Explanation of Process Costing
Product costing is used to calculate gross profits and to calculate ending inventory values. It is also used for making pricing decisions. Understanding your product cost is essential to understanding if you are making a profit. There are two primary methods used for product costing -- job order costing and process costing.
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Why Use Process Costing
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Process costing is generally used for the continuous production of identical products. As the name implies, it is used when there is an ongoing process of multiple items coming down the line. Materials and labor are added continuously to the production process.
Why Not Use Process Costing
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For all of its benefits, process costing is not always the best choice. Process costing is not the preferred costing method for customized products or services or for items produced in a single batch. These items are not produced continuously and are not identical in nature. Job order costing is a better fit for these types of items.
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Bill of Material
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There is a bill of material associated with each product being produced. This is sometimes called a process cost worksheet. It details out the materials and labor requirements for each item to be produced. While the products are not produced individually, the material and labor requirements for one unit are calculated based on the typical production quantity.
Standard Costing
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Standard costing is often used in conjunction with process costing. Standard costs are determined on an annual basis and use the material and labor requirements from the bill of material along with the standard cost per unit of material or hour of labor to determine a standard unit cost. A standard overhead cost is also calculated annually and included in the product cost.
Variances
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On a regular basis, the standard cost is compared with the actual costs. The difference between the standard cost and the actual cost is called the variance. There are material variances, labor variances and overhead variances. High variances need to be investigated to determine if the product cost is reasonable or if there are production problems.
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References
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