Process costing. Chapter 8. Real world case 8.1. Discussion points

Transcription

1 Chapter 8 Process costing Rea word case 8.1 This case study shows a typica situation in which management accounting can be hepfu. Read the case study now but ony attempt the discussion points after you have finished studying the chapter. Sugar beet processing British Sugar, part of Associated British Foods, provides sugar for the top brand names in sugar confectionery, chocoate confectionery, soft drinks and preserves, etc. The company has six factories in the UK, with each one spit between a beet end and a sugar end. Typicay, a factory processes beet between September and March, termed the Campaign. The beet end empoys various processes to create thick juice, a iquid which has 65 per cent sugar content. The sugar end bois the thick juice and seeds it with tiny sugar crystas, providing the nuceus for arger crystas to form and grow to create sugar. The business of processing beet gives rise to severa chaenges which directy affect process efficiency, sugar yieds from the beet, and utimatey factory profitabiity. Source: Process and Contro, March 2003 Maximising sugar beet processing, p Discussion points 1 Why is a specific kind of costing needed for a process of this kind? 2 Why might the quantity of materia output be ess than the quantity input?

2 182 Part 1 Defining, reporting and managing costs Contents 8.1 Introduction Aocation of costs to products in a process industry Process costing where there is no opening work-in-progress Process costing where there is work-in-progress at the start of the period Separate materia and conversion costs Joint product costs and by-products Joint costs aocated on the basis of physica measures Joint costs aocated by reative saes vaue at the point of separation Further processing costs Treatment of by-products Reevance of aocating joint costs Decisions on joint products: se or process further What the researchers have found Process costs, standard costs and ABC Joint costs Summary 198 Learning outcomes After reading this chapter you shoud be abe to: Expain how process costing differs from job costing. Carry out cacuations to aocate costs to products in a process industry. Expain and cacuate joint product costs and by-product costs. Expain how decisions are made about joint products based on cost information. Describe and discuss exampes of research into process costing and joint product costs.

3 Chapter 8 Process costing Introduction Specia process costing techniques are required where there is a continuous fow of production of simiar units of output. This situation of a continuous process arises in the chemica industry and in other industries such as texties, paint, food, stee, gass, mining, cement and oi. As an exampe of a company where processes are important, Exhibit 8.1 contains an extract from the annua report of a chemicas company describing the group s products. The products of this company which derive from these chemica processes are many and varied. Viscose rayon, the first ceuose fibre, is a chemica name most readiy reated to womenswear and furnishing fabrics, but it is aso found in cutch inings, insuating materia within raiway signaing cabes and tea bags. The rayon process is aso used to make fim for sweet wrappings, baked goods and soft cheeses. In the area of coatings, the company produces marine paint which keeps the hus of ships and yachts free of barnaces. Another type of paint for the superstructure of ships transforms rust stains into coouress deposits. Other products invoving a fow process incude the manufacture of speciaist fim which makes gass shatter-resistant, toothpaste tubes and rigid packaging products such as specia housings for asthma inhaers. Exhibit 8.1 The products of a chemicas company We are a chemica materias company. Our products are made by chemica processes. But with a few exceptions they are not themseves pure chemicas: they are products made from chemicas. These products are based on two reated technica discipines. The first of these is poymer technoogy inked with surface science used to coat, sea or protect a diverse range of surfaces. The second is fibre technoogy, with particuar emphasis on ceuose chemistry. This is the type of business where individua products are indistinguishabe in nature and there are no specia needs of customers in reation to individua items of product. What is of interest to management is the cost and performance of the continuous process as a whoe. Definition Process costing is appropriate to a business or operation where there is a continuous fow of a reativey high voume of simiar products during a reporting period. Management s purposes in a continuous process business are no different from those in any other organisation. There is an overa requirement on the part of management for decision making and judgement. In this context, accounting information is required for management purposes of panning, decision making and contro. Management accounting contributes by: directing attention keeping the score soving probems. In particuar, management accounting must be abe to show, in reation to a fow process, how much cost has fowed through with the product into finished goods and how much remains with the work-in-progress. That is part of the score-keeping aspect of management accounting. If the process spits, taking different directions for different output, the management accountant wi be expected to contribute information

