Unit III

PROCESS COSTING
Meaning & Definition of Process Costing
Process costing is a costing methodology, which is used by the manufacturing
industries, wherein the conversion of the raw-material into a finished product
involves its undergoing into more than one process. This methodology is quite
prevalent amongst manufacturers of chemicals, soaps, vegetable oils, paints,
varnishes, etc., where the manufacturing process is uninterrupted and the raw-
material is subject to pass through more than one process till the final product is
obtained. Process costing may be viewed as an accounting technique, which can
be:
i) Trace and collect direct costs,
ii) Allocate indirect costs in respect of a manufacturing process.
Generally, costs are assigned to the products in a size lot which provide a month
output. Ultimately, costs are required to be allocated to each unit of a product.
According to Chartered Institute of Management Accountants (CIMA) the
process costing has define as the costing method applicable where goods or
services result from a sequence of continuous or repetitive operations or
processes. Costs are arranged over the units produced during the period".
Applications of Process Costing
The application of process costing is most appropriate for and is used by the
manufacturers engaged in the production of homogeneous goods having same
standards. Such manufacturing units produce articles in an uninterrupted and
continuous manner. Such continuity of manufacturing activity is possible only if
the plants and machineries are arranged in such a manner that the production of
a standardized article takes place for a long period of time without any break.
The process costing may be preferred, under the following conditions:
1) A single article is being manufactured:
2) A single article is being processed for some specified period;
3) A number of articles with uniform standard design are manufactured in the
same plant; and
4) Separate processes are taking place in separate divisions of a factory.
Process costing is applied in the following Industries
1) Textiles mills;
2) Chemical works;
3) Oil refining:
4) Cement manufacture;
5) Paper manufacture;
6) Food processing
7) Steel mills;
8) Paint manufacture;
9) Soap making:
10) Sugar works;
11) Confectionaries;
12) Plastic manufacture, etc.
Benefits of Process Costing
In view of the following advantages, process costing may be considered
favourable, especially by the process industries:
1) Helpful in Comparison: Comparison of process costs is possible at regular
intervals (e.g. every month). In fact, such comparison may be undertaken at
weekly or even daily basis in case, where pre- determined overhead rates are
used.
2) Simple and Economic: Process costing is comparatively simple, less
expensive, and need minimum clerical support.
3) Use for Control: As the actual and projected figures are easily available in
respect of each process, the exercise of managerial control and monitoring is
easy.
4) Accurate Cost Allocation: Calculation of average cost of a homogenous
product is easy. Further, the calculated costs are considered accurate in view of
the smooth allocation of expenses to various processes.
5) Standard Process: In view of the standardization of process, which is the
standard of the process costing, submission of price quotation poses no
problem.
Limitations of Process Costing
The limitations of process costing are evident from the following:
1) Historical Costs: Costs arrived at the end of an accounting period are
historical in nature and significant to some extent only. They are not of much
use as a tool for the management control.

2) Inaccurate Average Costs: Average cost per unit arrived under this method
may not be taken as a basis for in-depth analysis and assessment of
operational efficiency, due to the fact that there is a possibility of such
figures being inaccurate. Even a small mistake in the calculation of average
cost per unit may be carried over through various processes, which may
result in distorted valuation of work in progress and finished goods.

3) Problem of Apportionment: If a single process is used for the production of a

number of products, the apportionment of the joint costs amongst different
products is a challenging job and there are chances of creeping in of the
approximation, which is unscientific and may lead to inaccuracies.

4) Inaccurate Work in Progress: During the valuation of work in progress

inventory, no scientific method is applied to ascertain the accurate completion
stage of work in progress, it is determined by estimation. Accuracy of the work
in progress completion stage is, therefore always doubtful.

Treatment of Wastage
In a broader perspective, the term 'losses', comprises of waste, scrap, spoilage
and every other phenomenon which lower down quantity of a product.
Wastage may be classified into the following categories:
Normal Loss
Abnormal Loss
Abnormal Gain/Effectiveness
Normal Loss
Normal loss is a loss, which is incurred in a business because of some
deficiencies in the raw-materials and production process. It takes place
under the normal circumstances and at times it is inevitable. However, it
may be assessed and forecasted on the basis of previous experience of an
industry or an individual business organization and occurs at the time of
process. There are various forms of normal loss, e.g. normal wastage,
normal scrap, normal spoilage and normal operational deficiencies.

Abnormal Loss
Abnormal losses occur due to abnormal and unforeseen circumstances or
events, like plant break-down, poor quality of raw-materials, fire, theft,
poor supervision, etc. Such losses are in excess to the normal anticipated
losses of a business organisation. The difference between the actual
losses and the anticipated losses is the abnormal loss. Unlike the normal
losses, it is not inevitable and can be avoided by taking precautions and
planning. The value of abnormal loss may be calculated by applying the
following formula:

Value of Abnormal Loss = Total Cost Incurred - Scrap

Value of Normal Loss /Input Units - Normal Loss Units x Units of

Abnormal Loss

Value of the 'Unit of abnormal losses' may be calculated as under:

Abnormal Loss (Units) = Input (Units) - Normal Loss (Units)- Actual
Output (Units)

Abnormal loss may be defined as the wastage which is not an integral

part of the manufacturing process. Any wastage in excess of the normal
wastage is considered as the abnormal wastage.

Some examples of the abnormal wastage / loss are sub- standard

materials, machine break-downs, slow machines, lack of appropriate
supervision, and natural disasters like fire, flood, etc.

Valuation of the abnormal loss units is treated in the same manner as the
valuation of the normal units. However, such valuation amount is debited
to an account specifically maintained for the purpose, which is named as
'abnormal loss account'. In case some value is realized out of the sale of
wastage, the same is credited to the 'abnormal wastage account'.

