
3. The basic formula used in target costing is:
Target Cost = Target Selling Price − Desired Profit, which helps determine the
maximum cost a company can incur.
4. Unlike traditional costing methods, target costing uses a backward calculation
approach, where cost is controlled after fixing the price and profit.
5. It mainly focuses on cost control at the design and development stage, since most of
the product cost is decided before actual production begins.
6. The approach requires cross-functional coordination among departments such as
engineering, production, marketing, and finance to achieve cost efficiency.
7. If the estimated cost exceeds the target cost, companies use techniques like value
engineering, process improvement, and cost optimization to reduce costs without
affecting quality.
8. For example, if the expected selling price of a product is ₹10,000 and the desired profit is
₹2,000, the target cost will be ₹8,000, and the product must be designed within this cost
limit.
9. Target costing helps firms achieve competitive pricing, cost efficiency, and desired
profitability, making it highly useful in competitive markets.

Life Cycle Costing (LCC)

1. Life Cycle Costing is a technique that considers all costs associated with a product
over its entire life, from initial research to final disposal.
2. It follows a long-term perspective, focusing on total profitability rather than just
production cost.
3. The life cycle of a product includes stages such as research and development, design,
production, marketing, distribution, after-sales service, and disposal.
4. This method helps in understanding that a large portion of costs is incurred even before
production begins.
5. It assists management in making better pricing, investment, and product design
decisions.
 6. Life cycle costing emphasizes cost control across all stages, not just during
manufacturing.
7. It is particularly useful in industries with high development costs and long product life
cycles, such as automobiles and electronics.
8. By considering total costs, firms can aim to maximize overall profitability rather than
short-term gains.

Quality Costing

1. Quality Costing refers to the process of identifying and measuring the costs associated
with maintaining good quality and the costs arising due to poor quality.
2. It helps organizations understand the financial impact of quality-related activities.
3. Quality costs are broadly classified into four categories:
o Prevention Costs (e.g., training, quality planning)
o Appraisal Costs (e.g., inspection, testing)
o Internal Failure Costs (e.g., scrap, rework before delivery)
o External Failure Costs (e.g., warranty claims, customer complaints)
4. The main objective is to minimize total quality cost by investing more in prevention and
appraisal.
5. It highlights that spending on prevention reduces costly failures later.
6. Quality costing improves product reliability, customer satisfaction, and brand
reputation.
7. It supports continuous improvement practices such as Total Quality Management
(TQM).
8. Overall, it helps firms achieve a balance between cost efficiency and high-quality
standards.

Activity-Based Costing (ABC)

1. Activity-Based Costing (ABC) is a costing method that allocates overhead costs based
on activities that drive costs, rather than using traditional methods like labor or machine
hours.
2. It focuses on identifying various activities involved in production or service delivery.
3. Costs are first assigned to activities and then to products based on cost drivers (e.g.,
number of setups, inspections, machine hours).
4. ABC provides more accurate product costing, especially in complex and diversified
production environments.
5. It helps identify non-value-added activities, which can then be reduced or eliminated.
6. This method improves cost control, pricing decisions, and profitability analysis.
7. ABC is particularly useful where overhead costs are high and products are diverse.
8. By providing detailed cost information, it supports better managerial decision-making
and operational efficiency.