4 184 Part 1 Defining, reporting and managing costs reevant to decision making about the various products. That is an exampe of the probem-soving aspects of management accounting. This description of the management accountant s roe is not substantiay different from a description which coud appy in any job-costing situation; however, there are some specific probems in the process industries which require speciay designed management accounting techniques. This chapter deas with two of these probems, as foows: 1 Individua products cannot be distinguished for costing purposes. Costs cannot be assigned directy to products but must be aocated (spread) using some averaging basis. 2 Joint products and by-products are produced as an unavoidabe resut of the process of creating the main products. Tota costs must therefore be shared across main products and by-products. Joint products each have a significant saes vaue. By-products usuay have reativey ow saes vaue. 8.2 Aocation of costs to products in a process industry In process costing, items in production fow from one process to the next unti they are competed. Each process contributes to the tota operation and then passes its output to the next process unti the goods are finished and can be stored to await sae. Recording of costs foows the physica fow as cosey as possibe. Because it is not possibe to identify each unit of output on its way through the various processes, the concept of an equivaent unit is appied. Each competed item is equivaent to one unit of output, but each incompete item is equivaent to ony a fraction of a unit of output. This concept is particuary important at the end of the reporting period for deaing with items in process which are incompete. Definition An equivaent unit of output is the amount of output, expressed in terms of whoe units, which is equivaent to the actua amount of party or fuy competed production. Process costing requires severa stages of anaysis of the costs. These are: (a) coect the data for the period; (b) prepare a statement of physica fows and equivaent units of output for the period; (c) ascertain the tota costs to be accounted for this period; (d) cacuate the cost per equivaent unit; (e) apportion the cost between finished output and work-in-progress; and (f) check that a costs are accounted for. Coecting data requires information on the quantities of materias, abour and other resources put into the process and the quantities of products emerging from the process in any period of time. Because of the continuous nature of any process, it is ikey that some products wi be party competed at the beginning and end of the period. Such party competed work is referred to as work-in-progress. Information is aso required on the costs of the period, separated into materia, abour and production overheads. Sometimes the abour and overhead costs are referred to coectivey as conversion costs because they convert the input materias into products. Physica fows into and out of the process have to be identified. There wi be opening work-in-progress at the beginning of the period which is competed during the period. Some products wi be started and finished in the period. Some wi be started but wi be incompete at the end and wi be described as cosing work-in-progress.

5 Chapter 8 Process costing 185 Materias may be introduced at the beginning of the period, whie further materias may be introduced part-way through the period. Identifying the tota costs to be accounted for requires some care. There wi be costs incurred during the period, but there wi aso be costs brought forward from the previous period, incuded in the opening work-in-progress. A these costs must be shared between the products competed during the period and the work-in-progress remaining at the end of the period. The cost per equivaent unit is a particuar feature of process costing which takes into account the probem of party competed units at the beginning and end of the period. If an item is 40 per cent competed, then it represents the equivaent of 40 per cent (or 0.4 as a fraction) of one competed unit. So if there are 3,000 units hed, each of which is 40 per cent compete, they can be said to represent the equivaent of 1,200 competed units and woud be described as 1,200 equivaent units. Apportioning costs between finished output and work-in-progress is reativey straightforward. Once the cost per equivaent unit has been cacuated, it is mutipied by the number of equivaent units of finished items to give the cost of finished output and by the number of equivaent units of cosing work-in-progress to give the cost of cosing work-in-progress. Finay, it is essentia to check that nothing has been gained or ost in the arithmetic process by comparing the tota costs of input to the process with the tota costs of output in the period. If the totas are the same, then the worst probem that can have occurred is a misaocation between finished goods and work-in-progress. If the totas are not the same, a carefu search for errors is required. These steps in the process-costing approach are convenienty iustrated and expained by working through an exampe and commenting on the main features of interest Process costing where there is no opening work-in-progress Process costing can be a compicated exercise. However, to earn the approach it is best to start with a simpified exampe and work up to the various compications one at a time. Exhibit 8.2 iustrates process costing for the first month of a reporting period where there is no work-in-progress at the start of the month but there is some by the end. Five steps are shown, corresponding to the first five stages of the process described earier in this section. Exhibit 8.2 Process costing iustration: No opening work-in-progress Step 1 Coect data for the period The foowing information reates to the assemby department in a company manufacturing shower units for bathrooms. A pack of materias is introduced at the start of the process. The pack contains a pastic shower head, fexibe hose and various pumbing items. These are assembed by empoyees and then passed from the assemby department to the eectrica department for connection to the eectric power unit. At the end of the month there wi be some shower units ony party competed. The supervisor of the assemby department has estimated that these units are 40 per cent competed at that date. Data in respect of month 1 No work-in-progress at start of month. 60,000 units of raw materias introduced for conversion. 40,000 units of output competed during the month. 20,000 units of work-in-progress, 40 per cent competed at end of month. Costs incurred on materia, abour and overheads: 120,000. t

6 186 Part 1 Defining, reporting and managing costs Exhibit 8.2 continued Step 2 Prepare a statement of physica fows and equivaent units of output for the month The physica fow invoves 60,000 units entering the process for assemby. Of these, 40,000 are fuy assembed and 20,000 party assembed at the end of the period. This physica fow is shown in the eft-hand coumn as a check that a items are kept under contro. For accounting purposes the concept of an equivaent unit, as expained earier, is more important. So the fina coumn contains the equivaent units. For the goods which are finished during the month, the equivaent units are 100 per cent of the physica units. For the goods which are sti in progress, the equivaent units of 8,000 are cacuated as 40 per cent of the physica amount of 20,000 units of work-in-progress. Physica fow Equivaent units (units) of output Input: Materias introduced 60,000 60,000 Output: Goods finished this month 40,000 40,000 Work-in-progress at end (40 per cent competed) 20,000 8,000 Tota equivaent units 60,000 48,000 Step 3 Ascertain tota costs to be accounted for this period As there is no work-in-progress at the beginning of the period, the ony costs to be accounted for are the costs of 120,000 incurred during the period. Opening work-in-progress none Incurred this month 120,000 Tota to account for 120,000 Step 4 Cacuate cost per equivaent unit Continuing the emphasis on equivaent units (rather than physica units), a unit cost is cacuated by dividing the costs of the period, 120,000 as shown in step 3, by the number of equivaent units, 48,000, as shown in step 2. The benefit of having a cost per equivaent unit is that it gives a fair aocation to competed and party competed units, as shown in step ,000 Cost per equivaent unit = = ,000 Step 5 Apportion cost between finished output and work-in-progress The cost per equivaent unit, which is 2.50, is now appied to the finished output and to the work-in-progress, measuring the quantity of each in equivaent units. Vaue of finished output 40, ,000 Work-in-progress 8, ,000 Tota costs accounted for 120,000

