Application of Process Costing in SGA Plc - Case Study Example

APPLICATION OF PROCESS COSTING IN SGA PLC. The Financing Director Process costing is type of costing method, which is mainly used where there is mass manufacturing of similar products whose associated individual costs cannot be differentiated from one another implying that, the cost of an individual product produced is assumed to be equal to the cost of other similar products produced (Accountingtools.com, n.d). Therefore, in the process costing the costs of manufacturing are accumulated over a specified period before they are summarized and assigned to the units produced during that period consistently. A good example where the process costing is used in the oil refining, chemical processing and food production (Garrison, Noreen & Brewer, 2003). For instance, how can we account for the cost of chemicals produced if we successfully acquire Ultra-processing Ltd? It is true the process costing methodology and not the current system of contract or job costing that our company uses. Therefore, we need to develop and implement the process costing method for our new subsidiary because the process costing differs from the other methods of costing as demonstrated below. On the other hand, job costing is a costing method in which the costs of manufacturing are allocated to individual or batches products, which are sufficiently different from one another. Therefore, because of significant variation in individual products produced, the job costing method used a cost card to record the cost of each product or batch order (Accountingtools.com, n.d). The job cost card will then report the cost for both the direct materials and labour, in addition to, the manufacturing overheads allocated to those products or jobs. A good example where the job costing method is used is in the building and construction industry because each building is a unique job or product. Moreover, the manufacturing of custom cabinetry or custom equipment are other good examples of industries that use the job costing method. Ultimately, it is imperative to note that the job cost card is an important record that serves s subsidiary ledger for recording the cost of WIP, completed goods inventory and the goods sold (Stremel et al., 1980). On the other side, contract costing is a costing method, which is used in tracing the specific costs associated with a given contract (Accountingtools.com, n.d). A good example of the contract costing method is a big construction project won by our current company in which we agree with the prospective contractee that we will reimburse some amount of the total cost of the contract based on some criteria such as at least part of the incurred cost by our company, in order fulfilling the contract terms (Stremel et al., 1980). Finally, we can base the reimbursements on the fixed fee of the contract, cost plus or time and materials method, which is almost like the cost plus method but in this case as a company we build profit into the contractee’s billings. Therefore, as a the new management accountant having outlined the significant differences between our current system and the new system that we want to implement for our subsidiary in case we win the bid, I am going to outline the entire process costing method in this report; out it works and some of the important terminologies that are associated with the method. Process Costing at Work In the process costing, it is important to note that it is the process that is costed and not the individual jobs or contracts as aforementioned. The process costing takes the total costs incurred in the production process and then averages it over the production units produced as shown below: Cost per unit = Cost of inputs/Expected output in units Important terminologies to understand and their accounting process In the production process, the output number of units produced may sometimes not be the number of input units since there can be instances of losses (Hansen, Mowen & Guan, 2007). Normal Loss This refers to the term used describing the normal anticipated wastage in the process of manufacturing under the normal operation conditions. This can result from evaporation, rejection or testing. The normal loss is assumed in accounting for the output units produced from the manufacturing process (Garrison, Noreen & Brewer, 2003). Normal Gain The normal gains refer to the gain expected in the manufacturing process. Therefore, it is difficult to note the normal gain because it is impossible to have more units produced than the number of units that used as inputs in the manufacturing process (Garrison, Noreen & Brewer, 2003). Abnormal Loss This refers to a loss occurring above and over the normal expected loss, which can be due to errors by workers or faulty machinery. When abnormal results during production, the abnormal cost is accounted for by deducting it from the total cost to arrive at the normal cost of production of the units produced after which the cost for each individual unit is determined using the formulae above (Horngren, 