Thomson Learning. Process Cost Systems. After studying this chapter, you should be able to:

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1 o b j e c t i v e s After studying this chapter, you should be able to: Process Cost Systems Distinguish between job order costing and process costing systems. Explain and illustrate the physical flows and cost flows for a process manufacturer. Calculate and interpret the accounting for completed and partially completed units under the fifo method. Prepare a cost of production report. Prepare journal entries for transactions of a process manufacturer. Use cost of production reports for decision making. Contrast just-in-time processing with conventional manufacturing practices. M2

2 Setting the Stage Comparing Job Order Costing and Process Costing objective 1 Distinguish between job order costing and process costing systems. Industry Automobile Beverages Chemicals Food Forest and paper products Metals Petroleum refining Pharmaceuticals Soap and cosmetics As we discussed in the previous chapter, the job order cost system is best suited to industries that make special orders for customers or manufacture different products in groups. Industries that may use job order cost systems include special-order printing, custom-made tailoring, furniture manufacturing, shipbuilding, aircraft building, and construction. Process manufacturing is different from job-order manufacturing. Process manufacturers typically use large machines to process a flow of raw materials into a finished state. For example, a petrochemical business processes crude oil through numerous refining steps to produce higher grades of oil until gasoline is produced. The cost accounting system used by process manufacturers is called the process cost system. In some ways, the process cost and job order cost systems are similar. Both systems accumulate product costs direct materials, direct labor, and factory overhead and allocate these costs to the units produced. Both systems maintain perpetual inventory accounts with subsidiary ledgers for materials, work in process, and finished goods. Both systems also provide product cost data to management for planning, directing, improving, Example Company controlling, and decision making. The main difference between General Motors the two systems is the form in which the product costs are accumulated and reported. Coca-Cola Dow Chemical Exhibit 1 illustrates the main differences between the job Campbell Soup order and process cost systems. In a job order cost system, product costs are accumulated by job and are summarized on job Georgia Pacific Alcoa cost sheets. The job cost sheets provide unit cost information ExxonMobil and can be used by management for product pricing, cost control, and inventory valuation. The process manufacturer does not Merck Procter & Gamble manufacture according to jobs. Thus, costs are accumulated Industries and examples of companies that may use process cost systems are: I f you bake cookies, the ingredients would include flour, sugar, and shortening. These ingredients would all be added at the beginning of the baking process by mixing them in a bowl. After mixing, do you have cookies? No. Why? Because they aren t baked (converted). But are they 100% complete with respect to materials? Yes, all the materials have been added to the baking process. When will they be cookies? When they are 100% complete with respect to materials and baking. Now, assume that you ask the question, How much cost have I incurred in baking cookies after 15 minutes (out of 30 minutes) of baking time? The answer would require that you separate the ingredients and the electricity costs. These two costs are incurred in the baking process at different rates, and so it is convenient to identify them separately. The ingredient costs have all been incurred, since they were all introduced at the beginning of the process. The electricity costs, however, are a different story. Since the baking is only 50% complete, only 50% of the electricity costs (for the oven) have been incurred in the baking process. Therefore, the answer to the question is that all the materials costs and half the electricity costs have been incurred in the baking process after 15 minutes of baking. In this chapter, we apply these concepts to manufacturers that use a process cost system. After introducing process costing, we discuss decision making with process cost system reports. We conclude the chapter with a brief discussion of just-in-time cost systems.

3 Chapter M2 Process Cost Systems M53 Exhibit 1 Job Order and Process Cost Systems Compared JOB ORDER COST SYSTEM Process manufacturers accumulate costs by department. PROCESS COST SYSTEM by department. Each unit of product that passes through the department is similar. Thus, the production costs reported by each department provide unit cost information that can be used by management for cost control. In a job order cost system, the work in process inventory at the end of the accounting period is the sum of the job cost sheets for partially completed jobs. In a process cost system, the amount of work in process inventory is determined by allocating costs between completed and partially completed units within a department. Physical Flows and Cost Flows for a Process Manufacturer objective 2 Explain and illustrate the physical flows and cost flows for a process manufacturer. Materials costs are a large portion of the costs for most process manufacturers. Often, the materials costs can be as high as 70% of the total manufacturing costs. Thus, accounting for materials costs is very important for process operations. Exhibit 2 illustrates the physical flow of materials for a steel processor. Direct materials in the form of scrap metal are placed into a furnace in the Melting Department. The Melting Department uses conversion costs (direct labor and factory overhead) during the melting process. The molten metal is then transferred to the