7 Chapter 8 Process costing 187 Fiona McTaggart has the foowing comment. FIONA: From step 5 of Exhibit 8.2 you wi see that the tota costs accounted for are the same as the costs in step 3 which required aocation. It is aways important to check back to the starting data to make sure that nothing has been ost or created inadvertenty in the cacuation process. There coud sti be an error within the aocations if the wrong approach has been taken, so a separate check of a cacuations is generay usefu. It is aso good practice to expain in words what each cacuation is intended to achieve. If you cannot expain it in words, that is an indication that you do not fuy understand the cacuation and neither wi anyone ese reading your work. If you can expain with confidence, then it is more ikey that you are correct or, if you are incorrect, that the cause of any error wi be seen readiy by another person. Activity 8.1 Starting again with the data of Exhibit 8.2, cose the book and check that you are abe to produce the process cost information ending with the vaue of finished output and the vaue of work-in-progress. You must understand and be confident about Exhibit 8.2 before you read further Process costing where there is work-in-progress at the start of the period The first compication to be introduced is the presence of work-in-progress at the start of the period. Opening work-in-progress introduces a compication because it carries costs from the end of one period to the beginning of the next. The probem faced by the management accountant is to decide between two possibe courses of action. The first is to take those costs as being added to (accumuated) with the costs incurred in the current period and spread over a equivaent units of output. The second is to regard them as remaining firmy attached to the party competed products with which they arrived. The first of these possibiities is caed the weighted average method and the second is caed the first-in-first-out method. It wi be sufficient for the purposes of this textbook to iustrate the weighted average method, which is the more commony used in practice. Exhibit 8.3 takes on to month 2 the story which began in Exhibit 8.2. Work-inprogress is carried from the end of month 1 to the start of month 2. The weighted average method foows the same five steps as were used in Exhibit 8.2. The cost figure cacuated at step 3 is the tota of the costs brought forward with the opening work-inprogress and the costs incurred in the month. At step 4 the cost per equivaent unit is cacuated by dividing a costs by tota equivaent output. Here is Fiona McTaggart to comment. FIONA: This method is caed the weighted average approach because it averages a costs over a equivaent output and ignores the fact that some of the production started in the previous period. I usuay ike the weighted average method because it is not too fiddy and aows me to divide a costs of the period by the equivaent units of output without having to worry about what started where. However, some of my cients do not ike this approach because, they say, it is mixing some of ast month s costs with other costs incurred this month. Instead of spreading a costs over a production, their suggestion is to aocate this month s cost to the items started and finished in the month and to aow opening work-in-progress to carry the costs with which it arrived. My answer is that it s a good idea, but more time-consuming. I aso mention, tactfuy, that the approach has aready been thought of and is caed the first-in-first-out method of process costing. It requires more work by the accountant but generay gives resuts that are ony marginay different from the weighted average method.

8 188 Part 1 Defining, reporting and managing costs Exhibit 8.3 Process costing iustration: opening work-in-progress Step 1 Coect data for the period Step 1 starts by bringing forward the work-in-progress of month 1. If you ook back to step 1 of Exhibit 8.2 you wi see that the cosing work-in-progress was 20,000 units, each 40 per cent compete. To this is added 30,000 shower head packs for assemby. We are then tod that 35,000 units are competed and 15,000 are one-third competed at the end of month 2. Data in respect of month 2 20,000 units work-in-progress at start, 40 per cent compete. 30,000 units of raw materias introduced for conversion. 35,000 units of output competed during the month. 15,000 units of work-in-progress, one-third competed at end of month. Costs incurred on materia, abour and overheads: 120,000. Step 2 Prepare a statement of physica fows and equivaent units of output for the month In step 2 the eft-hand coumn is used to keep track of the physica fow of units and the right-hand coumn shows the equivaent units of output for month 2. For the finished goods the equivaent units are 100 per cent of the finished physica units but for the work-inprogress the equivaent units are one-third of the physica units, as specified in step 1. Physica fow (units) Input: Work-in-progress at start 20,000 Materia introduced 30,000 50,000 Equivaent units of output Output: Goods finished this month 35,000 35,000 Work-in-progress at end (33.3 per cent competed) 15,000 5,000 Tota equivaent units 50,000 40,000 Step 3 Ascertain tota costs to be accounted for during this period There are two separate eements of cost which together must be aocated to the tota equivaent units of output for the period. The first eement is the vaue of work-in-progress at the start of the period. This is a portion of the costs incurred in the first month that has been brought forward to the second month in order to match it with the units competed during the period. The second eement is the new cost incurred during the second month. Opening work-in-progress brought forward 20,000 Incurred this month 120,000 Tota to account for 140,000 Step 4 Cacuate cost per equivaent unit Continuing the emphasis on equivaent units, the cost of 140,000 cacuated in step 3 is divided by the tota number of equivaent units cacuated as 40,000 in step 2. The resut is a cost of 3.50 per equivaent unit, cacuated as foows: Cost per equivaent unit = = ,000 40,000

