Process costing is appropriate where there are many units of a single product, each are indistinguishable from other units, and the identical nature of each unit of product makes it reasonable and efficient to assign the same average cost per unit. Processing departments have products that pass on to the next department or are sold. Often single products are produced on a continuing basis for a long period of time.
Process costing systems pool costs by department, compute unit costs based on these pools and allocate unit costs based on department production reports. Costs of goods sold, finished goods, and work in process (WIP) accounts are kept for each department.
Equivalent units of production are used to account for the costs of unfinished goods in work in progress at the end of the period. This is necessary because a department usually has some partially completed units in its beginning and ending inventory.
Equivalent Units = # of Partially Completed Units * the Percentage of Completion
Equivalent units are relative to each factor of production. That is, a different number of equivalent units may be considered complete relative to direct material, direct labor and factory overhead. For example, 80% of direct material, 60% of direct labor, and 100% of factory overhead may have been used so far.
Costing for equivalent units can be done using different inventory costing methods. The weighted-average costing method is usually chosen because it easily provides relatively accurate costs. However, FIFO may be better to use if costs go up significantly between the two periods.
Weighted cost per equivalent unit = [cost of beginning WIP inventory + cost added during period] / equivalent units of production
Equivalent Units of Production = Equivalent units to complete beginning inventory* + Units started and completed during the period + Equivalent units in ending work in process inventory
Equivalent Units of Production = Units transferred out + Equivalent units in ending work in process inventory − Equivalent units in beginning inventory.
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*Equivalent units to complete beginning inventory = Units in beginning inventory × (100% − Percentage completion of beginning inventory)