4 M54 Chapter M2 Process Cost Systems Exhibit 2 Physical Flows for a Process Manufacturer PHYSICAL FLOWS FOR A PROCESS MANUFACTURER Exhibit 3 Cost Flows for a Process Manufacturer (a) Purchases Materials (b) Direct materials (d) Indirect materials Casting Department, where it is poured into an ingot casting. The Casting Department also uses conversion costs during the casting process. The ingot castings are transferred to the finished goods inventory for shipment to customers. The cost flows in a process cost system reflect the physical materials flows and are illustrated in Exhibit 3. Purchased materials are debited to Materials (a) and credited to Accounts Payable (not shown). Direct materials (scrap metal) used by the Melting Department are debited to Work in Process Melting and credited to Materials (b). In addition, indirect materials and other overhead incurred are debited to department factory overhead accounts and credited to Materials (d) and other accounts. Direct labor in the Melting Department is debited to the department s work in process account (c) and credited to Wages Payable (not shown). Applied factory overhead is debited to Work in Process Melting, using a predetermined overhead rate (e). The cost of completed production from the Melting Department is transferred to the Casting Department by debiting Work in Process Casting and crediting Work in Process Melting (f). The transferred costs include the direct materials and conversion costs for completed production of the Melting Department. The direct labor and applied factory overhead costs in the Casting Department are debited to Work in Process Casting (g and h). The cost of the finished ingots is transferred out of the Casting Department by debiting Finished Goods and crediting Work in Process Casting (i). The cost of ingots sold to customers is transferred out of finished goods with a debit to Cost of Goods Sold and a credit to Finished Goods (j). Work in Process Melting (c) Direct labor (b) Direct materials (e) Factory overhead applied (f) Costs transferred out Work in Process Casting (g) Direct labor (f) Costs transferred in Finished Goods (h) Factory overhead applied (i) Costs transferred out (i) Costs transferred in (j) Cost of goods sold Factory Overhead Melting (d) Factory overhead incurred (e) Factory overhead applied Factory Overhead Casting (d) Factory overhead incurred (h) Factory overhead applied (j) Cost of Goods Sold Cost of goods sold

5 Chapter M2 Process Cost Systems M55 BUSINESS ON STAGE What Is a Product? In manufacturing, inputs are processed into a product with physical attributes. In business, however, a product is often thought of in terms other than just its physical attributes. For example, why a customer buys a product usually impacts how a business markets the product. Other considerations, such as warranty needs, servicing needs, and perceived quality, also affect business strategies. Four types of products are (1) convenience products, (2) shopping products, (3) specialty products, and (4) unsought products. To illustrate, consider the following four products: 1. Convenience product: Snickers candy bar 2. Shopping product: Sony television 3. Specialty product: Diamond ring 4. Unsought product: Prearranged funeral The First-In, First-Out (Fifo) Method objective 3 Calculate and interpret the accounting for completed and partially completed units under the fifo method. For each of these products, the frequency of purchase, the profit per unit, and the number of retailers differ. As a result, the sales and marketing approach for each product differs as shown below. Frequency Profit Number of per of Sales/Marketing Product Purchase Unit Retailers Approach Snickers often low many mass advertising Sony TV occasional moderate many mass advertising; personal selling Diamond ring seldom high few personal selling Prearranged rare high few aggressive personal funeral selling In a process cost system, the accountant determines the cost transferred out and thus the amount remaining in inventory for each department. For many manufacturing processes, materials are added at the beginning of production, and the units are moved through the production processes in a first-in, first-out (fifo) flow. That is, the first units entering the production process are the first to be completed. 1 Most process manufacturers have more than one department. In the illustrations that follow, McDermott Steel Inc. has two departments, Melting and Casting. Mc- Dermott melts scrap metal and then pours the molten metal into an ingot casting. To illustrate the first-in, first-out method, we will simplify by using only the Melting Department of McDermott Steel Inc. The following data for the Melting Department are for July of the current year: Inventory in process, July 1, 500 tons: Direct materials cost, for 500 tons $24,550 Conversion costs, for 500 tons, 70% completed 3,600 Total inventory in process, July 1 $28,150 Direct materials cost for July, 1,000 tons 50,000 Conversion costs for July 9,690 Goods transferred to Casting in July (includes units in process on July 1), 1,100 tons? Inventory in process, July 31, 400 tons, 25% completed as to conversion costs? We assume that all materials used in the department are added at the beginning of the process, and conversion costs (direct labor and factory overhead) are incurred 1 An alternative method the average cost method is discussed in advanced textbooks.

6 M56 Chapter M2 Process Cost Systems Exhibit 4 July Units to Be Costed Melting Department evenly throughout the melting process. The objective is to determine the cost of goods completed and the ending inventory valuation, which are represented by the question marks. We determine these amounts by using the following four steps: 1. Determine the units to be assigned costs. 2. Calculate equivalent units of production. 3. Determine the cost per equivalent unit. 4. Allocate costs to transferred and partially completed units. Step 1: Determine the Units to Be Assigned Costs The first step in our illustration is to determine the units to be assigned costs. A unit can be any measure of completed production, such as tons, gallons, pounds, barrels, or cases. We use tons as the definition for units in McDermott Steel. McDermott Steel had 1,500 tons of direct materials charged to production in the Melting Department for July, as shown below. Total tons charged to production: In process, July 1,500 tons Received from materials storeroom 1,000 Total units accounted for by the Melting Department 1,500 tons There are three categories of units to be assigned costs for an accounting period: (A) units in beginning in-process inventory, (B) units started and completed during the period, and (C) units in ending in-process inventory. Exhibit 4 illustrates these categories in the Melting Department for July. The 500-ton beginning inventory (A) was completed and transferred to the Casting Department. McDermott Steel started another 1,000 tons of material into the process during July. Of the 1,000 tons introduced in July, 400 tons were left incomplete at the end of the month (C). Thus, only 600 of the 1,000 tons were actually started and completed in July (B). The total units (tons) to be assigned costs for McDermott Steel can be summarized as shown below. (A) Inventory in process, July 1, completed in July,500 tons (B) Started and completed in July,600 Transferred out to the Casting Department in July 1,100 (C) Inventory in process, July 31,400 Total tons to be assigned costs 1,500 tons

