COST AND MANAGEMENT ACCOUNTING UNIT V: PROCESS COSTING AND ADVANCED COSTING CONCEPTS FOR MBA 2 SEM

 

UNIT V: PROCESS COSTING AND ADVANCED COSTING CONCEPTS

Learning Objectives

By the end of this unit, students will be able to:

• Understand the concepts of process costing and its applications
• Distinguish between normal loss, abnormal loss, and abnormal effectiveness
• Prepare process accounts, normal loss accounts, abnormal loss accounts, and abnormal gain accounts
• Handle process costing with opening and closing work-in-progress (WIP)
• Calculate equivalent units using FIFO method and allocate costs appropriately
• Apply joint cost allocation methods for joint and by-products
• Understand advanced costing concepts including target costing, life cycle costing, quality costing, and activity-based costing
• Compute standard variation analysis through standard costs
• Apply standard cost concepts for business decision-making

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1. INTRODUCTION TO PROCESS COSTING

1.1 Meaning of Process Costing

Process costing is a method of cost accounting used when products are manufactured through a series of continuous processes or operations. Unlike job costing where costs are accumulated for specific jobs, process costing accumulates costs for each process or department over a specific period.

1.2 Characteristics of Process Costing

• Continuous Production: Products flow through multiple processes
• Homogeneous Products: Similar products are produced in large quantities
• Cost Accumulation: Costs are collected by process or department
• Average Costing: Unit costs are calculated by averaging total costs over total units
• Transfer Pricing: Output of one process becomes input for the next process

1.3 Industries Using Process Costing

• Chemical industries
• Oil refineries
• Food processing
• Textile manufacturing
• Paper and pulp industries
• Pharmaceutical companies

1.4 Difference Between Job Costing and Process Costing

Aspect
Job Costing
Process Costing
Nature of Production
Customized products
Standardized products
Cost Accumulation
By specific jobs
By processes
Unit Cost Calculation
Actual cost per job
Average cost per unit
Work-in-Progress
Varies by job
Continuous flow
Cost Control
Job-specific
Process-specific

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2. CONCEPTS OF LOSSES AND GAINS

2.1 Normal Loss

2.1.1 Definition

Normal loss is the unavoidable loss that occurs during the production process under normal operating conditions. It is expected and inherent in the production process.

2.1.2 Characteristics

• Inevitable: Cannot be avoided under normal conditions
• Expected: Anticipated in the production planning
• Absorbed: Cost is absorbed by good production
• Not Valued: Usually has no scrap value or minimal scrap value

2.1.3 Treatment in Accounts

• Normal loss is not separately valued
• Cost of normal loss is absorbed by good production
• Only scrap value (if any) is credited to the process account

2.2 Abnormal Loss

2.2.1 Definition

Abnormal loss is the loss that occurs due to unexpected or avoidable circumstances beyond normal operating conditions. It represents inefficiency in the production process.

2.2.2 Characteristics

• Avoidable: Could have been prevented
• Unexpected: Not anticipated in normal production
• Controllable: Can be controlled through better management
• Valued: Valued at the same rate as good production

2.2.3 Causes of Abnormal Loss

• Machine breakdowns
• Power failures
• Accidents
• Defective materials
• Poor supervision
• Abnormal weather conditions

2.2.4 Treatment in Accounts

• Valued at the same cost per unit as good production
• Debited to Abnormal Loss Account
• Credited to Process Account
• Scrap value (if any) is credited to Abnormal Loss Account

2.3 Abnormal Effectiveness (Abnormal Gain)

2.3.1 Definition

Abnormal effectiveness or abnormal gain occurs when the actual production exceeds the expected production, resulting in lower than normal loss.

2.3.2 Characteristics

• Favorable: Indicates efficiency in production
• Unexpected: Not anticipated in normal production planning
• Valued: Valued at the same rate as good production
• Credit: Appears as a credit in the profit and loss account

2.3.3 Treatment in Accounts

• Credited to Abnormal Gain Account
• Debited to Process Account
• Normal loss account is debited with the scrap value of units gained

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3. PREPARATION OF PROCESS ACCOUNTS

3.1 Basic Process Account Format

Process Account (Dr. and Cr.)

