Process Costing

Process costing is probably the most widely used method of cost ascertainment.
It is used in mass production industries producing standard products, like steel,
sugar and chemicals. In all such industries, goods produced are identical and all
factory processes are standardized. Goods are produced without waiting for any
instructions or orders from customers and are put into warehouse for sale. Raw
materials move down the production line through a number of processes in a
particular sequence and costs are compiled for each process or department by
preparing a separate account for each process
In most of the industries in which process costing is used, two or more products
are unavoidably produced from the same process and same raw materials.
These products are produced in natural proportions which cannot be changed at
the will of the management. For example, in an oil refinery, when crude oil is
processed, many products are simultaneously produced from the same set of
inputs.
Examples of these products are petrol, kerosene oil, diesel, grease and
lubricatingoils. Such products are known as joint products or by-products.
Features
1. The production is continuous and the final product is the result of a sequence
of processes.
2. Costs are accumulated process-wise.
3. The products are standardized and homogeneous.
4. The cost per unit produced is the average cost which is calculated by dividing
the total process cost by the number of units produced.
5. The finished product of each but last process becomes the raw material for the
next process in sequence and that of the last process is transferred to the
finished goods stock.
6. The sequence of operations or processes is specific and predetermined.
7. Some loss of materials in processes (due to chemical action, evaporation, etc.)
is unavoidable.
8. Processing of a raw materials may give rise to the production of several
products. These several products produced from the same raw material may be
termed as joint products or by-products.
Job Costing vs. Process Costing
A comparison of process and job costing methods will help in the better
understanding of process costing system.
Process Costing Procedure and Process Cost Accounts
The essential stages in process costing procedure are:
1. The factory is divided into a number of processes and an account is
maintained for each process.
2. Each process account is debited with material cost, labour cost, direct
expenses and overheads allocated or apportioned to the process.
3. The output of a process is transferred to the next process in the sequence.
In other words, finished output of one process becomes input of the next process.
4. The finished output of the last process (i.e., the final product) is transferred to
the Finished Goods Account.
A product passes through three distinct processes to completion. These
processes are named respectively, X, Y and Z. During the week ended 31
January, 1,000 units are produced. The following information is obtained:
The indirect expenses for the period were Rs 2,800 and apportioned to the
processes on the basis of labour cost. Prepare the process accounts showing the
total cost and cost per unit (10 marks)

Process Process Process

Particulars
X Y Z

Materials 6,000 3,000 2,000

Labour 5,000 4,000 5,000

 Direct
1,000 200 1,000
expenses

Process Losses and Wastages

In industries which employ process costing, a certain amount of loss occurs at
various stages of production. Such a loss may arise due to chemical reaction,
evaporation, inefficiency, etc. It is, therefore, necessary to keep accurate records
of both input and output. Where loss occurs at a late stage in manufacture, it is
apparent that financial loss is greater. This is because more and more costs are
incurred in processes as products move towards completion stage.
Process losses may by classified into (a) normal, and (b) abnormal.
Normal Process Loss
That amount of loss which cannot be avoided because of the nature of material
or process is normal process loss. Such a loss is quite expected under normal
conditions. It is caused by factors, like chemical change, evaporation,
withdrawals for tests or sampling and unavoidable spoiled quantities.
Abnormal Process Loss
This type of loss consists of loss due to carelessness, machine breakdown,
accident, use of defective materials, etc. Thus, it arises due to abnormal factors
and represents a loss which is over and above the normal loss.
Accounting procedure for normal and abnormal loss differs.
Accounting Treatment of Normal Loss
It is a fundamental costing principle that the cost of normal losses should be
borne by the good production. Normal loss is generally determined as a
percentage of input. Sometimes such a loss is due to loss of weight, say, due to
evaporation or chemical action. Since such a wastage is not physically present,
obviously it cannot have any value.
However, when normal loss is physically present in the form of scrap, it may
have some value, i.e., it may be sold at some price. Whenever scrapped material
has any value, it is credited to the Process Account.
Accounting Treatment of Abnormal Process Loss
It has been stated earlier that abnormal loss is due to carelessness, accidents,
machine breakdown and other abnormal reasons. Unlike normal loss, abnormal
loss is not absorbed by good production, rather it is transferred to Costing Profit
and Loss Account. This is because if the cost of abnormal loss were to fall upon
the good production, the cost thereof will fluctuate and the information provided
would be misleading. Abnormal process loss cost is computed as below