7 Chapter M2 Process Cost Systems M57 Department 2 received 2,400 tons from Department 1. During the period, Department 2 completed 2,600 tons and had 600 tons of work in process at the beginning of the period. The ending work in process inventory was 400 tons. How many tons were started and completed during the period? 2,000 tons (2, , or 2, ) Department 3 had 400 tons in beginning work in process inventory (30% complete). During the period, 5,800 tons were completed. The ending work in process inventory was 600 tons (60% complete). What are the equivalent units for direct materials if materials are added at the beginning of the process? 6,000 tons (5, ) Note that the total tons to be assigned costs equals the total tons accounted for by the department. The three unit categories (A, B, and C) are used in the remaining steps to determine the cost transferred to the Casting Department and the cost remaining in work in process inventory at the end of the period. Step 2: Calculate Equivalent Units of Production Process manufacturers often have some partially processed materials remaining in production at the end of a period. In these cases, the costs of production must be allocated between the units that have been completed and transferred to the next process (or finished goods) and those that are only partially completed and remain within the department. This allocation can be determined by using the equivalent units of production. The equivalent units of production are the number of units that could have been completed within a given accounting period. In contrast, whole units are the number of units in production during a period, whether or not completed. For example, assume that 800 whole units are in work in process at the end of a period. If the units are 60% complete, the number of equivalent units in process is 480 (800 60%). Equivalent units for materials and conversion costs are usually determined separately because they are often introduced at different times or at different rates in the production process. In contrast, direct labor and factory overhead are combined together as conversion costs because they are often incurred in production at the same time and rate. The equivalent units of production are the number of units that could have been completed during a period. Materials Equivalent Units To allocate materials costs between the completed and partially completed units, it is necessary to determine how materials are added during the manufacturing process. In the case of McDermott Steel, the materials are added at the beginning of the melting process. In other words, the melting process cannot begin without the scrap metal. The equivalent unit computation for materials in July is as follows: Equivalent Total Percent Materials Units for Whole Added in Direct Units July Materials Inventory in process, July % 0 Started and completed in July (1, ) % 600 Transferred out to Casting Dept. in July 1, Inventory in process, July % 400 Total tons to be assigned cost 1,500 1,000 The whole units from Step 1 are multiplied by the percentage of materials that are added in July for the in-process inventories and units started and completed. The equivalent units for direct materials are illustrated in Exhibit 5. The direct materials for the 500 tons of July 1 in-process inventory were introduced in June. Thus, no materials units were added in July for the inventory in process on July 1. All of the 600 tons started and completed in July were 100% complete with respect to materials. Thus, 600 equivalent units of materials were added in July. All the materials for the July 31 in-process inventory were introduced at the beginning of the process. Thus, 400 equivalent units of material for the July 31 inprocess inventory were added in July.

8 M58 Exhibit 5 Direct Materials Equivalent Units DIRECT MATERIALS EQUIVALENT UNITS Chapter M2 Process Cost Systems Department 3 had 400 tons in beginning work in process inventory (30% complete). During the period, 5,800 tons were completed. The ending work in process inventory was 600 tons (60% complete). What are the equivalent units for conversion costs? 6,040 tons [(70% 400) (5, ) (60% 600)] Conversion Equivalent Units The conversion costs are usually incurred evenly throughout a process. For example, direct labor, utilities, and machine depreciation are usually used uniformly during processing. Thus, the conversion equivalent units are added in July in direct relation to the percentage of processing completed in July. The computations for July are as follows: Percent Total Conversion Equivalent Whole Completed Units for Units in July Conversion Inventory in process, July % 150 Started and completed in July (1, ) % 600 Transferred out to Casting Dept. in July 1, Inventory in process, July % 100 Total tons to be assigned cost 1, The whole units from Step 1 are multiplied by the percentage of conversion completed in July for the in-process inventories and units started and completed. The equivalent units for conversion are illustrated in Exhibit 6. The conversion equivalent units of the July 1 in-process inventory are 30% of the 500 tons, or 150 equivalent units. Since 70% of the conversion had been completed on July 1, only 30% of the conversion effort for these tons was incurred in July. All the units started and completed used converting effort in July. Thus, conversion equivalent units are 100% of these tons. The equivalent units for the July 31 in-process inventory are 25% of the 400 tons because only 25% of the converting has been completed with respect to these tons in July.

