By contrast, standard cost accounting typically determines so-called indirect and overhead costs simply as a percentage of certain direct costs, which may or may not reflect actual resource usage for individual items. In the early industrial age most of the costs incurred by a business were what modern accountants call “variable costs” because they varied directly with the amount of production. Money was spent on labour, raw materials, the power to run a factory, etc., in direct proportion to production.
As it is a tool for a more accurate way of allocating fixed costs into a product, these fixed costs do not vary according to each month’s production volume. For example, the elimination of one product would not eliminate the overhead or even direct labour cost assigned to it. Activity-based costing (ABC) better identifies product costing in the long run, but may not be too helpful in day-to-day decision-making. Wood and fastener metals are typically added at the beginning of the process and are easily tracked as direct material.
Marginal costing
In the first stage of production, Coca-Colamixes direct materials—water, refined sugar, and secretingredients—to make the liquid for its beverages. The second stageincludes filling cleaned and sanitized bottles before placing a capon each bottle. It can assist businesses in improving their processes in order to cut costs and offer products at more competitive pricing. It exposes the cost of each step in the production process, assisting businesses in identifying duplicate, obsolete, or inefficient processes. A process costing system is used by any large-scale firm that produces huge quantities of identical commodities. A petroleum refinery is a perfect example of a process costing system environment since it is hard to trace the cost of a specific unit of oil as it passes through the refinery.
Such companies use several different methods of process costing such as weighted average costing, standard costing, or first in, first out (FIFO) costing to determine the cost of one unit of output. We are going to discuss how these methods are used in a process costing system but first let’s have an understanding of what a process costing system is. The next step is to calculate cost per unit for both direct materials and conversion costs for each stage of the process.
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As such, each department adds its own direct materials, direct labor, and factory overhead costs. These three costs accumulate in a departmental account called Work in Process – Department Name, which is like the “tab” of the manufactured item. There will be three debits to Work in Process for each department – one for direct materials, one for direct labor, process costing examples and one for factory overhead. XYZ Inc makes paper products from wood pulp wherein raw materials go through a production cycle that ends with the production of identical reams of paper. Assume in the month of August, the company completes 150,000 reams of paper, spending raw materials total of $50,000, $70,000 in direct labor, and $30,000 for overhead.
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In a process costing system, an item cost is determined by tracking the cost of each stage in the production process, rather than tracking the costs for each individual item. The cost of all the stages in the production process is tracked and added up to get the total cost which is then divided by the number of items to get the cost per unit. A process costing system is used when producing a large number of identical goods where tracing the production costs for each individual unit is impossible. That is, in a process costing system, it is assumed that the price of each individual unit produced is identical to the price of every other individual unit produced in mass production. According to this costing system, the total costs gathered over a certain period of time are added up, and distributed uniformly across the products produced during that time. Examples of companies that use process costing methods would include processed food companies that make millions of identical packages of edibles and oil companies that produce millions of gallons of fuel.
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By doing this, a company can reduce the total expenses incurred in producing the product, which will in turn reduce the cost per unit of output. Another way to reduce the cost per unit of output is to produce in larger quantities. This will allow a company to spread the fixed costs over a larger number of units, which will reduce the cost per unit of output. Process costing follows a simple and easy calculation method; even non-accountant can understand it easily. Although it goes through many assembly lines as it incurs costs such as direct material, direct labor, and overhead, we can just sum up all costs and divide them by the total output of each process line.