Debit Side
Amount
Credit Side
Amount
To Materials
xxx
By Normal Loss
xxx
To Labor
xxx
By Abnormal Loss
xxx
To Overheads
xxx
By Transfer to Next Process
xxx
To Abnormal Gain
xxx
By Closing Stock
xxx
Total
xxx
Total
xxx

3.2 Normal Loss Account

Normal Loss Account

Debit Side
Amount
Credit Side
Amount
To Process A/c (Scrap Value)
xxx
By Cash/Bank (Scrap Sales)
xxx
To Abnormal Gain A/c
xxx
By Balance c/d
xxx
Total
xxx
Total
xxx

3.3 Abnormal Loss Account

Abnormal Loss Account

Debit Side
Amount
Credit Side
Amount
To Process A/c
xxx
By Normal Loss A/c (Scrap Value)
xxx
By Profit & Loss A/c
xxx
Total
xxx
Total
xxx

3.4 Abnormal Gain Account

Abnormal Gain Account

Debit Side
Amount
Credit Side
Amount
To Normal Loss A/c (Scrap Value)
xxx
By Process A/c
xxx
To Profit & Loss A/c
xxx
Total
xxx
Total
xxx

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4. PROCESS COSTING WITH OPENING AND CLOSING WIP

4.1 Work-in-Progress (WIP) Concepts

4.1.1 Opening WIP

• Incomplete units from the previous period
• Partially processed units carried forward
• Requires completion in the current period

4.1.2 Closing WIP

• Incomplete units at the end of current period
• Partially processed units to be carried forward
• Will be completed in the next period

4.2 Equivalent Units Concept

4.2.1 Definition

Equivalent units represent the number of complete units that could have been produced with the same amount of materials, labor, and overhead used in partially completed units.

4.2.2 Formula

Equivalent Units = Number of Incomplete Units × Percentage of Completion

4.2.3 Purpose

• To allocate costs between completed and incomplete units
• To calculate accurate unit costs
• To value closing work-in-progress

4.3 FIFO Method for Equivalent Units

4.3.1 Principles of FIFO Method

• First units completed are from opening WIP
• Current period costs are allocated to current period production
• Opening WIP costs are kept separate from current period costs

4.3.2 Steps in FIFO Method

1. Complete Opening WIP: Add costs to complete opening WIP
2. Start and Complete Units: Units started and completed in current period
3. Closing WIP: Partially complete units at period end
4. Calculate Equivalent Units: For materials, labor, and overheads separately
5. Allocate Costs: Based on equivalent units calculation

4.3.3 Equivalent Units Calculation (FIFO)

For Materials:

• Opening WIP completion: Opening WIP Units × (100% - Previous Completion %)
• Started and Completed: Units Started and Completed × 100%
• Closing WIP: Closing WIP Units × Current Completion %

For Labor and Overheads:

• Similar calculation but with respective completion percentages

4.4 Cost Allocation Process

4.4.1 Unit Cost Calculation

Unit Cost = Total Current Period Costs ÷ Equivalent Units

4.4.2 Cost Allocation

1. Opening WIP Completion Cost = Equivalent Units for Opening WIP × Unit Cost
2. Started and Completed Cost = Units Started and Completed × Unit Cost
3. Closing WIP Cost = Equivalent Units for Closing WIP × Unit Cost

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5. JOINT AND BY-PRODUCTS

5.1 Joint Products

5.1.1 Definition

Joint products are two or more products that are produced simultaneously from a common process or raw material, where each product has significant commercial value.

5.1.2 Characteristics

• Produced simultaneously
• Cannot be produced separately
• Each product has substantial value
• Require joint cost allocation

5.1.3 Split-off Point

The point in the production process where joint products become separately identifiable.

5.2 By-Products

5.2.1 Definition

By-products are secondary products that arise incidentally during the production of main products and have relatively minor commercial value.

5.2.2 Characteristics

• Incidental to main production
• Lower commercial value
• Secondary importance
• May require further processing

5.3 Joint Cost Allocation Methods

5.3.1 Physical Units Method

Formula: Allocation Ratio = Physical Units of Each Product ÷ Total Physical Units

Steps:

1. Identify physical units of each joint product
2. Calculate total physical units
3. Determine allocation ratio for each product
4. Allocate joint costs based on ratios

Example: If Product A = 1,000 units, Product B = 2,000 units Total Units = 3,000 units Allocation for A = (1,000 ÷ 3,000) × Joint Costs = 33.33% Allocation for B = (2,000 ÷ 3,000) × Joint Costs = 66.67%

5.3.2 Relative Market Value Methods

5.3.2.1 Sales Value at Split-off Method

Formula: Allocation Ratio = Sales Value of Each Product at Split-off ÷ Total Sales Value at Split-off