9 Chapter M2 Process Cost Systems Exhibit 6 Conversion Equivalent Units CONVERSION EQUIVALENT UNITS M59 Step 3: Determine the Cost per Equivalent Unit In Step 3, we calculate the cost per equivalent unit. The July equivalent unit totals for McDermott Steel s Melting Department are reproduced from Step 2 as follows: Direct Materials Equivalent Units Conversion Inventory in process, July Started and completed in July (1, ) Transferred out to Casting Dept. in July Inventory in process, July Total tons to be assigned cost 1, The cost per equivalent unit is determined by dividing the direct materials and conversion costs incurred in July by the respective total equivalent units for direct materials and conversion costs. The direct materials and conversion costs were given at the beginning of this illustration. These calculations are as follows: Equivalent unit cost for direct materials: $50,000 direct materials cost $50.00 per equivalent 1,000 direct materials equivalent units unit of direct materials Equivalent unit cost for conversion: $9,690 conversion cost 850 conversion equivalent units $11.40 per equivalent unit of conversion We will use these rates in Step 4 to allocate the direct materials and conversion costs to the completed and partially completed units.

10 M60 Chapter M2 Process Cost Systems What costs are included in the $28,150 beginning work in process inventory for McDermott Steel? 70% of the conversion cost and all of the materials costs for 500 tons. Step 4: Allocate Costs to Transferred and Partially Completed Units In Step 4, we multiply the equivalent unit rates by their respective equivalent units of production in order to determine the cost of transferred and partially completed units. The cost of the July 1 in-process inventory, completed and transferred out to the Casting Department, is determined as follows: Direct Materials Conversion Total Costs Costs Costs Inventory in process, July 1 balance $28,150 Equivalent units for completing the July 1 in-process inventory Equivalent unit cost $50.00 $11.40 Cost of completed July 1 in-process inventory 0 $1,710 1,710 Cost of July 1 in-process inventory transferred to Casting Department $29,860 The July 1 in-process inventory cost of $28,150 is carried over from June and will be transferred to Casting. The cost required to finish the July 1 in-process inventory is $1,710, which consists of conversion costs required to complete the remaining 30% of the processing. This total does not include direct materials costs, since these costs were added at the beginning of the process in June. The conversion costs required to complete the beginning inventory are added to the balance carried over from the previous month to yield a total cost of the completed July 1 in-process inventory of $29,860. The 600 units started and completed in July receive 100% of their direct materials and conversion costs in July. The costs associated with the units started and completed are determined by multiplying the equivalent units in Step 2 by the unit costs in Step 3, as follows: Direct Materials Conversion Total Costs Costs Costs Units started and completed in July Equivalent unit cost $50.00 $11.40 Cost to complete the units started and completed in July $ 30,000 $ 6,840 $36,840 The total cost transferred to the Casting Department is the sum of the beginning inventory cost from the previous period ($28,150), the additional costs incurred in July to complete the beginning inventory ($1,710), and the costs incurred for the units started and completed in July ($36,840). Thus, the total cost transferred to Casting is $66,700. The units of ending inventory have not been transferred, so they must be valued at July 31. The costs associated with the partially completed units in the ending inventory are determined by multiplying the equivalent units in Step 2 by the unit costs in Step 3, as follows: Direct Materials Conversion Total Costs Costs Costs Equivalent units in ending inventory Equivalent unit cost $50.00 $11.40 Cost of ending inventory $ 20,000 $ 1,140 $21,140 The units in the ending inventory have received 100% of their materials in July. Thus, the materials cost incurred in July for the ending inventory is $20,000, or 400 equivalent units of materials multiplied by $50. The conversion cost incurred in July for the ending inventory is $1,140, which is 100 equivalent units of conversion (400 units, 25% complete) for the ending inventory multiplied by $ Summing the conversion and materials costs, the total ending inventory cost is $21,140.

11 Chapter M2 Process Cost Systems Bringing It All Together: The Cost of Production Report M61 objective 4 Prepare a cost of production report. A cost of production report is normally prepared for each processing department at periodic intervals. The July cost of production report for McDermott Steel s Melting Department is shown in Exhibit 7. As can be seen on the report, the two question marks from page M55 can now be determined. The cost of goods transferred to the Casting Department in July was $66,700, while the cost of the ending work in process in the Melting Department on July 31 is $21,140. Exhibit 7 Cost of Production Report for McDermott Steel s Melting Department FIFO McDermott Steel Inc. Cost of Production Report Melting Department For the Month Ended July 31, 2003 Equivalent Units Whole Units (Step 2) UNITS (Step 1) Direct Materials Conversion Units charged to production: Inventory in process, July Received from materials storeroom ,000 Total units accounted for by the Melting Dept.... 1,500 Units to be assigned cost: Inventory in process, July 1 (70% completed) , 0,150 Started and completed in July ,600,600 Transferred to Casting Department in July ,100,600,750 Inventory in process, July 31 (25% complete) ,400,100 Total units to be assigned cost ,500 1,000,850 COSTS Direct Materials Conversion Total Costs Unit costs (Step 3): Total costs for July in Melting Dept $50,000 $9,690 Total equivalent units (from Step 2 above) ,000,850 Costs Cost per equivalent unit $ $11.40 Costs charged to production: Inventory in process, July $28,150 Costs incurred in July ,690 Total costs accounted for by the Melting Dept.... $87,840 Costs allocated to completed and partially completed units (Step 4): Inventory in process, July 1 balance $28,150 To complete inventory in process, July $, 0 $1,710 a 1,710 Started and completed in July ,000 b 6,840 c 36,840 Transferred to Casting Dept. in July $66,700 Inventory in process, July $20,000 d $1,140 e 21,140 Total costs assigned by the Melting Dept $87,840 a 150 units $11.40 $1,710 c 600 units $11.40 $6,840 e 100 units $11.40 $1,140 b 600 units $50.00 $30,000 d 400 units $50.00 $20,000

