Process Cost System
Some
companies have homogeneous or very similar products that are not made to order
and are produced in large volumes. They continually process their product,
moving it from one function to the next until it is completed. In these companies,
the manufacturing costs incurred are allocated to the proper functions or
departments within the factory process rather than to specific products.
Examples of products that companies produce continuously are cereal, bread,
candy, steel, automotive parts, chips, and computers. Companies that refine oil
or bottle drinks and companies that provide services such as mail sorting and
catalog order are also examples of continuous, homogeneous processing.
To illustrate, assume the Best Chips company manufactures potato
chips. The company has three work areas they call preparation, baking, and
packaging. The preparation area includes cutting potatoes and adding
flavorings. Conveyor belts are used to move the product from one function to
the next. In this company, raw materials are added in two of the functions: the
preparation function and the packaging function. Labor and overhead are
incurred in each function. Figure 1shows
the process flow and costs associated with Best Chip's process cost system.
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Figure
1
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Process Cost System Cost Flows
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The cost
report for Best Chips summarizes how manufacturing costs (direct materials,
direct labor, and manufacturing overhead) are assigned to the three
departments. The report for June is as follows:
Best Chips
Cost Summary For the Month Ended June 30, 20X2 Work-in-Process Inventory
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Raw
Materials Inventory
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Factory
Labor
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Factory
Overhead
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Preparation
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Baking
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Packaging
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Beginning
balance
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5,200
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3,200
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June
costs
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4,600
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7,100
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2,300
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Costs assigned
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Direct materials
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(6,500)
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2,800
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3,700
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Indirect materials
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(1,300)
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1,300
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Direct labor
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(5,300)
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2,900
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500
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1,900
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Indirect labor
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(1,800)
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1,800
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Factory overhead
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(5,525)
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435
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3,000
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2,090
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Predetermined overhead rates
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15%
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600%
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110%
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Best Chips started the
month of June with $5,200 in raw materials inventory. Best Chips uses the
perpetual inventory method, so raw materials purchased are added to the raw
material inventory account when they are received. Raw materials requisitioned
that become part of the final product or are used by a specific function are considered
direct materials used. The costs of direct materials are added to the proper
department's work-in-process inventory account. Raw materials requisitioned
that are used for general production purposes are added to factory overhead.
The journal entries related to raw material activity for June are:
General Journal
Date
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Account Title and Description
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Ref.
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Debit
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Credit
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20X2
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June
30
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Raw
Materials Inventory
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4,600
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(A)
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Accounts
Payable
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4,600
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Purchased
raw materials on credit
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(C)
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Factory
Overhead
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1,300
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Raw
Materials Inventory
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1,300
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Indirect
materials for June
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(F)
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Work-in-Process
Inventory-Preparation
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2,800
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Work-in-Process
Inventory-Packaging
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3,700
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Raw
Materials Inventory
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6,500
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Transfer
direct materials to work-in-process inventory
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At the end of the month,
$2,000 of materials remained in raw materials inventory.
Raw Materials Inventory
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beginning
balance
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5,200
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1,300
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(C)
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(A)
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4,600
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6,500
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(F)
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9,800
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7,800
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ending
balance
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2,000
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As the factory labor
payroll is prepared and recorded, the payroll costs are split between those
employees who work in specific functions (departments) and those involved in
the general functions of the factory. The specific function costs are called
direct labor and are assigned to work-in-process inventory. The general factory
labor costs are indirect labor costs that are added to factory overhead. Unlike
the accounting for payroll under the job order cost system, the employee does
not have to be physically involved in making a product to be assigned to a
specific function. If a specific maintenance worker or supervisor is assigned
to the preparation function, their wages are allocated to that function even
though these workers are not directly involved in preparing the chips to be
baked. The accounting for the labor costs for June includes the following
journal entries, shown in the following table.
General Journal
Date
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Account Title and Description
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Ref.
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Debit
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Credit
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20X2
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June
30
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Factory
Labor
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7,100
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Wages Payable
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7,100
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Record payroll for June
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(D)
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Factory Overhead
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1,800
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Factory Labor
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1,800
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Indirect labor for June
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(G)
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Work-in-Process Inventory-Preparation
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2,900
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Work-in-Process Inventory-Baking
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500
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Work-in-Process Inventory-Packaging
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1,900
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Factory Labor
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5,300
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Direct labor for June
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The
balance in the factory labor account should be zero at the end of each period.