Steps:

1. Determine sales value of each product at split-off point
2. Calculate total sales value of all products
3. Determine allocation ratio for each product
4. Allocate joint costs based on sales value ratios

Example: Product A Sales Value = $10,000 Product B Sales Value = $15,000 Total Sales Value = $25,000 Allocation for A = ($10,000 ÷ $25,000) × Joint Costs = 40% Allocation for B = ($15,000 ÷ $25,000) × Joint Costs = 60%

5.3.2.2 Net Realizable Value Method

Formula: Net Realizable Value = Final Sales Value - Further Processing Costs after Split-off

Steps:

1. Calculate final sales value of each product
2. Deduct further processing costs from sales value
3. Determine Net Realizable Value (NRV) for each product
4. Calculate allocation ratios based on NRV
5. Allocate joint costs based on NRV ratios

Example: Product A: Sales Value $12,000 - Processing Costs $2,000 = NRV $10,000 Product B: Sales Value $20,000 - Processing Costs $3,000 = NRV $17,000 Total NRV = $27,000 Allocation for A = ($10,000 ÷ $27,000) × Joint Costs = 37.04% Allocation for B = ($17,000 ÷ $27,000) × Joint Costs = 62.96%

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6. ADVANCED COSTING CONCEPTS

6.1 Target Costing

6.1.1 Definition

Target costing is a strategic cost management technique where the selling price is determined by market conditions, and the target cost is calculated by subtracting the desired profit margin from the target selling price.

6.1.2 Formula

Target Cost = Target Selling Price - Target Profit Margin

6.1.3 Process

1. Market Research: Determine market-acceptable selling price
2. Profit Target: Set desired profit margin
3. Target Cost: Calculate allowable cost
4. Cost Analysis: Compare target cost with estimated cost
5. Cost Reduction: Implement cost reduction strategies if needed

6.1.4 Benefits

• Market-oriented pricing
• Cost control focus
• Competitive advantage
• Customer satisfaction

6.2 Life Cycle Costing

6.2.1 Definition

Life cycle costing is a technique that considers all costs associated with a product throughout its entire life cycle, from research and development to disposal.

6.2.2 Life Cycle Phases

1. Research and Development
2. Design and Engineering
3. Manufacturing
4. Marketing and Distribution
5. Customer Support
6. Disposal/Recycling

6.2.3 Applications

• Product profitability analysis
• Investment decisions
• Resource allocation
• Environmental impact assessment

6.3 Quality Costing

6.3.1 Definition

Quality costing involves measuring and analyzing the costs associated with achieving and maintaining product quality.

6.3.2 Categories of Quality Costs

6.3.2.1 Prevention Costs

• Quality planning
• Training programs
• Process improvement
• Quality audits

6.3.2.2 Appraisal Costs

• Inspection and testing
• Quality control equipment
• Laboratory testing
• Field testing

6.3.2.3 Internal Failure Costs

• Rework and repair
• Scrap and waste
• Downtime costs
• Reinspection

6.3.2.4 External Failure Costs

• Warranty claims
• Customer complaints
• Product recalls
• Lost sales

6.3.3 Quality Cost Analysis

Total Quality Cost = Prevention Costs + Appraisal Costs + Internal Failure Costs + External Failure Costs

6.4 Activity-Based Costing (ABC)

6.4.1 Definition

Activity-based costing is a costing method that assigns overhead costs to products based on the activities and resources consumed by each product.

6.4.2 Key Concepts

• Activities: Tasks or processes that consume resources
• Cost Drivers: Factors that cause activities to consume resources
• Cost Pools: Groups of overhead costs related to specific activities
• Activity Rates: Cost per unit of cost driver

6.4.3 ABC Implementation Steps

1. Identify Activities: List all activities in the organization
2. Classify Activities: Group similar activities into cost pools
3. Identify Cost Drivers: Determine what causes each activity
4. Calculate Activity Rates: Cost Pool ÷ Total Cost Driver Units
5. Assign Costs: Activity Rate × Cost Driver Units per Product

6.4.4 Benefits of ABC

• More accurate product costing
• Better overhead allocation
• Improved decision making
• Activity-based management

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7. STANDARD VARIATION ANALYSIS THROUGH STANDARD COSTS

7.1 Integration with Process Costing

7.1.1 Standard Process Costing

• Combining standard costing principles with process costing
• Setting standards for each process
• Comparing actual process costs with standard costs
• Analyzing variances at process level

