Home / Courses / Managerial Accounting / Unit 3

Managerial Accounting Unit 3: Process Costing

Process costing averages costs over identical units flowing through departments. The key skill is computing equivalent units and using them to cost finished goods and ending work in process.

Covers: Process vs. job-order costing, Physical flow of units, Equivalent units: weighted-average, Equivalent units: FIFO, Cost per equivalent unit, Assigning costs and cost reconciliation, Transferred-in costs

Study guide

Process costing is used by companies that make large volumes of identical units in a continuous flow, such as refineries, food processors and paint makers. Instead of a cost sheet per job, each processing department has its own Work in Process account. Costs are accumulated by department for a period and divided by the units the department worked on to get an average cost per unit. When units leave one department they carry their costs to the next department's WIP account as transferred-in costs, and when the last department finishes them they move to Finished Goods.

The challenge is that at the end of a period some units are only partly finished. Equivalent units restate partial work as whole units: 500 units that are 40% complete equal 200 equivalent units. Materials and conversion costs are often added at different times, so equivalent units are computed separately for each. If materials are added at the start, every unit in process is 100% complete for materials; if added at the end, units in process are 0% complete. Conversion costs are usually added evenly, so the stated percentage of completion applies. Always start with the physical flow: beginning WIP plus units started equals units completed plus ending WIP.

The weighted-average method treats beginning WIP as if all its work happened this period. Equivalent units = units completed and transferred out + equivalent units in ending WIP, and cost per EU = (beginning WIP cost + current cost) ÷ EU. The FIFO method separates last period's work from this period's. FIFO equivalent units = work to finish beginning WIP + units started and completed + work on ending WIP, and cost per EU uses current costs only. The difference between the two EU figures is exactly the work already in beginning WIP. With no beginning WIP, the methods agree. FIFO gives a cleaner measure of current efficiency; weighted-average is simpler.

Once unit costs are known, assign costs. Under weighted-average, transferred-out cost = units completed × total cost per EU, and ending WIP = its equivalent units for each category times that category's unit cost. Under FIFO, units transferred out include beginning WIP (its prior cost plus the cost to finish it) and units started and completed (full current unit cost). The cost reconciliation proves the work: costs to account for (beginning WIP + current costs) must equal costs accounted for (transferred out + ending WIP). In later departments, transferred-in cost is treated like a material added at the start: 100% complete for every unit.

Key ideas

• Process costing accumulates costs by department and averages them over homogeneous units.
• Equivalent units convert partially completed units into whole-unit equivalents.
• Compute equivalent units separately for materials and conversion because they are added at different times.
• Weighted-average EU = units transferred out + EU in ending WIP; it blends prior and current costs.
• FIFO EU count only current-period work; FIFO unit cost uses only current costs.
• WA EU - FIFO EU = equivalent units already completed in beginning WIP.
• Transferred-in costs are 100% complete for all units in the receiving department.

Formulas and rules

Common mistakes

• Applying the conversion percentage to materials that were added at the start.
• Including beginning WIP cost in the FIFO cost per equivalent unit.
• Using the percentage of work remaining instead of work done for ending WIP.
• Counting beginning WIP units as fully done this period under FIFO.
• Forgetting that transferred-in costs are 100% complete in the next department.

Before the test, make sure you can

• Explain when process costing is used instead of job-order costing.
• Reconcile the physical flow of units for a department.
• Calculate equivalent units for materials and conversion under weighted-average.
• Calculate equivalent units under FIFO and explain the difference from weighted-average.
• Compute cost per equivalent unit under each method.
• Assign costs to units transferred out and ending WIP and prepare a cost reconciliation.
• Handle transferred-in costs and materials added at the start or end of a process.

Words to know

Process costing

A system that accumulates costs by department and averages them over large numbers of identical units.

Equivalent units

The number of complete units that the work done on partially completed units represents.

Weighted-average method

Process costing method that combines beginning WIP costs and work with current-period costs and work.

FIFO method

Process costing method that separates beginning WIP from current-period work and costs.

Conversion costs

Direct labor plus overhead, usually added evenly throughout a process.

Transferred-in costs

Costs carried with units from a prior department; treated as 100% complete in the next department.

Units started and completed

Units both begun and finished in the current period: units completed minus beginning WIP units (FIFO).

Physical flow of units

The tracking of actual units: beginning WIP + started = completed + ending WIP.

Cost per equivalent unit

Cost of a cost category divided by its equivalent units.

Cost reconciliation

Proof that costs to account for equal costs assigned to units transferred out and ending WIP.

Production report

A department's report showing physical units, equivalent units, unit costs and cost assignment.

Percentage of completion

How far along units in WIP are for a given cost category.

Homogeneous products

Identical units, such as gallons of paint, suited to process costing.

Sample practice questions

30 more questions like these, from level 1 to 5, are in the practice set.