Process costing is a method used to track production costs in industries that manufacture large volumes of identical products. It ensures accurate cost allocation, helping businesses improve pricing, efficiency, and profitability.
This blog will explore how process costing works, the different methods used, its benefits and challenges, and the role of technology in streamlining the process.
What is Process Costing?
Process costing is a cost accounting method used to assign production costs in industries where large quantities of identical products are manufactured. Instead of tracking expenses for individual units, costs are accumulated for each stage of production and then evenly distributed across all finished goods. This approach simplifies cost management and provides a clear view of production expenses.
Industries that rely on process costing include manufacturing, retail, food production, pharmaceuticals, and chemical processing. Businesses in these sectors operate with standardized production processes, making process costing an essential tool for accurate cost tracking and financial planning.
Key Features of Process Costing
Process costing ensures accurate cost allocation and efficient financial management by following these key principles:
- Standardized Production: Process costing applies to businesses that manufacture identical products in bulk. Since each unit goes through the same production steps, costs can be evenly distributed across all items.
- Cost Accumulation Per Process: Instead of tracking costs for individual jobs, expenses are assigned to specific production stages. This method helps businesses manage costs more efficiently in continuous production environments.
- Cost Flow Tracking: Costs move through various stages of production, from raw materials to finished goods. This ensures accurate expense allocation at each step, improving cost control and financial planning.
Process Costing vs. Other Costing Methods
Process costing isn’t the only approach to cost tracking. Depending on the type of production, businesses may use job costing for custom work or activity-based costing (ABC) for a more detailed breakdown. Here’s how they compare:
Process Costing vs. Job Order Costing
Process costing is used for large-scale production of identical products, where costs are averaged across all units. It suits industries like manufacturing, retail, and food production.
Job costing, in contrast, tracks expenses for individual projects or custom orders, making it ideal for construction, custom manufacturing, and specialized services. While process costing spreads costs evenly, job costing provides precise tracking for unique orders.
Process Costing vs. Activity-Based Costing (ABC)
Process costing allocates costs broadly across all units in standardized production, making it efficient for high-volume industries.
Activity-based costing (ABC) assigns costs based on specific activities, offering a more detailed breakdown. It helps businesses with diverse product lines identify inefficiencies and optimize pricing. While process costing is simpler, ABC provides deeper cost insights.
Types of Process Costing
Different methods are used in process costing to allocate production costs effectively. The choice of method depends on how a business tracks inventory and expenses over time.
Weighted Average Method
The Weighted Average method calculates the per unit cost by averaging the total production costs across all units, including those carried over from the previous period and those produced in the current period. This method does not differentiate between old and new costs but instead blends them together.
Because of its simplicity, the weighted average method is widely used in industries where production runs continuously, such as food processing, textiles, and chemical manufacturing. It is especially useful when price fluctuations in raw materials are minimal, as it smooths out cost variations over time. However, since it merges past and present costs, it may not provide the most precise cost breakdown in industries where material prices change frequently.
FIFO (First In, First Out) Method
The FIFO method follows the principle that older costs are assigned to finished goods first, while newer costs remain in inventory. This means that the earliest costs recorded in a given period are used to calculate the per unit cost of completed products, while costs associated with recently produced units remain in work-in-process inventory.
FIFO is beneficial in industries where material prices fluctuate significantly, such as pharmaceuticals, electronics, and oil refining, as it ensures that the most up-to-date material costs remain in inventory. This method provides a more precise cost breakdown than the weighted average method, particularly when tracking changes in production costs. However, it requires more detailed inventory tracking, making it slightly more complex to implement.
Standard Costing Method
The Standard Costing method assigns predetermined costs to materials, labor, and overhead based on historical data, expected expenses, or industry benchmarks. Businesses then compare actual costs to these estimates to measure variances and identify areas where expenses differ from expectations.
This method is particularly useful for budgeting, cost control, and performance evaluation, making it common in automotive manufacturing, consumer goods production, and large-scale retail operations. Since standard costing relies on projected values, it helps businesses streamline accounting and maintain cost consistency. However, when actual costs deviate significantly from standard costs, businesses may need to make frequent adjustments to ensure accurate financial reporting.