12 M62 Chapter M2 Process Cost Systems Journal Entries for a Process Cost System objective 5 Prepare journal entries for transactions of a process manufacturer. The report summarizes the four previous steps by providing the following production quantity and cost data: 1. The units for which the department is accountable and the disposition of those units. 2. The production costs incurred by the department and the allocation of those costs between completed and partially completed units. The cost of production report is also used to control costs. Each department manager is responsible for the units entering production and the costs incurred in the department. Any failure to account for all costs and any significant differences in unit product costs from one month to another should be investigated. To illustrate the journal entries to record the cost flows in a process costing system, we will use the July transactions for McDermott Steel. The entries in summary form for these transactions are shown here and on the following page. In practice, transactions would be recorded daily. Date Description a. Materials Accounts Payable Materials purchased on account. b. c. d. e. Work in Process Melting Factory Overhead Melting Factory Overhead Casting Materials Materials requisitioned. Work in Process Melting Work in Process Casting Wages Payable Direct labor used. Factory Overhead Melting Factory Overhead Casting Accumulated Depreciation Depreciation expenses. Work in Process Melting Work in Process Casting Factory Overhead Melting Factory Overhead Casting Factory overhead applied. JOURNAL Post. Ref. Debit Credit

13 Chapter M2 Process Cost Systems M63 f. Work in Process Casting Work in Process Melting Melting Department transferred $66,700 to Casting Department (from Exhibit 7) Exhibit 8 McDermott Steel s Cost Flows Materials July 1 Bal. 0 a. Purchases 62,000 b. 57,000 requisitioned Factory Overhead Melting b. Indirect materials 4,000 d. Depreciation 1,000 e. Applied 4,690 Factory Overhead Casting b. Indirect materials 3,000 d. Depreciation 7,000 e. Applied g. h. Finished Goods Work in Process Casting Casting Department transferred $78,600 to Finished Goods. Cost of Goods Sold Finished Goods Goods sold Exhibit 8 shows the flow of costs for each transaction. Note that the highlighted amounts in Exhibit 8 were determined from assigning the costs charged to production in the Melting Department. These amounts were computed and are shown at the bottom of the cost of production report for the Melting Department in Exhibit 7. Likewise, the amount transferred out of the Casting Department to Finished Goods would have also been determined from a cost of production report for the Casting Department. 9,640 July 1 Inventory b. Materials c. Labor e. Overhead applied Work in Process Melting 28,150 50,000 5,000 4,690 f. Transferred out 66,700 July 1 Inventory c. Labor e. Overhead applied Work in Process Casting 12,500 4,500 9,640 f. Transferred in 66,700 July 1 Inventory g. Transferred in g. Transferred out Finished Goods 8,100 78,600 78,600 h. Cost of goods sold 73,700

14 M64 Chapter M2 Process Cost Systems Using the Cost of Production Report for Decision Making objective 6 Use cost of production reports for decision making. Middle Tennessee Lumber Company produces cabinet and furniture panels from various hardwoods. The company purchased new computer and sawing technology that improved the cutting yield by approximately 10%. The cutting yield is the ratio of finished panel board feet to the number of board feet input to the sawing operation. The new equipment scans the rough-cut lumber with a laser beam. The scanned information is input to a software program that calculates the optimum cutting pattern for minimizing trim waste. The wood is then sent to a computer-controlled saw, which proceeds to cut the board according to the calculations from the laser scan. The cost of production report is one source of information that may be used by managers to control and improve operations. A cost of production report will normally list costs in greater detail than in Exhibit 7. This greater detail helps management isolate problems and opportunities. To illustrate, assume that the Blending Department of Holland Beverage Company prepared cost of production reports for April and May. In addition, assume that the Blending Department had no beginning or ending work in process inventory either month. Thus, in this simple case, there is no need to determine equivalent units of production for allocating costs between completed and partially completed units. The cost of production reports for April and May in the Blending Department are as follows: Cost of Production Reports Holland Beverage Company Blending Department For the Months Ended April 30 and May 31, 2003 April May Direct materials $ 20,000 $ 40,600 Direct labor 15,000 29,400 Energy 8,000 20,000 Repairs 4,000 8,000 Tank cleaning 3,000 8,000 Total $ 50,000 $ 106,000 Units completed 100, ,000 Cost per unit $ 0.50 $ 0.53 Note that the preceding reports provide more cost detail than simply reporting direct materials and conversion costs. The May results indicate that total unit costs have increased from $0.50 to $0.53, or 6% from the previous month. What caused this increase? To determine the possible causes for this increase, the cost of production report may be restated in per-unit terms, as shown below. Blending Department Per-Unit Expense Comparisons April May % Change Direct materials $0.200 $ % Direct labor % Energy % Repairs % Tank cleaning % Total $0.500 $ % Both energy and tank cleaning per-unit costs have increased dramatically in May. Further investigation should focus on these costs. For example, an increasing trend in energy may indicate that the machines are losing fuel efficiency, thereby requiring the company to purchase an increasing amount of fuel. This unfavorable trend could motivate management to repair the machines. The tank cleaning costs could be investigated in a similar fashion. In addition to unit production cost trends, managers of process manufacturers are also concerned about yield trends. Yield is the ratio of the materials output quantity to the input quantity. A yield less than one occurs when the output quantity is less than the input quantity due to materials losses during the process. For