2012). It is given as ["Abnormal Loss" = "Normal Output" − "Actual Output"] Abnormal Gains The term refers to a situation when the actual loss of production is lower than the expected loss of production. Abnormal gain often can result from factors such as efficient machinery e.g. newly purchased machine. Because abnormal do not have an impact in the total cost, they are neither added nor deducted from the total cost. However, they help reduce the cost of each unit since the number of units increases from the normal expected units (Williams et al., 2005). Work in progress (WIP) WIP refers to the term used to refer to the units that remain partially unfinished at the end of the period. This can be either opening WIP (for the beginning period) or closing WIP (for the end of the period) (Horngren, 2012). The Equivalent Units Concept Equivalent units refer to the concept of converting the partly completed units, which would be in terms of work in process to an equivalent number of fully/wholly completed units during the end of the accounting period. In a layman’s language equivalent units are partially completed units that are converted/expressed as complete units (Williams et al., 2005). For instance, a manufacturer has 1000 units, which are 40% complete at the end of the accounting period. Therefore, this can be expressed as complete units equivalent to (1000*40%) that is equal to 400 units (Accountingtools.com, n.d). Accounting for Equivalent Units At the end of the period of the firm, the management accountant will have to draw a report for the entire period outlining the number of equivalent units, which were added to the production process as work in progress (WIP) from the previous period and the number of materials introduced during the period, to determine the number of manufactured and completed units during the period, which will ultimately help him/her determine the closing WIP at the end of the period. Therefore, from this report the management accountant can determine the total cost of manufacturing for the entire accounting period, which will ultimately help him/her determine the cost of an individual units produced and completed during the period. Therefore, it is evident that equivalent units are imperative in determining the cost of each individual unit produced in an given accounting period as they are easily converted into wholly/complete units and added to the complete units to determine the cost of an individual unit. Therefore, it is imperative to note that the term equivalent units is process costing terminology that is used to refer to the closing WIP of a manufacturing, which is theorized to reflect complete units a firm would have manufactured for a given amount of direct materials and labour and the production overhead costs for a given accounting period items that are incomplete. Moreover, it’s important also to note that different methods of accounting such the weighted average method or FIFO are used to account for the equivalent units at the end of the accounting period. For instance, when you allocate cost to equivalent units of manufacturing, you typically allocate the cost under the weighted average method using the cost of beginning WIP and the cost of new materials introduced or the oldest cost of beginning WIP for the case of the FIFO method. Thus, to account for equivalent units in process costing, you can only use the WAM, standard costing or FIFO methods but not the LIFO because process costing is based on the assumption that the first unit will be produced. Joint products and By-Products As already mentioned, the chemical processing industry uses the process costing method in accounting for its activities. Therefore, Ultra-Processing Ltd. being a chemical company uses the process costing method in the mass production of its products because of the similarity of products whose associated individual costs cannot be differentiated from one another. Therefore, as SGA plc. We need to incorporate the processing system into our existing job and contract costing method as already mentioned so that we can integrate the subsidiary into SGA plc. Successfully. Joint products refer to multiple products, which are generated simultaneously by a single production process. Therefore, joint products incur similar joint costs until the products reach a split-off point when the products begin to incur separate products. Thus, before the split-point our joint chemicals to be manufactured by Ultra-Processing Ltd will have to be assigned the costs of manufacturing using the new system of the processing costing method. Therefore, in this regard, as a company we will accumulate the costs of direct material and labour, in addition to, overheads to create joint costs, which we will allocate proportionately to the joint products up to the split-off point (Hansen, Mowen & Guan, 2007). On the other hand, by-products refer to secondary products, which have a relatively lower total sales value compared to the main products or the joint products. However, it is imperative noting that the relationship between