Process costing is a method of cost accounting that allocates direct costs and apportions indirect costs incurred over a specific period of time to the production process. This method is primarily used when an entity produces a large volume of identical or similar products. Industries such as oil refining, food manufacturing, chemical manufacturing, pharmaceuticals, and cement production often use process costing.
In process costing, costs are accumulated for a “process” or department, rather than for individual products. The total costs for each process or department are then divided by the total output from that process or department to calculate a per-unit cost.
For example, in a candy manufacturing company, all candies of the same type go through the same process of production. The costs of ingredients, labor, and overhead for each process or department (e.g., mixing, shaping, packaging) are added up and then divided by the number of candies produced to determine the cost of producing one candy.
Process costing is useful when it is impractical to trace costs to a specific product or job, or when the output is homogeneous. It helps in setting prices for the products, controlling operations, and making strategic decisions.
Example of Process Costing
Let’s take an example of a bread-making company that uses process costing.
Let’s say, in a given month:
- The company purchases $100,000 worth of raw materials (flour, yeast, salt, etc.).
- It incurs $50,000 in direct labor costs.
- It also incurs $30,000 in overhead costs, including factory rent, utilities, and equipment depreciation.
All these costs together make up the total production costs for the month, which is $180,000.
Now, let’s say the company produced 90,000 loaves of bread in the same month.
To find the cost per loaf of bread, the company would divide the total production costs by the total number of loaves produced:
$180,000 ÷ 90,000 loaves = $2 per loaf
So, in this example, it costs the company $2 to make one loaf of bread using the process costing method.
This costing method helps the company in setting the price for each loaf and understanding whether the bread-making process is efficient or if there are areas where costs can be reduced.