15 Chapter M2 Process Cost Systems M65 example, if 1,000 pounds of sugar entered the packing operation, and only 980 pounds of sugar were packed, the yield would be 98%. Two percent or 20 pounds of sugar were lost or spilled during the packing process. Just-in-Time Processing objective 7 Contrast just-in-time processing with conventional manufacturing practices. Exhibit 9 Traditional Production Line Furniture Manufacturer The Internet complements a just-in-time processing strategy. Ford Motor Company states that the impact of the Internet is the equivalent of the moving assembly line of the 21st Century. This is because the Internet will connect the whole supply chain from customers to suppliers to create a fast and efficient manufacturing system. As stated by William Clay Ford, Chairman of Ford Motor, The automobile is about to undergo the most profound and revolutionary changes it s seen since the Model T first hit the streets. The objective of many companies is to produce products with high quality, low cost, and instant availability. One approach to achieving this objective is to implement just-in-time processing. Just-in-time processing (JIT) is a philosophy that focuses on reducing time and cost and eliminating poor quality. A JIT system achieves production efficiencies and flexibility by reorganizing the traditional production process. In a traditional production process (illustrated in Exhibit 9), a product moves from process to process as each function or step is completed. Each worker is assigned a specific job, which is performed repeatedly as unfinished products are received from the preceding department. For example, a furniture manufacturer might use seven production departments to perform the operating functions necessary to manufacture furniture, as shown in the diagram in Exhibit 9. TRADITIONAL PRODUCTION LINE For the furniture maker in the illustration, manufacturing would begin in the Cutting Department, where the wood would be cut to design specifications. Next, the Drilling Department would perform the drilling function, after which the Sanding Department would sand the wood, the Staining Department would stain the furniture, and the Varnishing Department would apply varnish and other protective coatings. Then, the Upholstery Department would add fabric and other materials. Finally, the Assembly Department would assemble the furniture to complete the process. In the traditional production process, production supervisors attempt to enter enough materials into the process to keep all the manufacturing departments operating. Some departments, however, may process materials more rapidly than others. In addition, if one department stops production because of machine breakdowns, for example, the preceding departments usually continue production in order to avoid idle time. This may result in a build-up of work in process inventories in some departments.

16 M66 Chapter M2 Process Cost Systems Exhibit 10 Just-in-Time Production Line Furniture Manufacturer American automakers are continuing to look for ways to be more efficient and catch up with their Japanese counterparts. One basis for comparison is the number of workers needed to make one vehicle a day, as shown in the table below: Ford General Motors Honda Toyota Source: Keith Bradsher, Efficiency on Wheels, The New York Times, June 16, In a just-in-time system, processing functions are combined into work centers, sometimes called manufacturing cells. For example, the seven departments just illustrated for the furniture manufacturer might be reorganized into three work centers. As shown in the diagram in Exhibit 10, Work Center One would perform the cutting, drilling, and sanding functions, Work Center Two would perform the staining and varnishing functions, and Work Center Three would perform the upholstery and assembly functions. JUST-IN-TIME PRODUCTION LINE In the traditional production line, a worker typically performs only one function. However, in a work center in which several functions take place, the workers are often cross-trained to perform more than one function. Research has indicated that workers who perform several manufacturing functions identify better with the end product. This creates pride in the product and improves quality and productivity. Implementing JIT may also result in reorganizing service activities. Specifically, the service activities may be assigned to individual work centers, rather than to centralized service departments. For example, each work center may be assigned the responsibility for the repair and maintenance of its machinery and equipment. Accepting this responsibility creates an environment in which workers gain a better understanding of the production process and the machinery. In turn, workers tend to take better care of the machinery, which decreases repairs and maintenance costs, reduces machine downtime, and improves product quality. In a JIT system, wasted motion from moving the product and materials is reduced. The product is often placed on a movable carrier that is centrally located in the work center. After the workers in a work center have completed their activities with the product, the entire carrier and any additional materials are moved just in time to satisfy the demand or need of the next work center. In this sense, the product is said to be pulled through. Each work center is connected to other work centers through information contained on Kanbans, which is a Japanese term for cards. The experience of Caterpillar Inc. illustrates the impact of JIT. Before implementing JIT, an average transmission would travel 10 miles through the factory and require 1,000 pieces of paper for materials, labor, and movement transactions. After implementing JIT, Caterpillar improved manufacturing so that an average transmission traveled only 200 feet and required only 10 pieces of paper. In summary, the primary benefit of JIT systems is the increased efficiency of operations, which is achieved by eliminating waste and simplifying the production process. At the same time, JIT systems emphasize continuous improvement in the manufacturing process and the improvement of product quality.