9 Chapter 8 Process costing 189 Exhibit 8.3 continued Step 5 Apportion cost between finished output and work-in-progress The cost of 3.50 per equivaent unit is appied to the equivaent units of finished output and to the equivaent units of work-in-progress. This gives a fair aocation of the tota cost of 140,000 between the finished and unfinished goods as foows: Vaue of finished output 35, ,500 Work-in-progress 5, ,500 Tota costs accounted for 140,000 Activity 8.2 Pause here to test your confidence of Exhibit 8.3. Take a note of the data provided at the start of the exampe, cose the book and write out the steps of the process cost cacuations. Write down a brief expanation of each step which you coud give to a feow student who has not read this chapter but woud ike an idea of what it contains Separate materia and conversion costs The iustrations provided so far have assumed that a materias are introduced at the start of the process. In practice, materias may be added at intervas during the process, so that conversion work can be carried out in stages. Exhibit 8.4 shows the separate anaysis of materias and conversion costs. It reates to a company which introduces materias into the process in two batches, so that work-in-progress might have a its materias added or might contain ony haf of the tota, depending on the stage of production reached at any particuar month-end. The conversion work is continuous throughout the month. Exhibit 8.4 Separate materias and conversion costs Step 1 Coect data for the period The business assembes pant propagation boxes. At the start of the process a set of pastic components is introduced, assembed and coated with a weather-proof protective coating. The gass pates are then added and a decorative finish given to the assembed unit. Because there are two points at which materias are introduced (pastic components and then gass pates), some items may be ony 50 per cent compete in respect of materias at the end of the reporting period. Data in respect of the month of Apri 4,000 units work-in-progress at start, 100 per cent compete in respect of materias, 25 per cent compete in respect of conversion. 6,000 units of raw materias introduced for conversion. 8,000 units of output competed during the month. 2,000 units of work-in-progress, 50 per cent compete in respect of materias, 10 per cent compete in respect of conversion. Cost of opening work-in-progress, 60,000, consisting of 30,000 for materias and 30,000 for conversion costs. Costs incurred in the month on materias are 150,000 and on conversion costs 216,000. t

10 190 Part 1 Defining, reporting and managing costs Exhibit 8.4 continued Step 2 Prepare a statement of physica fows and equivaent units of output for the month As in Exhibits 8.2 and 8.3, the physica fow is recorded in the eft-hand coumn. However, there are now two coumns to the right of this, each showing one component of the equivaent units of output. Using two coumns aows different percentages to be appied to work-inprogress for materias and conversion costs as foows: Physica fow Equivaent units of output (units) Materia Conversion Input: Work-in-progress at start 4,000 Materia introduced 6,000 10,000 Output: Goods finished this month 8,000 8,000 8,000 Work-in-progress at end 2,000 50% 1,000 10% 200 Tota equivaent units 10,000 9,000 8,200 Step 3 Identify tota costs to be accounted for this period In step 1 there is information about costs brought forward and costs incurred in the month. In each case the costs of the components of materias and conversion are shown separatey. This separate cassification aows the cacuation of a separate unit cost for each component. The tota costs to be accounted for under each heading are as foows: Materia Conversion Tota Opening work-in-progress brought forward 30,000 30,000 60,000 Incurred this month 150, , ,000 Tota costs to be accounted for 180, , ,000 Step 4 Cacuate cost per equivaent unit Two costs per equivaent unit can now be cacuated, one reating to materias and one to conversion. The tota costs from step 3 are divided by the equivaent units from step 2. Materias have been used in 9,000 equivaent units of output but conversion costs have been appied to ony 8,200 equivaent units of output. The cacuations are as foows: Tota costs to be accounted for Number of equivaent units Materia 180,000 9,000 Conversion Cost per equivaent unit The tota cost of an item of competed output is therefore 50 per equivaent unit. Work-inprogress at the end of the period is cacuated in two separate components, using the figures of 20 per equivaent unit of materias and 30 per equivaent unit of conversion work. Step 5 Apportion cost between finished output and work-in-progress 246,000 8,200 The unit costs cacuated in step 4 may now be appied to the finished goods and work-inprogress. The finished goods are 100 per cent compete in respect of materias and conversion costs, so it saves cacuation time to use the tota unit cost of 50 and mutipy it by the 8,000 finished units. For work-in-progress some care is needed. For the materias component, the work-inprogress is equivaent to 1,000 units, but for conversion costs it is equivaent to ony

