KADUNA STATE UNIVERSITY

FACULTY OF SOCIAL MANAGEMENT SCIENCES

DEPARTMENT OF ACCOUNTING

PGD IN ACCOUNTING

COURSE CODE: PDA711

COURSE TITLE:
COST AND MANAGEMENT ACCOUNTING

ASSIGNMENT

BY

NATA'ALA BABANGIDA
KASU/PGD/ACC/20/0019

QUESTION:

Discuss process Costing & Absorption costing with clear examples and
distinctive features of each process and absorption with adequate reference.

JANUARY, 2022

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Process Costing

Process costing is a method of costing used mainly in manufacturing

where units are continuously mass-produced through one or more
processes. Examples of this include the manufacture of erasers, chemicals
or processed food.

In process costing it is the process that is costed (unlike job costing

where each job is costed separately). The method used is to take the total
cost of the process and average it over the units of production.

What is process costing?

Process costing refers to a cost accounting method that is used for

assigning production costs to mass-produced goods.

For instance, large manufacturing companies that mass-produce

inventory might use process costing to calculate the total amount of direct
and indirect costs associated with products that are completed and left in-
process at the end of a given time period.

Some industries where process costing methods might be applied are the
food industry, fuel and oil industries and chemical processing industries.

Example of process costing

Different departments, such as a design team, a floor team, an assembly

department and even a shipping and receiving department can have
separate processing costs associated with unit production. As the
inventory moves through each stage of development, each department
may add its calculated costs to the overall process costing of producing
goods.

A company that produces ink cartridges applies process costing through

several departments. The first department—the design department—is

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where the overall shape, dimensions and other design elements of the
cartridges are processed.

During a 30-day period, the design department accumulates a total

amount of $80,000 of direct costs for materials and resources and
$100,000 of converted costs for labor and overhead costs. The design
department processes 10,000 cartridges during the 30-day period, which
means that the per-unit cost of the cartridges amounts to $8 for direct
costs (materials and resources) and $10 for conversion, or indirect, costs.

As the ink cartridges move through other departments during the

production period, different costs will be added to the total amount of
costs incurred during production.

The importance of using process costing

Process costing is a vital tool companies and production supervisors use

to track product costs in industries that deal with mass amounts of
produced goods and are subject to regular price fluctuations due to
process and multiple production lines. Process costing results in a cost of
goods manufactured (COGM) figure that is often listed on your company’s
income statement.

More specifically, process costing is important because it helps

companies:

Control inventory numbers and be able to distribute accurately

Monitor profits to know precisely how much they are spending and
earning

Report numbers from each department uniformly and accurately

Types of process costing

A company can use several different methods of process costing to

determine the total costs incurred before, during and after production, as
well as the total amount of units produced. Standard process costing may

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be used for simply calculating production costs, while averaging assigns
costs to specific units of production, and first-in, first-out calculates unit
costs as they are started and completed.

A company may use one or all methods of calculating process costing,

depending on what they produce, how they produce it and how they track
their production processes. The most common methods of process costing
include:

Standard cost

Standard cost refers to calculating costs for production units instead of

actual costs. Actual costs are compared with the total costs accumulated
based on standard costs, and the difference between the total costs
accumulated and the actual costs accumulated is recorded and charged to
another account, in this instance, a variance account.

Weighted average

This type of process costing groups together all the costs associated with
production and assigns them to the units the company produced. This
type of method may not take into account the time period of production
and can be the simplest type of process costing to calculate.

First-in, first-out

This method of process costing focuses on assigning costs to units in the

order that they are produced. Products that are produced first are
assigned a cost first, and then, they are the first products to ship or
otherwise put out. Furthermore, first-in, first-out assigns one set of costs
to products started in prior accounting periods but not finished, and
another set of costs for products started in the current accounting period.

Important terms to understand

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In a manufacturing process the number of units of output may not
necessarily be the same as the number of units of inputs. There may be a
loss.

Normal loss

This is the term used to describe normal expected wastage under usual
operating conditions. This may be due to reasons such as evaporation,
testing or rejects.

