Process costing focuses on the direct and allocated costs associated with the operation of a given area of the manufacturing flow. Maybe it’s a work center, a cost center, or a specific production line, but what it really represents is an area where you want to determine the unique cost added to the product as a result of traveling through that area.
Step 1 – Collect Direct Spending
In order to calculate a process cost, the first thing you need is to collect the pools of direct spending at the account or sub-account level. These pools represent dollars that you plan to spend (or actually spend in the case of actual costs) in the area. Typical pools include labor, depreciation, and energy and the information is usually found in the general ledger.
Step 2 – Allocate Indirect Spending
Next, you need to focus on the spending that occurs outside the manufacturing areas based on the appropriate drivers. Trying to determine the most appropriate driver is sometimes challenging (see Picking the Right Driver Is Important To More Than Just Your Golf Game), but the focus should lie in finding a driver that you are able to measure and capture.
Step 3 – Calculate Cost Center Rates
Once you’ve pooled the dollars for the production area, you can then calculate rates expressed in dollars per “something”. That something depends on the rate. In most cases, the rate is stated in dollars per machine hour, dollars per batch, or even a simple dollars per unit produced rate. Now, you can keep the rates at the natural cost element or cost pool level so you’re able to use a unique driver for each rate and provides a better view of the composition of the production area.
Step 4 – Proper Assignment of Process Rates to Products
Finally you can assign costs to the products using the calculated rates. As products move through the production area, you’re able to assign costs at the natural cost element or cost pool level using a differed driver for each pool.
Comparing the costs associated with a particular machine, department, line or location gives you the information to decide where and how to manufacture products. By calculating process costs, you know how costs are accrued as they pass through your manufacturing process.
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Slowly, automation crept into factories, and the direct labor basis for allocations began to deliver less-accurate results. Why? Because automation means there is less human involvement in the production process. Let’s say the plant has some half of the factory’s lines are automated. The products made on the automated lines are assigned less overhead while the more conventionally produced products are overcharged. As you can imagine, some really poor decisions can occur with the wrong allocation rates.