Why Is Process Costing Important?
Process costing helps businesses figure out exactly how much it costs to make their products. Without it, companies might guess their expenses, leading to pricing mistakes and lost profits. By spreading costs evenly across all units, businesses can keep track of spending, set fair prices, and make smarter financial decisions. It also helps them plan for the future and stay profitable as they grow.
Pros and Cons of Process Costing
Process costing is a valuable accounting method for businesses with continuous or large-scale production, but it comes with both benefits and limitations. Understanding these can help businesses determine if it’s the right approach for their cost management needs.
Advantages of Process Costing
- Efficient for Large-Scale Production: Process costing is ideal for industries that produce high volumes of identical products. By spreading costs evenly across all units, it simplifies expense allocation and reduces the complexity of tracking costs per unit.
- Helps in Pricing Strategies and Cost Control: With a clear view of production costs at each stage, businesses can set competitive prices while ensuring profitability. It also helps identify cost fluctuations, enabling better budgeting and cost management.
- Simplifies Accounting for Repetitive Processes: Since process costing assigns expenses to entire production stages rather than individual products, it streamlines accounting. This makes financial reporting more efficient and reduces administrative workload, especially in industries where processes remain consistent.
- Ensures Better Inventory Valuation: By averaging costs across all units, process costing provides a more accurate valuation of inventory. This consistency is particularly beneficial for businesses that need to maintain stable financial records and comply with accounting standards.
Challenges of Process Costing
- Less Flexibility for Customized Production: Unlike job costing, which assigns costs to specific projects, process costing works best for uniform products. Businesses that produce custom orders or varied product lines may find it less effective in tracking specific costs.
- Complex Tracking for Multiple Production Stages: Manufacturing processes often involve multiple stages, each with its own materials, labor, and overhead costs. Allocating these costs accurately requires careful tracking, which can become complex without the right accounting tools.
- Variances in Costs May Require Frequent Adjustments: Material prices, labor rates, and overhead expenses fluctuate over time. Since process costing averages costs across production, businesses may need to regularly adjust their calculations to reflect these changes, ensuring accurate financial reporting.
Using the Process Costing Method
Process costing follows a structured approach to track and allocate production costs accurately. By breaking down the manufacturing process into distinct stages and considering work-in-process (WIP) inventory, businesses can manage expenses efficiently and ensure consistent pricing. Here’s a refined step-by-step breakdown:
Step 1: Analyze Inventory
The first step is to assess the flow of inventory during the accounting period. This involves reviewing the beginning inventory, which includes any units that were unfinished at the start of the period. It also accounts for the number of units that were started and completed within the period, as well as those that remain classified as work in process at the end.
Understanding WIP inventory ensures accurate cost allocation and helps prevent the overstatement or understatement of production expenses.
Step 2: Calculate Equivalent Units
Since some products may still be in process at the end of the period, process costing uses equivalent units to measure partially completed products. This calculation considers the percentage of completion for unfinished units.
For example, if 1,500 units remain unfinished at the end of the period and have reached 60% of the production process, they are considered equivalent to 900 fully completed units for cost allocation (1,500 × 0.60 = 900).
Step 3: Track Costs at Each Stage
At every stage of production, businesses record three key cost components:
- Direct Materials: Raw materials added at different points in the production process.
- Direct Labor Costs: Wages for workers involved in manufacturing.
- Overhead Costs: Indirect costs such as utilities, equipment depreciation, and factory maintenance.
Tracking these costs across each production stage ensures expenses are properly distributed.
Step 4: Calculate Cost Per Unit
Once all production costs are recorded, they are divided by the total equivalent units to determine the per-unit cost. This calculation includes both fully completed and partially completed units.
For instance, if a business completed 5,000 units and had 900 equivalent units in process, totaling 5,900 units, and total costs for the period equaled $23,600, the cost per unit would be:
$23,600 ÷ 5,900 = $4.00 per unit
Step 5: Allocate Costs to Completed and In-Process Units
Finally, costs are distributed between completed products and work-in-process inventory:
- Completed products: Multiply the number of finished units by the cost per unit.