Abnormal loss

This is when a loss occurs over and above the normal expected loss. This
may be due to reasons such as faulty machinery or errors by labourers.

Abnormal gain

This occurs when the actual loss is lower than the normal loss. This could,
for example, be due to greater efficiency from newly-purchased
machinery.

Work in progress (WIP)

This is the term used to describe units that are not yet complete at the
end of the period. Opening WIP is the number of incomplete units at the
start of a process and closing WIP is the number at the end of the
process.

Scrap value

Sometimes the outcome of a loss can be sold for a small value. For
example, in the production of screws there may be a loss such as metal
wastage. This may be sold to a scrap merchant for a fee.

Equivalent units

This refers to a conversion of part-completed units into an equivalent

number of wholly-completed units. For example, if 1,000 cars are 40%
complete then the equivalent number of completed cars would be 1,000 x

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40% = 400 cars. Note: If 1,000 cars are 60% complete on the painting,
but 40% complete on the testing, then equivalent units will need to be
established for each type of cost. (See numerical example later.)

Features

 Each plant is divided into several processes/centres. Each such

division is a stage of production or process. Thus, we first clearly
identify the cost centres.
 Direct & indirect costs assigned and accumulated to each process in
the factory.
 The output of one process may become input for another process.
 The finished products are identical & cannot be easily distinguished
unless batch coding is done.
 The production process is continuous for all days in the year except
regular breakdown hours required during the year for maintenance
of the machinery.
 The total cost of production is divided among each process on a
suitable basis.
 The company requires to keep records for each production process,
such as units or costs introduced in each process and passed on to
the next stage of production.
 The production may result in joint-products or by-products.

What Is Absorption Costing?

Absorption costing, sometimes called “full costing,” is a managerial

accounting method for capturing all costs associated with manufacturing a
particular product. The direct and indirect costs, such as direct materials,
direct labor, rent, and insurance, are accounted for by using this method.

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Absorption costing is required by generally accepted accounting
principles (GAAP) for external reporting.

Understanding Absorption Costing

The costs observed under absorption costing include variable costs, fixed
costs, and semi-variable costs. Variable costs increase or decrease in the
proportion of the goods produced. Fixed costs do not alter irrespective of
the quantity of production. Semi-variable costs increase or decrease in
batches.

Absorption costing is part of accounting methods and procedures.

Absorption costing determines the cost of the inventory at the end of an
accounting period. The closing inventory also consists of fixed costs, thus
increasing the value of the inventory. This method of inventory valuation
increases the profit of the company.

Absorption costing is also known as full costing since it includes all the
costs associated with production. Variable costs are direct labour and
material costs. Fixed costs include rent, security, and insurance expenses.
Semi-variable costs include electricity charges for the factory. Thus, under
full costing, all the expense are absorbed by the product irrespective of
the product being sold.

Absorption costing enables precise accounting for the overall cost of

production, unlike in variable costing, which considers only variable costs.
The method of absorption costing enables reporting of high profit with a
high value of closing inventory. This is because the cost of production is
completely absorbed.

Example of Absorption Costing

Assume that ABC Company makes widgets. In January, it makes 10,000

widgets, of which 8,000 are sold by the end of the month, leaving 2,000
still in inventory. Each widget uses $5 of labor and materials directly
attributable to the item. In addition, there are $20,000 of fixed overhead

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costs each month associated with the production facility. Under the
absorption costing method, ABC will assign an additional $2 to each
widget for fixed overhead costs ($20,000 total ÷ 10,000 widgets
produced in the month).

The absorption cost per unit is $7 ($5 labor and materials + $2 fixed
overhead costs). As 8,000 widgets were sold, the total cost of goods sold
is $56,000 ($7 total cost per unit × 8,000 widgets sold). The ending
inventory will include $14,000 worth of widgets ($7 total cost per unit ×
2,000 widgets still in ending inventory).

How to calculate absorption costing

Here are some steps for calculating and assigning absorption costing:

1. Develop cost pools

First, determine the costs associated with the production of a product and
then assign them to different cost pools. A cost pool groups expenses by
activity. You might group marketing, customer service and research and
development into different cost pools. As you spend money, you will
assign costs to the cost pool that best describes it.