11 Chapter 8 Process costing 191 Exhibit 8.4 continued 200 units, as shown in step 2. Separate cacuations are shown in the tabe beow for each component. The tota costs accounted for are 426,000 which is equa to the tota costs shown in step 3 above. Vaue of finished output 8, ,000 Work-in-progress: Materias 1, ,000 Labour ,000 26,000 Tota costs accounted for 426,000 Activity 8.3 Go back to the start of Exhibit 8.4. Take a note of the data provided and then cose the book. Write out a the steps of cost aocation for the process and make sure that you understand each stage. Imagine that you are a manager instructing an empoyee who wi prepare the monthy process cost statements. How woud you expain the steps of cost aocation in such a way that the empoyee coud produce reiabe data? How woud you check the work of such an empoyee? Rea word case 8.2 Reducing heat production costs The main markets for New Zeaand s forest industry are either dry or treated timber. In both cases heat energy is required. This heat demand comprises the arger part of the energy requirements of a sawmi. Process heat can be produced through either fossi fues or bioenergy. Burning wood waste to produce heat is a common way of saving costs on sawmiing sites. Amost haf of the wood in a sawmiing process ends up as some form of wood waste or is used for some other process. In a arge number of New Zeaand mis, this wood waste is burned to produce heat for drying kins and timber treatment pants. This fue is free in the sense that it is coected on site, but there are sti costs associated with handing the wood waste, storing the wood waste and capita investment. Mis that don t use wood waste wi be using some form of fossi fue in their heating pants, and the rising costs of fossi fues wi be impacting on the cost of manufacturing dry and treated timber. Source: Discussion points 1 Why is the wood waste fue not a free resource? 2 How coud the business estimate the cost saving in recycing wood waste as a fue?

12 192 Part 1 Defining, reporting and managing costs 8.3 Joint product costs and by-products A manufacturing process may resut in more than one product. If the second item is produced as an unavoidabe resut of producing the first, but has a significant saes vaue in comparison with the first, then it is caed a joint product. If the second item is produced as an unavoidabe resut of producing the first, but is of negigibe saes vaue, then it is caed a by-product. In the case of joint products, it is desirabe to know the separate cost of each item. Product costs may be required for vauing stocks and work-in-progress, cacuating product profitabiity, setting seing prices which cover costs and deciding whether to vary the mix of products. The accounting treatment of a by-product is somewhat different. Any proceeds of sae of the by-product are used to offset the cost of the main product, which incudes the cost of manufacturing the by-product. In the case of by-products it is not necessary to have a vauation for stock purposes because the item is reativey insignificant. It is more important for management purposes to know that the proceeds of sae of the by-product reduce the effective cost of the main product. Definitions Joint products are two or more products arising from a process, each of which has a significant saes vaue. A by-product is a product arising from a process where the saes vaue is insignificant by comparison with that of the main product or products. This section ooks firsty at joint costs and then at by-products. There are severa methods of aocating cost to joint products, two of which wi be expored here. These are: by physica measures and by reative saes vaue. The exampe contained in Exhibit 8.5 wi be used to compare both approaches. Exhibit 8.5 Data for use in aocation of joint costs A chemica process requires input of materias costing 900 per batch. From each batch there are two products, being 1,000 itres of perfume oi base which ses for 2 per itre and 500 itres of oi for artists paint which ses at 1 per itre Joint costs aocated on the basis of physica measures As stated in Exhibit 8.5, the proportions of physica measures are 1,000:500, which reduces to 2:1. Aocating the joint costs of 900 on the basis 2:1 gives 600 as the cost of perfume oi and 300 as the cost of artists paint oi. A statement of product profit is shown in Tabe 8.1. The cacuation of profit on each product is based on subtracting the aocated joint costs from the separate saes figures. In the fina ine of the exhibit the profit as a percentage of saes is shown. This is not a particuary good method of aocating costs because it shows one product as being much more profitabe, in reation to saes, than the other. That profitabiity is very much dependent on the aocation method used for the joint costs. Taken out of context, such an aocation might ead the managers of the business into an over-hasty decision to raise the price of the perfume oi base. It woud, however, be

13 Chapter 8 Process costing 193 a mistake to base such a decision on an aocation of costs that coud change when a different method is used. Now ook at what happens when the joint costs are aocated by reference to the saes vaue at the point of separation. Tabe 8.1 Statement of product profit for joint products: physica measures Perfume oi base Oi for artists paint Saes 2, Joint costs aocated Profit 1, Profit as % of saes 70% 40% Joint costs aocated by reative saes vaue at the point of separation A method which is generay thought to be an improvement on aocation by physica measures is that of aocating the joint cost of 900 in reation to the saes vaue at the point of separation. The saes vaue proportions are 2,000:500 so that the aocation is as foows: Perfume oi base 2,000/2, Oi for artists paint 500/2, A statement of product profit, based on this aocation, woud appear as in Tabe 8.2. Tabe 8.2 Statement of product profit for joint products: reative saes vaue Perfume oi base Oi for artists paint Saes 2, Joint costs aocated Profit 1, Profit as % of saes 64% 64% This approach eads to a profit which is 64 per cent of saes for each product. Aocating joint costs in proportion to saes vaue means that the performance measure, taken as the profit margin on saes, is not distorted by the cost aocation process. The cacuation woud eave the managers of a business satisfied that they had no probems with either product and woud avoid bringing on an i-considered decision to cease production of one product item Further processing costs Now consider a variation on the previous story. Suppose there are further costs incurred after the separation of the joint products. The information used earier is now amended somewhat in Exhibit 8.6, to introduce and iustrate this variation. The amendments are shown in bod print.

