Basic Approach to Process Costing in Cost Accounting
In cost accounting, you need to trace or allocate all of the costs attached to a product to know the full cost of the product. After you know the full cost, you can compute a reasonable profit level and set a sale price for the product. That’s easy to say, but getting it done takes a little work.
To fully price the product, each unit must absorb material, labor, and overhead costs. Because the goods are identical, the costs you eventually assigned to each unit are identical. Note the word used was eventually; the process takes time.
Process costing is all about moving costs from one production department to another. Say you manufacture blue jeans. Denim material goes to the cutting room and is cut from patterns. The cut material then goes to the sewing department. After the blue jeans are sewn, they move to the dyeing department to add color. As the blue jeans move, so do the costs accumulated along the way.
So as you can see in the blue-jeans example, as a product moves through production, it accumulates costs. Now consider when the costs are incurred.
Direct material costs in cost accounting
In most cases, material costs go into production before labor and overhead costs. You need material before you can perform most of your work. The employee can’t run the sewing machine if there isn’t any denim to sew. At any point in production, you’ll probably see a higher percentage of material costs incurred, compared with labor and overhead costs.
Material costs are often incurred all at once. Consider the blue jeans. You decide to put all the denim you need into production at once. Because the first production area is the cutting department, all of the material cutting happens as soon as possible. If the denim is brought into production gradually, the cutting department may have to stop and wait for more denim. That would slow up your production, and you’re unlikely to do that.
Material costs lead most of the time, but not all of the time. Keep your eyes open for exceptions. For example, auto bodywork is labor-intensive. So is the work of plumbers. Service businesses, of course, sell services.
Conversion costs in cost accounting
Conversion costs are all costs other than material costs. They are costs you incur to “convert” material into a final product. So labor and overhead are conversion costs.
Also, keep in mind that conversion costs are put into production gradually. Maybe your product moves through several stages of production. If you make baseball gloves, for example, you have a department that cuts the leather for the baseball gloves and another department that sews the leather. Because there are workers and machines in each department, you add costs as the product moves through production — gradually.