2. Determine usage for each cost

Next, go through every activity and figure out the amount each was used
during production. You will need to determine usage for activities such as
the number of hours spent on labor or equipment usage throughout the
manufacturing process.

3. Calculate the costs

Lastly, calculate the allocation rate, which tells you the cost per unit. You
can do this by following this formula:

Absorption cost per unit = (Direct Material Costs + Direct Labor

Costs + Variable Manufacturing Overhead Costs + Fixed
Manufacturing Overhead Costs) / Number of units produced

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Advantages of absorption costing

Though absorption costing is required to comply with GAAP, there are also
several advantages to using this system.

Accounting for all production costs

Absorption costing takes every cost associated with production into

account, making it an invaluable tool when determining appropriate
product pricing. This information allows companies to ensure that their
product's price point covers expenses involved in production. It also
enables them to price their products more competitively within their
market.

Tracking profits

Absorption costing gives a company a more accurate picture of

profitability especially if all of its products are not sold during the same
period when they are manufactured. This is an important consideration if
a company plans to ramps up production in anticipation of a seasonal
sales increase.

Suitable for smaller companies

Absorption costing makes it easier for small businesses to track since they
probably do not have a large number of products. The companies can
absorb fixed costs in advance and sell their products for a more realistic
price and profit.

Suitable for changing demands

Absorption costing is an advantage for companies that have a constant

demand for products. It provides a simple and systematic costing tool for
active businesses while taking into account the fluctuating turnover as
costs are already fixed to the products.

Disadvantages of absorption costing

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Though absorption costing is extremely useful, there are some
disadvantages to this method of costing. Some of absorption costing's
disadvantages include:

Over-assigning overhead costs

With absorption costing, even overhead costs that are unable to be

directly traced back to the product are assigned to each unit.

Overproduction to cut costs

This pricing method makes it possible to increase profitability by

overproducing a product. That is because the fixed overhead is assigned
to the total number of produced units, lowering the cost for each
additional unit produced. Then, when units are left unsold, the fixed
overhead costs aren't transferred to expense reports, increasing the
profitability.

Incomplete data

The data gathered for determining a product's cost through absorption

costing includes fixed overhead. This can inflate the actual cost of
manufacturing and result in insufficient data to perform a comprehensive
analysis.

Uninformed profitability

Since fixed costs are unable to be subtracted from revenue until the units
are sold, absorption costing can provide an incomplete view of a
company's profit levels. This can result in costs that remain unaccounted
for on a company's income statement, temporarily increasing a
company's apparent profitability on its balance sheet.

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Conclusion

The method of absorption costing is specified in the generally accepted

accounting principles (GAAP) for reporting of accounts under various
statutes. In this method, the fixed cost per unit produced decreases with
incremental production. This is contrary to variable costing, where
incremental production bears the same variable costs of production. Also,
the method of variable costing does not depict a correct picture of the
accounting profits or losses.

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References

Bhabatosh Banerjee. Cost Accounting Theory and Practice 12Th Ed.

Burgstahler, D., Horngren, C., Schatzberg, J., Stratton, W., & Sundem, G.
(2008). Introduction to Management Accounting, 14th ed. Upper
Saddle River: Prentice Hall. Chapters 4 & 13.
Dennis C. Zane & Daddy Octa (2009,2000,1992). Modern Cost
Management and Analysis 3rd Ed. Barron's Education Series, Inc.
ISBN 978-0-7641-4103-4.
Drury, C. (2008). Management and Cost Accounting, 7th ed. London:
South‐Western Cengage Learning. Chapters 7 & 10.
Garrison, Ray H; Noreen, Eric W; Brewer, Peter C (2012). Managerial
Accounting (14th ed.). McGraw-Hill.
Horngren, C. T., Datar, S. M., Foster, G., Raian, M. & Ittner, C. (2009).
Cost Accounting: A Managerial Emphasis, 13th ed. Upper Saddle
River: Prentice Hall. Chapters 5 & 9.
Lucey, T. (2009). Costing, 7th ed. London: South‐Western Cengage
Learning. Chapter 19.

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