17 Chapter M2 Process Cost Systems M67 ENCORE What do Procter & Gamble and Formula One racing have in common? The answer begins with P&G s Packing Department, which is where detergents and other products are filled on a pack line. Containers move down the pack line and are filled with products from a multihead packing machine. When it was time to change from a 36-oz. to a 54-oz. Tide box, for example, the changeover involved stopping the line, adjusting guide rails, retrieving items from the tool room, placing items back in the tool room, changing and cleaning the pack heads, and performing routine maintenance. Changing the pack line could be a very difficult process and typically took up to eight hours. Management realized that it was important to reduce this time significantly in order to become more flexible and cost efficient in packing products. Where could they learn how to do changeovers faster? They turned to Formula One racing, reasoning that a pit stop was much 1 Distinguish KEY POINTS between job order costing and process costing systems. The process cost system is best suited for industries that massproduce identical units of a product that often have passed through a sequence of processes on a continuous basis. In process cost accounting, costs are charged to processing departments, and the cost of the finished unit is determined by dividing the total cost incurred in each process by the number of units produced. P & G s Pit Stops like a changeover. As a result, P&G videotaped actual Formula One pit stops. These videos were used to form the following principles for conducting a fast changeover: Position the tools near their point of use on the line prior to stopping the line, to reduce time going back and forth to the tool room. Arrange the tools in the exact order of work, so that no time is wasted looking for a tool. Have each employee perform a very specific task during the changeover. Design the workflow so that employees don t interfere with each other. Have each employee in position at the moment the line is stopped. Train each employee, and practice, practice, practice. Put a stop watch on the changeover process. 2 Explain and illustrate the physical flows and cost flows for a process manufacturer. Materials are introduced, converted, and passed from one department to the next department or to finished goods. The accumulated costs transferred from preceding departments and the costs of direct materials and direct labor incurred in each processing department are debited to the related work in process account in a process cost system. Each Plot improvements over time on a visible chart. As a result of these changes, P&G was able to reduce pack-line changeover time from eight hours to 20 minutes. This allowed them to produce a much larger variety of products every day and to improve the cost performance of the Packing Department. work in process account is also debited for the factory overhead applied. 3 Calculate and interpret the accounting for completed and partially completed units under the fifo method. Frequently, partially processed materials remain in various stages of production in a department at the end of a period. In this case, the manufacturing costs must be allocated between the units that have been completed and those

18 M68 4 Prepare that are only partially completed and remain within the department. To allocate processing costs between the output completed and the inventory of goods within the department under fifo, it is necessary to determine the number of equivalent units of production during the period for the beginning inventory, units started and completed currently, and the ending inventory. a cost of production report. A cost of production report is prepared periodically for each processing department. It summarizes (1) the units for which the department is accountable and the disposition of those units and (2) the production costs incurred by the department and the allocation of those costs. The report is used to control costs and improve the process. ILLUSTRATIVE PROBLEM 5 Prepare 6 Use journal entries for transactions of a process manufacturer. Summary journal entries for common process manufacturer transactions are illustrated for McDermott Steel in the text. Basic entries include debiting the processing department work in process account for direct materials, direct labor, and applied factory overhead costs incurred in production. Costs for completed units are credited to the transferring department s work in process account and debited to the receiving department s work in process account. cost of production reports for decision making. The cost of production report provides information for controlling and improving operations. Most cost of production reports include the detailed manufacturing costs incurred for completing production during the period. Analyzing trends in each of these costs over time can provide insights about process performance. 7 Contrast Chapter M2 Process Cost Systems just-in-time processing with conventional manufacturing practices. The just-in-time processing philosophy focuses on reducing time, cost, and poor quality within the process. This is accomplished by combining process functions into work centers, assigning overhead services directly to the cells, involving the employees in process improvement efforts, eliminating wasteful activities, and reducing the amount of work in process inventory required to fulfill production targets. Southern Aggregate Company manufactures concrete by a series of four processes. All materials are introduced in Crushing. From Crushing, the materials pass through Sifting, Baking, and Mixing, emerging as finished concrete. All inventories are costed by the firstin, first-out method. The balances in the accounts Work in Process Mixing and Finished Goods were as follows on May 1, 2003: Work in Process Mixing (2,000 units, 1/4 completed) $13,700 Finished Goods (1,800 units at $8.00 a unit) 14,400 The following costs were charged to Work in Process Mixing during May: Direct materials transferred from Baking: 15,200 units at $6.50 a unit $98,800 Direct labor 17,200 Factory overhead 11,780 During May, 16,000 units of concrete were completed, and 15,800 units were sold. Inventories on May 31 were as follows: Work in Process Mixing: 1,200 units, 1/2 completed Finished Goods: 2,000 units Instructions 1. Prepare a cost of production report for the Mixing Department. 2. Determine the cost of goods sold (indicate number of units and unit costs). 3. Determine the finished goods inventory, May 31, 2003.