14 194 Part 1 Defining, reporting and managing costs Exhibit 8.6 Joint cost aocation where there are further processing costs A chemica process requires input of materias costing 900 per batch. From each batch there are two products, being 1,000 itres of perfume oi base which ses for 2 per itre and 500 itres of oi for artists paint which ses at 1 per itre. After the two products have been separated, further processing costs are incurred, amounting to 600 per batch in the case of perfume oi base and 100 per batch in the case of oi for artists paint. The recommended approach in this situation is to cacuate a notiona saes vaue at the point of separation. That is not as fearsome as it sounds. It requires taking the fina saes price of the item and deducting the processing costs incurred after separation. That eaves the notiona saes vaue at the point of separation. Cacuations are shown in Tabe 8.3, and from these cacuations it may be seen that the profit as a percentage of saes is no onger the same for each product. That is to be expected, however, because the costs after separation have a reativey different impact on each product. Tabe 8.3 Cost aocation based on notiona saes vaue at the point of separation (a) Cacuation of notiona saes vaue at the point of separation Seing price per batch 2, Costs incurred after separation Notiona seing price before separation 1, (b) Aocation of joint cost based on notiona seing price before separation Perfume oi base 1,400/1, Oi for artists paint 400/1, (c) Cacuation of profit for each joint product Perfume oi base Oi for artists paint Saes 2, Joint costs aocated Costs after separation , Profit Profit as % of saes Treatment of by-products By-products are items of output from a process which have a reativey minor saes vaue compared with that of the main product. The accounting treatment of by-products is simiar to the accounting treatment of scrap. The proceeds of sae are offset against the cost of the main product. An exampe of a process which eads to a by-product is set out in Exhibit 8.7. The cacuation of the cost of the main product, perfume oi base, and the resuting profit is shown in Tabe 8.4. The joint cost of 900 is reduced by the saes proceeds from the by-product, which are 50. The net cost of 850 becomes the cost of saes of the perfume oi, which is the main product. There woud be no usefu purpose in aocating cost to the by-product and then cacuating a separate figure of profit, because the amounts are insignificant.

15 Chapter 8 Process costing 195 Exhibit 8.7 Process which creates a by-product A chemica process requires input of materias costing 900 per batch. From each batch there are two products, being 1,000 itres of perfume oi base which ses for 2 per itre and 500 itres of waste oi which ses at 10 pence per itre. Tabe 8.4 Joint cost aocation and profit cacuation Saes of perfume oi base, per batch 2,000 Joint costs 900 Less: saes proceeds of waste oi by-product (50) Net cost per batch 850 Profit per batch 1, Reevance of aocating joint costs Is the aocation of joint costs usefu? In this chapter we have shown that this type of cost aocation is an exercise where there is a variety of possibe outcomes. Sometimes this variety of outcomes is described as an arbitrary aocation process because it depends so much on the choice made by the individua manager. Throughout this management accounting text there is an emphasis on the management purposes of panning, decision making and contro. If the purpose of the joint cost exercise is to aocate a costs in the fairest possibe manner for purposes of panning and contro, then using notiona saes vaue at the point of separation wi give a fair aocation in many circumstances. The aocation of fu cost may be required for purposes of stock vauation or it may be required for contro purposes to make senior managers aware that utimatey they have a responsibiity for a costs. If, however, a decision has to be made, such as processing further or changing a seing price, then that decision must be based on reevant costs rather than on a fu aocation of joint costs. Definition Reevant costs are those future costs which wi be affected by a decision to be taken. Non-reevant costs wi not be affected by the decision. The decision-making process therefore requires carefu attention to those costs which are reevant to the decision. This chapter concudes by setting out a decision where joint costs are present, but the aocation of those costs is not reevant to the decision. Activity 8.4 Expain to a production manager the joint cost probems raised by the foowing description of a process producing gass bottes. A typica mixture might be sand 60 per cent; imestone 8 per cent; soda ash 18 per cent; minera additives 5 per cent. Up to 25 per cent of the mix can comprise cuet (recyced gass). From one mixture the moten gass woud be run off into mouds for narrow bottes (such as wine bottes) and wide-mouth containers (such as jam jars). Bottes which have faws or chips are broken up and recyced.

