Process Costing System for Manufacturing CompanyThe two basic types of manufacturing processes are the job order approach where each order is customized, and mass production, where the product is always the same. To accompany these procedures are the two traditional types of cost accounting systems: job order costing system and “Process Costing System.” The information captured by these cost accounting systems aids managers in determining total production costs. Process costing system used by manufacturing companies that produce homogeneous product. Other manufacturing companies that produce various similar products also use the same costing system. How does “Process Costing System” work? How the cost accounting carried on the manufacturing process using the process costing approach?

Advertisement

This post describes process costing system for manufacturing companies. For better understanding, cost accounting for manufacturing company in general is described first. For faster page load, this post is broken down into two pages:

 

 

Cost Accounting for Manufacturing Company in General

Manufacturing companies have several different accounts compared to service and merchandising companies. These include three types of inventory accounts—raw materials, work-in-process, and finished goods—and several long-term fixed asset accounts. A manufacturing company uses purchased raw materials and/or parts to produce a product for sale. At a point in time, the company’s inventories consist of raw materials, those materials and parts waiting to be used in production; work-in-process, all material, labor, and other manufacturing costs accumulated to date for products not yet completed; and finished goods, the cost of completed products that are ready to be sold. The value of each type of inventory is disclosed in a company’s financial statements. The amounts may be shown individually on the face of the balance sheet or disclosed in footnotes.

In the long-term asset section of a manufacturing company’s balance sheet, one would expect to find factory buildings and equipment and possibly a small tools account. A manufacturer often has patents for its products or processes. The capitalized costs associated with a patent would be included in the intangible asset section of the balance sheet. The income statement for a manufacturing company is similar to that prepared for a merchandising company. In calculating cost of goods sold, only the finished goods inventory account is used, as shown.

 

1. Costing TerminologyExpenses on an income statement are considered product or period costs. Product costs are those costs assigned to an inventory account that eventually become part of cost of goods sold. Examples of manufacturing product costs are raw materials used, direct labor, factory supervisor’s salary, and factory utilities. In a manufacturing company, product costs are also called manufacturing costs. In a service company, product costs are also accumulated as inventory (such as the cost of an audit or of a will). Period costs are those costs recorded as an expense in the period they are incurred. Selling expenses such as sales salaries, sales commissions, and delivery expense, and general and administrative expenses such as office salaries, and depreciation on office equipment, are all considered period costs. In a manufacturing company, these costs are often referred to as non-manufacturing costs. There are three categories of manufacturing costs: direct materials, direct labor, and overhead.

  • Direct Materials – are those materials (including purchased parts) that are used to make a product and can be directly associated with the product. Some materials used in making a product have a minimal cost, such as screws, nails, and glue, or do not become part of the final product, such as lubricants for machines and tape used when painting. Such materials are called indirect materials and are accounted for as manufacturing overhead.
  • Direct Labor – is the cost of the workers who make the product. The cost of supervisory personnel, management, and factory maintenance workers, although they are needed to operate the factory, are classified as indirect labor because these workers do not use the direct materials to build the product.
  • Manufacturing Overhead Costs – include indirect materials, indirect labor, and all other manufacturing costs. Depreciation on factory equipment, factory rent, factory insurance, factory property taxes, and factory utilities are all examples of manufacturing overhead costs.

 

Together, the direct materials, direct labor, and manufacturing overhead are referred to as manufacturing costs. The costs of selling the product are operating expenses (period cost) and not part of manufacturing overhead costs because they are not incurred to make a product.

 

2. Cost of Goods Manufactured Schedule – The cost of goods manufactured schedule is used to calculate the cost of producing products for a period of time. The cost of goods manufactured amount is transferred to the finished goods inventory account during the period and is used in calculating cost of goods sold on the income statement. The cost of goods manufactured schedule reports the total manufacturing costs for the period that were added to work-in-process, and adjusts these costs for the change in the work-in-process inventory account to calculate the cost of goods manufactured. (Note: See how the cost of goods manufactured schedule connected with Cost of Goods Sold and Income Statement at the end of this section)

 

3. Accounting by Manufacturing Companies – The accounting cycle is the same in a manufacturing company, merchandising company, and a service company. Journal entries are used to record transactions, adjusting journal entries are used to recognize costs and revenues in the appropriate period, financial statements are prepared, and closing entries are recorded. Raw material purchases are recorded in the raw material inventory account if the perpetual inventory method is used, or the raw materials purchases account if the periodic inventory method is used.