by-products and the join products can change over time due to market and technological changes. Thus, because of such changes, the by-products can become more & more important that they ultimately become joint products. Therefore, because of this relative change in importance, it becomes necessary to reclassify the by-products and costing procedures to take into account the changes in costs of the individual products (Hansen, Mowen & Guan, 2007). In the process costing, the joint products and the by-products can be accounted for using the weighted average method (WAM) method. However, other methods such as the physical units methods, the sales-value-at split off technique, the net realizable value (NRV) technique, sales to production ratio technique and the constant gross margin % method. For instance, the WAM method uses the weight factors of the products manufactured such as the material, labour (time consumed) difficulty in production, labour differentials and unit size to account for the joint products (Horngren, 1989). It is given as Weighted physical units = Number of units × Weight factor Therefore, given having examined the distinction and the relationship that exist between the joint products and the by-products, in addition, to the different accounting methods, which can be used accounting for these products, it is evident that the adoption of the new process costing system after the acquisition and integration of Ultra-Processing Ltd into SGA plc, will be imperative for the purpose of accounting for the costs of both the joint products and by-products that will be produced by the chemical plant. Ultimately, it is important noting that the process costing method has a couple of advantages over the other methods of costing. Firstly, the method is flexible and allows manufacturers to create production processes that are efficient and effective (Smallbusiness.chron.com, n.d). For instance, the methods allow management accountants to review the amount of labour and materials used for each process of the production process. Moreover, the method is easy to use to use; brings the concept of equivalent to account for all costs of production incurred in the period among many other advantages (Smallbusiness.chron.com, n.d). Bibliography Accountingtools.com, n.d. Process Costing | Process Cost Accounting: Process Costing Overview. Available at http://www.accountingtools.com/questions-and-answers/what-is-contract-costing.html [Accessed 3 Dec. 2014]. Accountingtools.com, n.d. What are equivalent units of production? Available at http://www.accountingtools.com/questions-and-answers/what-is-contract-costing.html [Accessed 3 Dec. 2014]. Accountingtools.com, n.d. What is contract costing? Available at http://www.accountingtools.com/questions-and-answers/what-is-contract-costing.html [Accessed 3 Dec. 2014]. Cánez, L. E., Platts, K. W., & Probert, D. R., 2000. 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Available at http://smallbusiness.chron.com/advantages-disadvantages-process-costing-4098.html [Accessed 3 Dec. 2014]. Stremel, J. P., Jenkins, R. T., Babb, R. A., & Bayless, W. D., 1980. Production costing using the cumulant method of representing the equivalent load curve. Power Apparatus and Systems, IEEE Transactions on, (5), 1947-1956. Williams, J. R., Haka, S. F., Bettner, M. S., & Carcello, J. V., 2005. Financial and managerial accounting. China Machine Press. Zimmerman, J. L., & Yahya-Zadeh, M., 2011. Accounting for decision making and control. Issues in Accounting Education, 26(1), 258-259. References Accountingtools.com, n.d. Process Costing | Process Cost Accounting: Process Costing Overview. Available at http://www.accountingtools.com/questions-and-answers/what-is-contract-costing.html [Accessed 3 Dec. 2014]. Accountingtools.com, n.d. What are equivalent units of production? Available at http://www.accountingtools.com/questions-and-answers/what-is-contract-costing.html [Accessed 3 Dec. 2014]. Accountingtools.com, n.d. What is contract costing? Available at http://www.accountingtools.com/questions-and-answers/what-is-contract-costing.html [Accessed 3 Dec. 2014]. Garrison, R. H., Noreen, E. W., & Brewer, P. C., 2003. Managerial accounting. New York: McGraw-Hill/Irwin. Hansen, D., Mowen, M., & Guan, L., 2007. Cost management: accounting and control. Cengage Learning. Horngren, C. T., 2012. Cost Accounting: A Managerial Emphasis, 13/e. Pearson Education India. Horngren, C. T., Harrison Jr, W. T., & Oliver, M. S., 1989. Accounting (Chapters 15-23). Smallbusiness.chron.com, n.d. What Are the Advantages & Disadvantages of Process Costing? Available at http://smallbusiness.chron.com/advantages-disadvantages-process-costing-4098.html [Accessed 3 Dec. 2014]. Stremel, J. P., Jenkins, R. T., Babb, R. A., & Bayless, W. D., 1980. Production costing using the cumulant method of representing the equivalent load curve. Power Apparatus and Systems, IEEE Transactions on, (5), 1947-1956. Williams, J. R., Haka, S. F., Bettner, M. S., & Carcello, J. V., 2005. Financial and managerial accounting. China Machine Press. Read More