19 Chapter M2 Process Cost Systems M69 Solution 1. Southern Aggregate Company Cost of Production Report Mixing Department For the Month Ended May 31, 2003 Equivalent Units UNITS Whole Units Direct Materials Conversion Units charged to production: Inventory in process, May ,000 Received from Baking ,200 Total units accounted for by the Mixing Dept ,200 Units to be assigned cost: Inventory in process, May 1 (25% completed) ,000, 0 1,500 Started and completed in May ,000 14,000 14,000 Transferred to finished goods in May ,000 14,000 15,500 Inventory in process, May 31 (50% complete) ,200 1,200,600 Total units to be assigned cost ,200 15,200 16,100 COSTS Direct Materials Conversion Total Costs Unit costs: Total cost for May in Mixing $ 98,800 $ 28,980 Total equivalent units (from above) ,200 16,100 Costs Cost per equivalent unit $ 6.50 $ 1.80 Costs charged to production: Inventory in process, May $ 13,700 Costs incurred in May ,780 Total costs accounted for by the Mixing Dept $141,480 Direct Materials Conversion Total Costs Costs allocated to completed and partially completed units: Inventory in process, May 1 balance $ 13,700 To complete inventory in process, May $, 0 $ 2,700 (a) 2,700 Started and completed in May ,000 (b) 25,200 (c) 116,200 Transferred to finished goods in May $132,600 Inventory in process, May $ 7,800 (d) $ 1,080 (e) 8,880 Total costs assigned by the Mixing Department $141,480 (a) 1,500 $1.80 $2,700 (c) 14,000 $1.80 $25,200 (e) 600 $1.80 $1,080 (b) 14,000 $6.50 $91,000 (d) 1,200 $6.50 $7, Cost of goods sold: 1,800 units at $8.00 $ 14,400 (from finished goods beginning inventory) 2,000 units at $8.20* 16,400 (from work in process beginning inventory) 12,000 units at $8.30** 99,600 (from May production started and completed) 15,800 units $130,400 *($13,700 $2,700) 2,000 **$116,200 14, Finished goods inventory, May 31: 2,000 units at $8.30 $16,600

20 M70 SELF-EXAMINATION QUESTIONS Chapter M2 Process Cost Systems Answers at End of Chapter Matching Match each of the following statements with its proper term. Some terms may not be used. A. cost of production report B. cost per equivalent unit C. equivalent units of production D. first-in, first-out (FIFO) cost method E. just-in-time processing F. manufacturing cells G. oil refinery H. process cost system I. process manufacturers J. transferred-out costs K. yield Multiple Choice For which of the following businesses would the process cost system be most appropriate? A. Custom furniture manufacturer B. Commercial building contractor C. Crude oil refinery D. Automobile repair shop 2. There were 2,000 pounds in process at the beginning of the period in the Packing Department. Packing received 24,000 pounds from the Blending Department during the month, of which 3,000 pounds were in process at the end of the month. How many pounds were completed and transferred to finished goods from the Packing Department? A. 23,000 C. 26,000 B. 21,000 D. 29, Information relating to production in Department A for May is as follows: A type of cost system that accumulates costs for each of the various departments within a manufacturing facility. Manufacturers that use large machines to process a continuous flow of raw materials through various stages of completion into a finished state. The number of production units that could have been completed within a given accounting period, given the resources consumed. A method of inventory costing that assumes the unit product costs should be determined separately for each period in the order in which the costs were incurred. The rate used to allocate costs between completed and partially completed production. A report prepared periodically by a processing department, summarizing the costs incurred by the department and the allocation of those costs between completed and incomplete production. A measure of materials usage efficiency. A grouping of processes where employees are cross-trained to perform more than one function. A processing approach that focuses on eliminating time, cost, and poor quality within manufacturing and nonmanufacturing processes. May 1 Balance, 1,000 units, 3/4 completed $22, Direct materials, 5,000 units 75, Direct labor 32, Factory overhead 16,250 If 500 units were one-fourth completed at May 31, 5,500 units were completed during May, and inventories are costed by the first-in, first-out method, what was the number of equivalent units of production with respect to conversion costs for May? A. 4,500 C. 5,500 B. 4,875 D. 6, Based on the data presented in Question 3, what is the conversion cost per equivalent unit? A. $10 C. $25 B. $15 D. $32 5. Information from the accounting system revealed the following: Day 1 Day 2 Day 3 Day 4 Day 5 Materials $ 20,000 $18,000 $ 22,000 $ 20,000 $ 20,000 Electricity 2,500 3,000 3,500 4,000 4,700 Maintenance 4,000 3,800 3,400 3,000 2,800 Total costs $ 26,500 $24,800 $ 28,900 $ 27,000 $ 27,500 Pounds produced 10,000 9,000 11,000 10,000 10,000 Cost per unit $ 2.65 $ 2.75 $ 2.63 $ 2.70 $ 2.75

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