16 196 Part 1 Defining, reporting and managing costs Rea word case 8.3 Corox is the goba eader in the production of beach. Corox aso makes aundry and ceaning items (Formua 409, Pine-So, Tiex), cat itter (Fresh Step), car-care products (Armor A, STP), the Brita water-fitration system (in North America), and charcoa briquettes (Kingsford). Its First Brands buy gave Corox Gad-brand pastic wraps, storage bags, and containers. Process Cost Evauation Corox s approach to cost management is grounded on an in-depth understanding of its key processes and the resources consumed by these processes. Corox conducts an exhaustive anaysis to map its 25 key processes and, based on historica activity-based costing information, it assesses a god-standard cost for each process. The company continuousy evauates the resources consumed by each process against this god standard to uncover potentia inefficiencies. The company s process orientation is based on the beief that a tota-vaue-chain view rather than a (traditiona/redundant) isoated-activity view is key to understanding inefficiencies. The company tries to understand the interreationships between each step in a process and between processes to identify unnecessary redundancy and compexity Source: Discussion points 1 What are the aspects of the beach manufacturing industry that make process costing usefu? 2 Why is process costing particuary suitabe for this company? 8.4 Decisions on joint products: se or process further Where there are joint products there may be a decision required at the point where they separate. The decision usuay invoves the prospect of incurring further costs with the hope of improving revenue thereby. Is it worthwhie to incur the extra cost of adding perfume? The decision shoud be based on incrementa costs and incrementa revenues, as iustrated in the exampe shown in Exhibit 8.8, which is anaysed in Tabe 8.5. Definition Incrementa costs are the additiona costs that arise from an activity of the organisation. To justify incurring incrementa costs it is necessary to show they are exceeded by incrementa revenue.

17 Chapter 8 Process costing 197 Exhibit 8.8 Situation requiring a decision In a company manufacturing persona care products, a process requires the input of ingredients costing 400 per batch. Separation of the output from each batch yieds 200 itres of hand cream which ses at a price of 1.60 per itre and 200 itres of soap soution which ses at a price of 80 pence per itre. The soap soution in that form is suitabe for industria use, but at a further cost of 50 per batch of 200 itres it coud be perfumed and sod for domestic use at 1.20 per itre. Activity 8.5 Write down, with reasons, the action you woud recommend for the situation described in Exhibit 8.8. Then read the commentary by Fiona McTaggart and check your answer against Tabe 8.5. Did you arrive at the same answer? If not, what was the cause of the difference? Fiona McTaggart has given some thought to this probem. FIONA: The decision question contained in Exhibit 8.8 is, Do we make soap for industria use or do we make it suitabe for domestic use? What is not in question is the production of hand cream and the production of soap soution. This means that the information about hand cream is not reevant to the decision and neither is the information about the costs of ingredients. I have rewritten the information in Exhibit 8.8 and highighted the information reevant to this decision probem, as foows: In a company manufacturing persona care products, a process requires the input of ingredients costing 400 per batch. Separation of the output from each batch yieds 200 itres of hand cream which ses at a price of 1.60 per itre and 200 itres of soap soution which ses at a price of 80 pence per itre. The soap soution in that form is suitabe for industria use, but at a further cost of 50 per batch of 200 itres it coud be perfumed and sod for domestic use at 1.20 per itre. My cacuation of the incrementa revenue and costs is shown in Tabe 8.5. It shows that there is an extra profit of 30 per batch if the soap soution is perfumed for domestic use. So the decision shoud be to go ahead. In reation to the decision, aocation of the joint cost of 400 is not reevant because it is a cost which is incurred regardess of whether the perfume is added. In a simiar vein, pricing decisions shoud have regard to the need to cover tota costs but shoud not be based on arbitrary aocations of costs across products. Tabe 8.5 Statement of incrementa costs and revenues Incrementa revenue 200 itres ( ) 80 Incrementa cost 50 Incrementa profit per batch What the researchers have found Process costs, standard costs and ABC Sharman and Vikas (2004) are enthusiastic supporters of German cost accounting. Sharman, in particuar, is concerned that there has been too much emphasis in the US

18 198 Part 1 Defining, reporting and managing costs on financia reporting and auditing. He sees management accounting as a part of the processes inside an organisation that hep to create good governance. Their paper incudes a description of process-based costing as appied by Deutsche Teekom. This process-based costing is described as a more discipined form of activity based costing where standard costs are inked to ABC in providing cost information about the processes in a terrestria teephone system. Understanding the business process is an essentia condition of designing a usefu and reevant costing anaysis. The paper is interesting for its description of the system used by Deutsche Teekom, but it aso iustrates how a major company can design its own management accounting by taking aspects of a range of textbook modes. In this case it inks ABC and standard costs to produce a company-wide costing of the processes of the business Joint costs Trenchard and Dixon (2003) expain a rea-ife joint cost probem found in the not-forprofit manufacture of bood products in the UK. There is a ega requirement for cost-based transfer pricing. However, the cost of the bood products is not cear. Transfusion services provide a joint pateet product and a more costy, but better quaity, non-joint aternative. For accounting convenience, a the joint costs are aocated to red ces and none to pateets. So the pateets have a zero cost at the point of spitting them off from the red bood ces. The paper is a research note in which the authors describe the probem, rather than soving it. They suggest that one method of aocating the joint costs woud be to reate these to a measure of the reative usefuness of each product. Then they discuss the ways of measuring usefuness in a cinica sense. This proposa to evauate usefuness gives a not-for-profit aternative to the saes-based method normay suggested for aocating joint costs. 8.6 Summary Key themes in this chapter are: Process costing is a technique which can be appied to a business or operation where there is a continuous fow of a reativey high voume of simiar products during a reporting period. It is a contrast to job costing (see Chapter 6) where separate jobs or products may be identified for cost aocation and apportionment. In a process some units are compete but others are part-compete. The idea of an equivaent unit of output aows whoe units and part units to be added so that costs can be shared across them. The weighted average approach averages a costs over a the equivaent output of the period and ignores the fact that some of the production started in the previous period. Joint products arise when a manufacturing process eads to two or more products, each having a significant saes vaue. A by-product is a product arising from a process where the saes vaue is insignificant by comparison with that of the main product or products. When a decision is required on whether to process joint products further rather than se them at the point of separation, reevant costs must be compared. The reevant costs are the incrementa costs, which are justified if they produce a higher incrementa revenue.