Abnormal Gain or Effectiveness

The normal process loss represents the loss that would be expected under
normal conditions. It is an estimated figure. The actual loss may be greater or
less than the normal loss. If the actual loss is greater than normal loss, it is
known as abnormal loss. But if actual loss is less than normal loss, a gain is
obtained which is termed as abnormal gain or effectiveness. The value of
abnormal gain is calculated in a manner similar to abnormal loss. It is shown on
the debit side of the Process Account and credit side of the Abnormal Gain
Account. Like abnormal loss, it is ultimately transferred to Costing Profit and Loss
Account.
The following information is given regarding Process A:
Materials - 1000 kgs at Rs 6 per kg
Labour - Rs 5,000
Direct expenses- Rs 1,000
Indirect expenses allocated to process A is Rs 1,000. Normal wastage is 10% of
input
Show the Process A account when:
 Scrap value of normal loss is NIL
 Scrap value out of normal loss has a sale value of Rs 1 per unit
From the following information, prepare
 a process account,(5 marks)
 abnormal gain account (3 marks
 normal loss account (2 marks)
Input of raw materials 840 units @Rs 40 per unit
Direct materials -Rs 5,924
Direct wages-Rs 8,000
Overheads- Rs 8,000
Actual output - 750 units
Normal loss - 15%
Value of scrap per unit - Rs 10 per unit
 CONTRACT COSTING
Contract costing is a sub-type of job costing. Herein accounts for each and every
contract is opened separately since each contract is considered to be a cost unit.
This type of costing has several benefits. It helps the managers ascertain cost
per contract, the total cost of contracts as well as the profit made over every
contract. There is also no delay in the work being completed. The managers have
a control over the performance of the contract and there are minimal chances of
incurring losses. In this unit, you will learn the procedure of contract costing and
will further learn about the different types of contract costing
PROCEDURE FOR CONTRACT COSTING
The basic procedure for costing of contracts is as follows:
1. Contract account: Each contract is allotted a distinct number and a separate
account is opened for each contract.
2. Direct costs: Most of the costs of a contract can be allocated direct by to the
contract. All such direct costs are debited to the contract account.
Direct costs for contracts include: (i) Materials; (ii) Labour and supervision; (iii)
Direct expenses; (iv) Depreciation of plant and machinery; (v) Subcontract costs,
etc.
3. Indirect costs: Contract account is also debited with overheads which tend to
be small in relation to direct costs. Such costs are often absorbed on some
arbitrary basis as a percentage on prime cost, or materials, or wages, etc.
Overheads are normally restricted to head office and storage costs.
4. Transfer of materials or plant: When materials, plant or other items are
transferred from the contract, the contract account is credited by that amount.
5. Contract price: The contract account is also credited with the contract price.
However, when a contract is not complete at the end of the financial year, the
contract account is credited with the value of work-in-progress as on that date.
6. Profit or loss on contract: The balance of contract account represents profit or
loss which is transferred to Profit and Loss Account. However, when contract is
not completed within the financial year, only a part of the profit arrived is taken
into account and the remaining profit is kept as reserve to meet any contingent
loss on the incomplete portion of the contract.
Special Points in Contract Costing
Some of the important points to be considered in contract costing are now
discussed:
Cost of Materials
Materials include: (i) materials specifically purchased for the contract; (ii)
materials issued from store against material requisition notes. The cost of both
these types of materials is debited to the contract account.
Materials Returned to Store: Whenever materials are issued in excess of
requirements, for instance, cement, sand, pipes and bricks, these are later
returned to the store accompanied by a Material Return Note which gives the
details of the materials returned. Such returned materials are credited to
contract account.
Materials at Site: At the end of each accounting period, value of materials lying
unused at site is credited to contract account and is carried forward for charging
against the next period.
Cost of Labour
All wages of workers engaged on a particular contract are charged direct to the
contract, irrespective of the type of work they perform. When several contracts
are running at different locations, payroll is normally sectionalized so as to have
separate payroll for each contract. Difficulties in costing may be encountered
when some workers may have to move from one site to another if a number of
small contracts are undertaken. In such situations, it becomes necessary to
provide time sheets from which allocations can be made. In order to control
labour utilization and prevent fraud in the payment of wages, surprise visits by
head-office personnel will be necessary
Payment based on Architect’s Certificate
In case the contract is small, full payment is usually made on the completion of
the contract. But in case of large contracts, it may take more than one year to
complete. In such a case, if no payment is received until the completion of the
contract, the financial resources of the contractor could surely become strained.
Therefore, a system of progress payments is followed. In this system, part
payments of the contract amount are paid from time to time on the basis of
certificate issued by the architects (acting for the contractee), certifying the
value of the work satisfactorily completed. Such payments received by the
contractor are usually credited to the personal account of the contractee. It
should be noted that such payments are not entered in the Contract Account.
Work Certified and Work Uncertified
When the contract is not completed till the end of the accounting year, the
architect is required to value the work-in-progress. Such work-in-progress is
classified into work certified and work uncertified.
Work Certified: This is that part of the work-in-progress which has been approved
by the contractee’s architect or engineer for payment. Work certified is valued at
contract price (i.e., selling price), and includes an element of profit.
Work Uncertified: This is that part of the work-in-progress which is not approved
by the architect or engineer. This is valued at cost and thus does not include an
element of profit.
Both work certified and uncertified appear on the credit side of the contract
account and also on the assets side of the balance sheet
TYPES OF CONTRACT COSTING
In this section, you will study the different types of contracts and in essence
types of contract costing.
Profit from Incomplete Contract
Contracts which are started and finished during the same financial year create
no accounting problems. But in case of those contracts which take more than
one year to complete, a problem arises whether profit on such contracts should
be worked out only on the completion of the contract or at the end of each
financial year on the partly completed work. If profit is computed only on the
completion of the contract, profit will be high in the year of completion of the
contract, whereas in other years of working on contract, profit will be nil. This
would result not only in distorted profit pattern but also higher tax liability
because income tax at higher rates may have to be paid. Therefore, when
contracts extend beyond a year, it becomes necessary to take into account the
profit earned (or loss incurred) on the work performed during each year. This
helps in avoiding distortion of the year-toyear profit trend of the business.
There are two aspects of profit computation:
(a) Computation of notional profit or estimated profit.
(b) Computation of the portion of such profit that is to be transferred to Profit and
Loss Account.
Notional Profit
Notional profit is the difference between the value of work-in-progress certified
and the cost of work-in-progress certified.
Notional profit is the difference between the value of work-in-progress certified
and the cost of work-in-progress certified. It is computed as follows (Figures are
assumed):
Value of work certified 20,00,000
Add: Cost of work not yet certified 1,50,000
Less: Cost of work to date 19,00,000
Notional Profit 2,50,000
If in any year, cost of work done exceeds the value of work certified and
uncertified, the result will be a notional loss.
Estimated Profit
Estimated profit represents the excess of the contract price over the estimated
total cost of the contract. It is computed as follows (Figures are assumed):
Contract Price 30,00,000
Less: Total cost already incurred 21,00,000
Less: Estimated additional costs to complete the contract 3,50,000
Estimated Profit 5,50,000
Portion of Notional Profit or Estimated Profit to be Transferred to Profit and Loss
Account
The portion of the notional or estimated profit to be transferred to P&L Account
depends upon the stage of completion of the contract, i.e., ratio of work-in-
progress certified to total contract work. For this purpose work-in-progress
uncertified is not considered. Prudence requires that the total notional profit
should not be transferred to P&L Account but a portion of it should be withheld as
a reserve to meet any unforeseen future expenses or contingencies.
Loss on Uncompleted Contracts: In the event of a loss on uncompleted contracts,
this should be transferred in full to the Profit and Loss Account, whatever be the
stage of completion of the contract. It was stated earlier also that these are not
hard and fast rules. The practice may vary from firm-to-firm depending upon the
nature of work involved, degree of risk in the business, extent of work
completed, etc. But whatever method is adopted, it should be applied
consistently from year-to-year so as not to disturb the trend of profits.
The following expenditure was incurred on a contract of Rs 12,00,000 for the
year ending 31-12-2022.
Materials - Rs 2,40,000
Wages - Rs 3,28,000
Plant - 40,000
Overheads- 17,200
Cash received on account of the contract to 31st December 2022 was Rs
4,80,000, being 80% of the work certified. The value of materials on hand was
Rs20,000. The plant has undergone 20% depreciation
Prepare contract account