- WIP inventory: Multiply the equivalent units of unfinished products by the cost per unit.
Using the previous example, if 5,000 units are completed, the total cost assigned to finished goods is:
5,000 × $4.00 = $20,000
For the 900 equivalent units in WIP, the cost is:
900 × $4.00 = $3,600
By following these steps, businesses can accurately assign production costs, improve inventory valuation, and maintain financial control over high-volume manufacturing.
Examples of Process Cost Accounting
Process cost accounting is used when businesses produce identical products in large quantities, ensuring costs are accurately tracked at each stage of production. Below are three fictional examples demonstrating how companies apply this method.
EverGlow Candles – Mass Candle Production
EverGlow Candles produces scented candles in bulk for retail stores. The production cycle includes wax melting, fragrance blending, molding, and packaging. In March, the molding department accumulates $50,000 in direct material costs for wax and essential oils and $90,000 in conversion costs, covering wages, facility rent, and overhead. The total number of units produced for the month is 100,000 candles.
- Direct material cost per unit: $50,000 ÷ 100,000 = $0.50 per candle
- Conversion cost per unit: $90,000 ÷ 100,000 = $0.90 per candle
- Total cost per unit: $1.40 per candle
- Total cost for completed units: 100,000 × $1.40 = $140,000
Since EverGlow Candles follows a continuous production process, process costing allows for efficient expense tracking across multiple production departments.
BrightLens Optical – Contact Lens Manufacturing
BrightLens Optical produces disposable contact lenses through multiple production stages, including polymer mixing, lens shaping, sterilization, and packaging. Since production runs continuously, some lenses remain in process at the end of each period. To ensure accurate cost allocation, the company accounts for Work-in-Process (WIP) inventory alongside completed units.
In September, the sterilization department incurs $120,000 in raw material costs and $180,000 in conversion costs (direct labor and overhead). The company has completed 280,000 lenses, while an additional 40,000 lenses are still in process, with an estimated 50% completion.
- Calculate Equivalent Units
Since 40,000 lenses are only 50% complete, they count as 20,000 equivalent units for process costing.- Total equivalent units: 280,000 (completed) + 20,000 (WIP) = 300,000 units
- Determine Cost Per Unit
- Material cost per unit: $120,000 ÷ 300,000 = $0.40 per lens
- Conversion cost per unit: $180,000 ÷ 300,000 = $0.60 per lens
- Total cost per unit: $1.00 per lens
- Allocate Costs to Completed and WIP Inventory
- Completed units cost: 280,000 × $1.00 = $280,000
- WIP inventory cost: 20,000 × $1.00 = $20,000
Process costing helps BrightLens Optical distribute expenses accurately across all units, ensuring proper inventory valuation and cost control in a highly regulated industry.
How BrightPearl Helps with Process Costing
BrightPearl offers a process costing system that automates cost tracking, inventory management, and financial reporting. Instead of manually allocating expenses, businesses can rely on the system to distribute materials, labor, and overhead costs accurately across production stages.
With real-time inventory monitoring, BrightPearl ensures that work-in-process (WIP) inventory is accounted for correctly, preventing miscalculations and improving cost control. Automated cost-per-unit calculations also help businesses set accurate pricing and maintain profitability.
By integrating process costing with financial reporting, BrightPearl provides better visibility into production costs, helping businesses track expenses, reduce errors, and improve efficiency. Whether managing a small operation or scaling production, BrightPearl makes cost management easier and more reliable.
Simplify Cost Tracking and Improve Efficiency
Process costing is essential for businesses that produce large volumes of identical products, ensuring accurate cost allocation and better financial management. By breaking down production into stages, tracking expenses, and using methods like Weighted Average, FIFO, or Standard Costing, companies can maintain cost efficiency, optimize pricing, and improve profitability.
Managing process costing manually can be complex, but BrightPearl simplifies the process with automated cost tracking, real-time inventory management, and seamless financial reporting. Whether you’re looking to streamline cost allocation, track work-in-process inventory, or improve overall efficiency, BrightPearl provides the tools to make process costing easier.
Ready to optimize your cost management? Book a BrightPearl demo today to see how our solution can help your business stay accurate and profitable!