19 References and further reading Chapter 8 Process costing 199 Sharman, P. and Vikas, K. (2004) Lessons from German cost accounting, Strategic Finance, December: Trenchard, P.M. and Dixon, R. (2003) The cinica aocation of joint bood product costs: research note, Management Accounting Research, 14: QUESTIONS The Questions section of each chapter has three types of question. Test your understanding questions to hep you review your reading are in the A series of questions. You wi find the answer to these by reading and thinking about the materia in the textbook. Appication questions to test your abiity to appy technica skis are in the B series of questions. Questions requiring you to show skis in Probem soving and evauation are in the C series of questions. A symbo [S] means that there is a soution avaiabe at the end of the book. A Test your understanding A8.1 Which industries might need to use the techniques of process costing (section 8.1)? A8.2 What is meant by the term equivaent unit (section 8.2)? A8.3 What are the steps to foow in cacuating the cost of finished goods and the vaue of cosing work-in-progress in respect of a reporting period (section 8.2.1)? A8.4 Where there is work-in-progress at the start of any reporting period, how is this accounted for using the weighted average approach (section 8.2.2)? A8.5 Why may it be necessary to account for materias and conversion costs separatey (section 8.2.3)? A8.6 What is the difference between a joint product and a by-product (section 8.3)? A8.7 How may joint costs be aocated to joint products using a basis of physica measures (section 8.3.1)? A8.8 How may joint costs be aocated to joint products using a basis of reative saes vaue (section 8.3.2)? A8.9 How is reative saes vaue at the point of separation determined when there are further processing costs of each joint product after the separation point (section 8.3.3)? A8.10 What is the accounting treatment of cash coected from the sae of a by-product (section 8.3.4)? A8.11 Why shoud care be taken when using process costing information for decision making in respect of joint products (section 8.4)? A8.12 Why is it necessary to use incrementa revenues and costs in making a decision on whether to se or to process further in the case of joint products (section 8.4)? A8.13 What have researchers found about the potentia for inking process costs, standard costs and activity-based costs (section 8.5.1)? A8.14 What have researchers found about the impact of joint cost probems in a not-for-profit situation (section 8.5.2)? A8.15 [S] Work-in-progress at the end of the month amounts to 2,000 physica units. They are a 40% compete. What are the equivaent units of production? The cost of production is 3 per equivaent unit. What is the vaue of work-in-progress?

20 200 Part 1 Defining, reporting and managing costs A8.16 [S] In process X there are 12,000 units competey finished during the month and 3,000 units of work-in-progress. The work-in-progress is 60% compete for materias and 20 per cent compete for conversion costs (abour and overhead). What are the equivaent units of production for the work-in-progress? A8.17 [S] XYZ Ltd processes and purifies a basic chemica which is then broken down by reaction to give three separate products. Expain the approaches to joint cost aocation using the foowing information: Product Units produced Fina market vaue Costs beyond per unit ( ) spit-off point ( ) A 3, ,000 B 1, ,800 C 2, ,400 Joint costs incurred up to the spit-off point are 2,000. B Appication B8.1 [S] In a continuous fow process, the foowing information was coected in reation to production during the month of May: Units Work-in-progress at start of month (60% compete) 50,000 New units introduced for processing 80,000 Competed units transferred to store 100,000 Work-in-progress at end of month (20% compete) 30,000 Opening work-in-progress was vaued at cost of 42,000. Costs incurred during the month were 140,000. Required Cacuate the vaue of finished output and work-in-progress using the weighted average method. B8.2 [S] Cay Products Ltd produces handmade decorative vases. A process costing system is used. A materias are introduced at the start of the process. Labour costs are incurred uniformy throughout the production process. The foowing information is avaiabe for the month of Juy: Work-in-progress at 1 Juy (60% compete) Work-in-progress at 31 Juy (30% compete) The vaue of work-in-progress at 1 Juy is as foows: 2,000 units 1,200 units Direct materias cost 1,700 Direct abour costs 1,900 3,600 During the month of Juy, 7,000 vases were transferred to finished goods stock. Materias introduced cost 14,700. Labour costs incurred were 12,820. Required Using the method of weighted averages, prepare a process cost statement for the month of Juy showing unit costs, the vaue of finished goods and the vaue of work-in-progress at the end of the month.