Factor
Labor
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(B)
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7,100
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1,800
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(D)
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5,300
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(G)
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7,100
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7,100
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0
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In a process company,
factory overhead represents those costs not directly assigned to one function.
For example, the depreciation expense of a machine used solely by the
preparation function would be assigned to work-in-process inventory for the
preparation department while depreciation expense for the plant (the factory
building) would be assigned to factory overhead as all functions occupy the
plant. The journal entries that follow illustrate the accounting for general
overhead costs.
General Journal
Date
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Account Title and Description
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Ref.
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Debit
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Credit
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20X2
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June
30
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Factory
Overhead
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2,300
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(E)
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Prepaid
Insurance
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1,000
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Accounts
Payable-Electric Utilities
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1,200
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Cash
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100
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June
overhead × costs
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(H)
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Work-in-Process
Inventory-Preparation
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435
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Work-in-Process
Inventory-Baking
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3,000
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Work-in-Process
Inventory-Packaging
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2,090
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Factory
Overhead
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5,525
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Overhead
allocated based on predetermined rates
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At the end of the period,
the factory overhead account has a credit balance of ($125). This is called
overapplied overhead and an entry would be made at the end of the period to
move it to cost of goods sold, or alternatively, to allocate the difference to
work-in-process inventories, finished goods inventory, and cost of goods sold.
After recording this entry, the balance in the factory overhead account is
zero.
General Journal
Date
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Account Title and Description
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Ref.
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Debit
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Credit
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20X2
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June
30
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Factory
Overhead
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125
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(M)
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Cost
of Goods Sold
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125
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Close
out overapplied overhead
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At the end of the period,
entries are needed to record the cost of the products moved from one function
(department) to another. In this example, costs are moved from work-in-process
inventory-preparation to work-in-process inventory-baking and from work-in-process
inventory-baking to work-in-process inventory-packaging. This is how the
entries would look:
General Journal
Date
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Account Title and Description
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Ref.
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Debit
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Credit
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20X2
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June
30
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Work-in-Process
Inventory-Baking
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XXX
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(I)
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Work-in-Process
Inventory-Preparation
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XXX
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Transfer
June costs to Baking
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(J)
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Work-in-Process
Inventory-Packaging
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XXX
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Work-in-Process
Inventory-Baking
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XXX
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Transfer
June costs to Packaging
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When the packaging function
(department) completes its work, the product is ready to be sold. The costs of
the completed products are then transferred from work-in-process
inventory-packaging to finished goods inventory. This transfer also requires a
journal entry.
General Journal
Date
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Account Title and Description
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Ref.
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Debit
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Credit
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20X2
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June
30
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Finished
Goods Inventory
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XXX
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(K)
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Work-in-Process
Inventory-Packaging
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XXX
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Transfer
to finished goods inventory
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The
amounts for these journal entries are calculated by multiplying the cost per
unit times the number of units that moved from one function to the next. The
number of units is determined separately for each function using the actual
number of units completed and transferred out of the function adjusted for
partially completed units that were not transferred. This calculated number of
units used is called equivalent units. If there are no in-process units at the beginning or end of the
period, the per unit cost is calculated by dividing the total costs assigned to
a function (department) by the total number of units that were started and
completed during the period. The total costs include materials, labor, and
overhead.
If the function has
work-in-process inventory at the beginning of the period, the number of
equivalent units must be calculated. Equivalent units represent the number of
units that could have been 100% completed during the period. For example, if
two employees each work 20 hours a week, this is the equivalent of one
full-time employee (one equivalent unit). On a production line, if one product
is 40% complete and a second one is 60% complete, this is the equivalent of
100% complete for one unit (one equivalent unit). This number is needed to
spread the costs of the function over all the units worked on during the period.
For example, if a company started 1,000 units of product during the period and
at the end of the period these were 40% completed, the equivalent units would
be 400 (1,000 units × 40% complete). This calculation assumes that the
materials, labor, and overhead are all added evenly throughout the time the
units are in process in the function. In many companies, the materials are all
added at the beginning of the process while the labor and overhead costs are
incurred throughout the process. Labor and overhead are also called conversion costs because they “convert” the
materials into a product. If materials, labor, and overhead are added at
different times in the production process, two separate calculations of
equivalent units are necessary, one for the materials and one for conversion
costs.