For example, using the periodic inventory method, the purchase of $750 of raw materials on account is recorded as an increase (debit) to raw materials purchases and an increase (credit) to accounts payable.

[Debit]. Raw Materials Purchases = 750

[Credit]. Accounts Payable—ABC Co. = 750

(To record purchase materials from ABC)

 

The entry to record payroll would include an increase (debit) to direct labor instead of wages expense and an increase (credit) to the withholding liability account and wages payable. To record $1,000 wages for Patrick Morgan, the entry would be:

[Debit]. Direct Labor = 1,000

[Credit]. Federal Income Taxes Payable = 150.00

[Credit]. Payroll Taxes Payable = 76.50

[Credit]. Credit Union Payable = 50.00

[Credit]. Wages Payable = 723.50

(To record Patrick Morgan wages)

 

The factory building depreciation of $9,500 is classified as a manufacturing cost. It is recorded with an increase (debit) to factory depreciation and an increase (credit) to accumulated depreciation—building.

[Debit]. Factory Depreciation Expense = 9,500

[Credit]. Accumulated Depreciation—Building = 9,500

(To record factory building depreciation)

 

Some companies use one account, factory overhead, to record all costs classified as factory overhead. If one overhead account is used, factory overhead would be debited in the previous entry instead of factory depreciation.

At the end of the month, they get three types of report:

 

(a). Cost of Goods Manufactured Schedule

Cost of Goods Manufactured Schedule

(b). Cost of Goods Sold

Cost of Goods Sold Example

 

(c). Income Statement

Income Statement - Manufacturing Company

Note: Have a look how those three report connected (see the red and blue arrows)

 

4. Closing Procedure – At the end of the cycle, the closing entries are prepared. For a manufacturing company that uses the periodic inventory method, closing entries update retained earnings for net income or loss and adjust each inventory account to its period end balance. A special account called “Manufacturing Summary” is used to close all the accounts whose amounts are used to calculate cost of goods manufactured. The manufacturing summary account is closed to income summary. Income summary is eventually closed to retained earnings. The manufacturing accounts are closed first.

 

Step-1 (C1). Adjust inventory balances:

[Debit]. Raw Materials Inventory (Ending) = 5,800

[Debit]. Work-in-Process Inventory (Ending) = 9,800

[Credit]. Manufacturing Summary = 15,600

 

Step-2. (C2). Close manufacturing accounts and adjust inventory balances:

[Debit]. Manufacturing Summary = 270,600

[Credit].Raw Materials Inventory (Beginning) = 6,200

[Credit].Work-in-Process Inventory (Beginning) = 10,200

[Credit].Raw Materials Purchases = 49,400

[Credit].Direct Labor = 125,600

[Credit].Indirect Materials = 4,100

[Credit].Indirect Labor = 43,700

[Credit].Depreciation—Factory Building = 9,500

[Credit].Depreciation—Factory Equipment = 5,400

[Credit].Insurance—Factory = 12,000

[Credit].Property Taxes—Factory = 4,500

 

Step-3. (C3). Close manufacturing summary:

[Debit]. Income Summary = 255,000

[Credit]. Manufacturing Summary = 255,000

 

Step-4 (C4). Close revenue accounts and adjust inventory:

[Debit]. Finished Goods Inventory (Ending) = 12,600

[Debit]. Sales = 427,000

[Debit]. Interest Revenue = 5,100

[Credit]. Income Summary = 444,700

 

Step-5 (C5). Close operating expense accounts and adjust inventory:

[Debit]. Income Summary = 169,875

[Credit].Finished Goods Inventory (Beginning) = 14,500

[Credit].Sales Salaries Expense = 65,300

[Credit].Depreciation—Sales Equipment = 21,000

[Credit].Office Salaries Expense = 35,000

[Credit].Depreciation–Office Equipment = 12,000

[Credit].Insurance Expense = 9,000

[Credit].Office Supplies Expense = 2,400

[Credit].Income Tax Expense = 10,675

 

Step-6 (C6). Close income summary:

[Debit]. Income Summary = 19,825

[Credit].Retained Earnings = 19,825

 

The following T-accounts illustrate the impact of the closing entries on the special closing accounts and retained earnings:

Manufacturing and Income Summary Closing Entries

 

Note: Have a look how “manufacturing summary” closed to the “income summary” and income summary finally closed to the “retained earning” that will be shown up on the company “balance sheet” under the equity sub heading.

 

Continue reading: Page-2. Process Costing System for Manufacturing Company