Process costing is used in situations where homogeneous products or services are produced on a continuous basis. Costs flow through the manufacturing accounts in basically the same way in both job-order and process costing systems. A process costing system differs from a job-order system primarily in that costs are accumulated by department (rather than by job) and the department production report replaces the job cost sheet.

To compute unit costs in a department, the department's output in terms of equivalent units must be determined. In the weighted-average method, the equivalent units for a period are the sum of the units transferred out of the department during the period and the equivalent units in ending work in process inventory at the end of the period.

The activity in a department is summarized on a production report. There are three separate (though highly interrelated) parts to a production report. The first part is a quantity schedule, which includes a computation of equivalent units and shows the flow of units through a department during a period. The second part consists of a computation of costs per equivalent unit, with unit costs being provided individually for materials, labor, and overhead as well as in total for the period. The third part consists of a cost reconciliation, which summarizes all cost flows through a department for a period.

Key Terms to learn in Process Costing

Conversion cost
direct labor cost plus manufacturing overhead cost.

Cost reconciliation
The part of a production report that shows what costs a department has to account for during a period and how those costs are accounted for.

Equivalent units
The product of the number of partially completed units and their percentage of completion with respect to a particular cost. Equivalent units are the number of complete whole units one could obtain from the materials and effort contained in partially completed units.

Equivalent units of production (weighted-average method)
The units transferred to the next department (or to finished goods) during the period plus the equivalent units in the department's ending work in process inventory.

FIFO method
A method of accounting for cost flows in a process costing system in which equivalent units and unit costs relate only to work done during the current period.

Operation costing
A hybrid costing system used when products are manufactured in batches and when the products have some common characteristics and some individual characteristics. This system handles materials the same as in job-order costing and labor and overhead the same as in process costing.

Process costing
A costing method used in situations where essentially homogeneous products are produced on a continuous basis.

Processing department
Any location in an organization where work is performed on a product and where materials, labor, or overhead costs are added to the product.

Production report
A report that summarizes all activity in a department's Work in Process account during a period and that contains three parts: a quantity schedule and a computation of equivalent units, a computation of total and unit costs, and a cost reconciliation.

Quantity schedule
The part of a production report that shows the flow of units through a department during a period and a computation of equivalent units.

Transferred-in cost
The cost attached to products that have been received from a prior processing department.

Weighted-average method
A method of process costing that blends together units and costs from both the current and prior periods.
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Job-order costing and process costing are widely used to track costs. Job-order costing is used in situations where the organization offers many different products or services, such as in furniture manufacturing, hospitals, and legal firms. Process costing is used where units of product are homogeneous, such as in flour milling or cement production.

Materials requisition forms and labor time tickets are used to assign direct materials and direct labor costs to jobs in a job-costing system. Manufacturing overhead costs are assigned to jobs through use of a predetermined overhead rate. The predetermined overhead rate is determined before the period begins by dividing the estimated total manufacturing cost for the period by the estimated total allocation base for the period. The most frequently used allocation bases are direct labor-hours and machine-hours. Overhead is applied to jobs by multiplying the predetermined overhead rate by the actual amount of the allocation base used by the job.

Since the predetermined overhead rate is based on estimates, the actual overhead cost incurred during a period may be more or less than the amount of overhead cost applied to production. Such a difference is referred to as under- or overapplied overhead. The under- or overapplied overhead for a period can be either (1) closed out to Cost of Goods Sold or (2) allocated between Work in Process, Finished Goods, and Cost of Goods Sold. When overhead is underapplied, manufacturing overhead costs have been understated and therefore inventories and/or expenses must be adjusted upwards. When overhead is overapplied, manufacturing overhead costs have been overstated and therefore inventories and/or expenses must be adjusted downwards

Key Terms to learn in Job Order Costing

Absorption costing
A costing method that includes all manufacturing costs - direct materials, direct labor, and both variable and fixed overhead - as part of the cost of a finished unit of product. This term is synonymous with full cost.

Allocation base
A measure of activity such as direct labor-hours or machine-hours that is used to assign costs to cost objects.

Bill of materials
A document that shows the type and quantity of each major item of materials required to make a product.

Cost driver
A factor, such as machine-hours, beds occupied, computer time, or flight-hours, that causes overhead costs.

Full cost
See Absorption costing.

Job cost sheet
A form prepared for each job that records the materials, labor, and overhead costs charged to the job.

Job-order costing system
A costing system used in situations where many different products, jobs, or services are produced each period.

Materials requisition form
A detailed source document that specifies the type and quantity of materials that are to be drawn from the storeroom and identifies the job to which the costs of materials are to be charged.

Multiple predetermined overhead rates
A costing system in which there are multiple overhead cost pools with a different predetermined rate for each cost pool, rather than a single predetermined overhead rate for the entire company. Frequently, each production department is treated as a separate overhead cost pool.

Normal cost system
A costing system in which overhead costs are applied to jobs by multiplying a predetermined overhead rate by the actual amount of the allocation base incurred by the job.

Overapplied overhead
A credit balance in the Manufacturing Overhead account that arises when the amount of overhead cost applied to Work in Process is greater than the amount of overhead cost actually incurred during a period.

Overhead application
The process of charging manufacturing overhead cost to job cost sheets and to the Work in Process account.

Plantwide overhead rate
A single predetermined overhead rate that is used throughout a plant.

Predetermined overhead rate
A rate used to charge overhead cost to jobs in production; the rate is established in advance for each period by use of estimates of total manufacturing overhead cost and of the total allocation base for the period.

Process costing system
A costing system used in those manufacturing situations where a single, homogeneous product (such as cement or flour) is produced for long periods of time.

Time ticket
A detailed source document that is used to record an employee's hour-by-hour activities during a day.

Underapplied overhead
A debit balance in the Manufacturing Overhead account that arises when the amount of overhead cost actually incurred is greater than the amount of overhead cost applied to Work in Process during a period.

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