7.1.2 Process-Specific Standards

• Material Standards: Standard material cost per process
• Labor Standards: Standard labor hours and rates per process
• Overhead Standards: Standard overhead rates per process
• Output Standards: Expected output quantities per process

7.2 Variance Analysis in Process Costing

7.2.1 Material Variances in Processes

• Material Price Variance: (Actual Price - Standard Price) × Actual Quantity
• Material Usage Variance: (Actual Usage - Standard Usage) × Standard Price
• Material Mix Variance: Standard Price × (Actual Mix - Standard Mix)
• Material Yield Variance: Standard Cost per Unit × (Actual Yield - Standard Yield)

7.2.2 Labor Variances in Processes

• Labor Rate Variance: (Actual Rate - Standard Rate) × Actual Hours
• Labor Efficiency Variance: (Actual Hours - Standard Hours) × Standard Rate
• Labor Mix Variance: Standard Rate × (Actual Mix - Standard Mix)

7.2.3 Overhead Variances in Processes

• Variable Overhead Variance: Actual Variable Overhead - Standard Variable Overhead
• Fixed Overhead Variance: Actual Fixed Overhead - Standard Fixed Overhead
• Overhead Efficiency Variance: Standard Rate × (Actual Hours - Standard Hours)

7.3 Process Loss Variances

7.3.1 Normal Loss Variance

Normal Loss Variance = (Actual Normal Loss - Standard Normal Loss) × Standard Cost per Unit

7.3.2 Abnormal Loss Variance

• When actual abnormal loss differs from expected
• Indicates process control issues
• Requires investigation and corrective action

7.4 Standard Cost Applications in Process Industries

7.4.1 Performance Measurement

• Process efficiency evaluation
• Cost control assessment
• Quality performance monitoring
• Resource utilization analysis

7.4.2 Decision Making Support

• Process optimization decisions
• Resource allocation choices
• Capacity planning
• Investment justification

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8. PRACTICAL APPLICATIONS AND CASE STUDIES

8.1 Manufacturing Example

Consider a chemical company with three processes:

• Process A: Raw material processing
• Process B: Mixing and heating
• Process C: Finishing and packaging

Each process has specific cost structures, normal loss percentages, and transfer mechanisms.

8.2 Service Industry Application

Process costing can be adapted for service industries:

• Banking: Transaction processing stages
• Healthcare: Patient care processes
• Education: Course delivery processes

8.3 Integration Benefits

• Comprehensive cost management
• Improved decision making
• Enhanced performance measurement
• Better resource allocation

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9. CONCLUSION

Process costing, combined with advanced costing concepts and standard cost analysis, provides a comprehensive framework for cost management in process industries. Understanding the treatment of normal and abnormal losses, proper accounting procedures, and the application of equivalent units ensures accurate cost allocation and effective management control.

The integration of these concepts with modern costing approaches like ABC, target costing, and life cycle costing enables organizations to remain competitive while maintaining cost effectiveness and quality standards.

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KEY TERMS

• Process Costing: Cost accounting method for continuous production processes
• Normal Loss: Expected and unavoidable loss in production
• Abnormal Loss: Unexpected and avoidable loss due to inefficiencies
• Abnormal Gain: Efficiency gain resulting in lower than expected loss
• Equivalent Units: Complete units equivalent to partially completed units
• FIFO Method: First-in-first-out method for equivalent units calculation
• Joint Products: Multiple products produced simultaneously from common input
• By-Products: Secondary products with minor commercial value
• Target Costing: Cost management technique starting with target selling price
• Life Cycle Costing: Costing approach considering entire product life cycle
• Quality Costing: Measurement and analysis of quality-related costs
• Activity-Based Costing: Overhead allocation based on activities and cost drivers

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PRACTICE QUESTIONS

1. Explain the concept of process costing and its applications in different industries.
2. Distinguish between normal loss, abnormal loss, and abnormal gain with examples.
3. Prepare process accounts with normal and abnormal losses.
4. Calculate equivalent units using FIFO method for a process with opening and closing WIP.
5. Allocate joint costs using physical units method and relative market value methods.
6. Compare different joint cost allocation methods and their applications.
7. Explain the concept and implementation of target costing.
8. Analyze quality costs and their impact on business profitability.
9. Design an activity-based costing system for a manufacturing company.
10. Apply standard cost variance analysis in a process costing environment.
11. Integrate advanced costing concepts for strategic decision making.
12. Evaluate the effectiveness of different costing methods in various business scenarios.