Using the
previous example of 1,000 units started during the period that were 40%
completed, assume that in a particular function, all of the materials are added
at the beginning of the process and the labor and overhead are added evenly
throughout the process. The equivalent units for materials would be the number
of units times the percent complete. In this example, all the materials are
added at the beginning of the process so 100% of materials for this function are
included in all the units at the end of the period. The equivalent units for
materials are 1,000 (1,000 units × 100% complete for materials). The total
materials costs are divided by 1,000 to calculate the materials cost per unit.
Unlike
materials, more labor and overhead will be needed before these units are
transferred to another function or to finished goods. The equivalent units for
conversion costs (labor and overhead) are 400 (1,000 units started × 40%
complete for labor and overhead). The total conversion costs are divided by 400
to calculate the conversion costs per unit. To calculate total cost per unit,
the materials cost per unit is added to the conversion cost per unit.
When a
company has units that are started and completed during a period and has an
ending inventory of units in process, most often the weighted average method is
used to calculate equivalent units. If needed, based on the company's
production processes, separate calculations of equivalent units for materials
and conversion costs are made. Assume a company has two functions in its
production process called Department 1 and Department 2. For the month of
January, Department 1 completed and transferred out 2,000 units to Department 2
and had 800 units in process at month end that were 80% completed as to
materials, labor, and overhead. Using the weighted average method, equivalent
units for Department 1 for January are 2,640 [(2,000 × 100%) + (800 × 80%)].
The beginning units and those started and completed are not separately identified
in the calculation of equivalent units. When calculating the per unit cost
using the weighted average method, the beginning work-in-process costs for the
function are added to those costs incurred during the period and then divided
by the equivalent units.
Equivalent
units may also be calculated using the first-in, first-out (FIFO) method. Under
the FIFO method of calculating equivalent units, the beginning units would be
identified separately from those started and completed. Continuing with the
previous example, if 700 units were in process and 40% completed at the
beginning of January, during January Department 1 would have added the
additional 60% of the costs necessary to complete the units. Using the FIFO
method, the equivalent units for January would be 3,060, calculated as follows:
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Actual
Units
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%
Completed during Month
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Equivalent
Units
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Beginning units
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700
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60%
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420
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Started and completed
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2,000
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100%
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2,000
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Transferred out
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2,700
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2,420
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Ending units
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800
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80%
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640
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Total
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3,500
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3,060
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Process costing summary
Once the
physical units have been identified and the equivalent units calculated, the
per unit cost is calculated and the cost summary is prepared for each function.
Assume the following facts and costs for Department 1 for August. Overhead
costs are based on direct labor hours.
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%Completed
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Total
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Materials
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Conversion
Costs
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Beginning inventory
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3,000
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100%
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60%
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Started and completed
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5,000
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100%
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100%
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Ending
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2,000
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100%
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30%
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Total
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10,000
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Total
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Materials
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Conversion
Costs
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Beginning inventory
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$ 5,010
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$2,760
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$ 2,250
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Incurred in August
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Direct materials
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5,740
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5,740
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Direct labor
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5,100
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5,100
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Overhead
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3,400
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3,400
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Total Costs
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$ 19,250
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$ 8,500
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$s 10,750
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Figures 2 and 3 show the process cost
summary for Department 1 using the previous information for August under
the weighted average and FIFO methods, respectively. The summary includes
sections for the flow of the units, equivalent units, unit costs for the
period, costs to be allocated (costs to be accounted for), and allocation of
costs to the units transferred out and those units in process at the end of the
period (costs accounted for).
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Figure
2
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Department 1 Cost Summary Weighted Average Method for
the Month of August 20X0
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Figure
3
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Department 1 Cost Summary FIFO Method for the Month of
August 20X0
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In the
weighted average example (see Figure 2 ), the
calculation of number of units accounted for does not differentiate between
units in beginning inventory and those units started and completed during the
period because the costs are averaged for all these units. The per unit costs
are based on the equivalent units completed and the total costs incurred on
those units. Under the FIFO method (see Figure 3 ), costs are tracked based on specific units. Per unit costs are
current period unit costs and calculated based on equivalent units completed
and costs incurred for the current period. For the units in the beginning
inventory, once the current period costs are calculated, they are added to the
costs incurred in prior periods to determine the total costs for these units.
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