The MMM Construction Company undertakes large contracts. The following

particulars relates to Contract number 444 carried out during the year ended 31,
March 2022.
Work certified by Architect - 1,43,000
Cost of work not certified - 3,400
Plant installed at site - 11,300
Value of plant on 31 March 2022 - 8,200
Materials sent to site - 64,500
Labour - 54,800
Establishment charges- 3,250
Wages accrued on 31 March 2022 - 1,800
Direct expenditure - 2,400
Materials on hand on 31st March 2022 - 1,400
Materials returned to store - 400
Direct expenses accrued on 31 March 2022- Rs 200
Contract price- 2,00,000
Cash received from contractee- Rs 1,30,000
Estimate the profit on the contract by preparing the Contract account. It was
decided to transfer 2/3 of the profit on cash basis to Profit and Loss account

The following expenses were incurred on an unfinished contract during the year
2022.
Materials – Rs 90,000
Wages – Rs 60,000
Other expenses- Rs 30,000
Rs 2,00,000 was received by the contractor, being 80% of the work certified.
Work done but not yet certified was Rs 5,000.
Determine the profit to be credited to the profit and loss account and profit
reserve kept in all the three alternatives given below:
Contract price is Rs 3,00,000
Contract price is Rs 5,50,000
Contract price is Rs 12,00,000