Abnormal Gains/Effectiveness
Abnormal Effectiveness is also known as Abnormal Gain. The amount of
abnormal loss is just an estimation and not the actual one, which may be
more or less than the estimated loss. The gap between the above two, i.e.
the actual loss and the estimated loss may be positive or negative.

If the actual loss happens to be more than the estimated loss (negative
gap), the result is abnormal loss. However, if the actual loss happens to be
less than the estimated loss (positive gap), the result is what may be
termed as abnormal gains, which is also referred to as Abnormal
Effectiveness.

Valuation of the abnormal gain is carried out in the same way as the
valuation of the abnormal loss is carried out, by applying the following
formula:

Value of Abnormal Gain= Total Cost Incurred - Scrap

Value of Normal Loss/ Input Units-Normal Loss Units x Units of

Abnormal Gain

Value of the abnormal gain units is calculated by applying the following

formula: Abnormal Gain (units) = Input (units) - Normal Loss – Actual
Output (units)

Normal loss account is required to be credited with the sale proceeds of

abnormal gain units, and as a result that account (normal loss account)
stands benefitted. The difference is transferring to costing Profit & Loss
Account.

For the calculation of abnormal loss and abnormal gain, same methods
are used. However, there is a difference in the accounting treatments;
while the abnormal gain finds a place on the debit side of the process
account; the abnormal loss is shown on the credit side of the process
account.
JOINT PRODUCTS
Meaning and Definition of Joint Products
When using a single input in a process, two or more products emerge
having competitive significance, then the same is termed as the Joint
Products.

According to the Terminology of CIMA, joint products. are "Two or

more products separated in the course of processing, each having a
sufficiently high saleable value to merit recognition as a main product".

Following are few examples:

1) Industry - Mining
Joint Products - Several metals from the same ore, e.g.. copper, silver,
zinc, etc.
2) Oil refining - Petrol, diesel, kerosene, grease, lubricating oils, etc.
3) Dairy - Skimmed milk, butter.
4) Meat - Meat hides processing

Joint Product Terminologies

1) Joint Cost: Cost is incurred on single production process but that
produce multiple products of the identical nature.
2) Split-Off Point: The stage during the production process where the
products under manufacture are identified and separated.
3) Separable Costs: The cost that is incurred after the split-off stage and
the products are separately identified.
4) Product: It represents the output having a certain sale value and the
same exceeding the cost. Generally, the sale value of the main and joint
products is higher than the sale value of by-products.

Features of the Joint Products

Joint products have the following features:
1) Equal Significance: The products that are produced jointly normally
possess equal significance. No product is deemed to be possessing
higher importance over the other. The importance may be in terms of
the sales value or the profitability or even in terms of the contribution.
So, all the jointly produced products constitute the main product.
2) No Separation till Split-off Point: The joint products are only
identifiable at the split off cost. So, it is not possible to make any
differentiation among the products before this stage.
 3) Primary Objective: The joint products must be produced keeping in
view their production as primary objective i.e. the production of the
products must be intentional.

4) No Control over Relative Quantities: The production manager should

have least control on the ratio of the evolving joint products. There
should be no chance in increasing the quantity of a certain product and
decreasing the quantity of the other product.

5) Produced in Relatively Larger Quantum: In case of the joint products,

the production is usually carried out in large quantities and the output
by far exceeds the output of the by-products.
Objectives of Joint Products
Joint products have the following objectives:
1) Suitable apportionment of the joint cost.
2) Involving decision-making for further production or selling at the split-off
stage.
3) Determining the incomes and expenses for each product type.
4) Depending upon the cost and profit analysis, ascertaining the most profitable
product mix.
5) Price fixation using historic data.
6) Using marginal contribution technique for the profit maximisation of the
organisation.
ACTIVITY BASED COSTING (ABC)
Meaning and Definition Activity Based Costing
Activity Based Costing (ABC) is a system by virtue of which the cost is
allocated in different activities instead of different products and services. This
further ensures that the overhead costs are assigned in an accurate manner to
different products and services.
According to Chartered Institute of Management Accounts (CIMA), London,
"Cost attribution to cost units on the basis of benefits received from indirect
activities, i.e.. ordering, setting-up, assuring quality, etc." So, Activity based
costing is quite general and can be adopted while using an order costing system
and a process costing system.
According to Horngren, "Activity based costing is a system that focuses on
activities as fundamental cost objects and utilizes cost of these activities as
building blocks or compiling the costs of other cost objects". Activity based
costing also ensures strategic cost management. It depicts the consumption of
the resources in different activities and also allocates the costs of the products or
customers on the basis of their consumption pattern.
According to activity based costing, all the activities of the firm are designed to
satisfy the customer's requirements. It ensures that the managers are equipped
with the timely information which assists in the competitive environment and in
the formulation of the strategies.
Features of Activity Based Costing
Following are the features of activity based costing:
1) Activity based costing enhances the cost pools that are required for the
accumulation of the overhead costs. So, the overhead costs are not allocated on
the basis of company-wise pool or the departmental pools, rather they are
allocated on the basis of the driving activities.
2) The overheads are attributed to different jobs or the products in the ratio of
the cost driving activities. A single rate calculated on the basis of direct labour
hour or machine hour is avoided.
3) In this case, the per unit cost calculated is more accurate and the overheads
are completely traceable.
4) helps in the elimination of the non-value added items as costs are identified
during the course of the activities This climination will further assist in bringing
down the cost of the product.
Objectives of Activity Based Costing
Following are the primary objectives of the ABC system:
1) To calculate the correct product cost by assigning the overhead cost in a
careful manner after considering various factors.
2) To calculate the optimum product mix and the price fixation.
Following are few other objectives of ABC system:
1) It involves identification of the value added activities.
2) To reduce the non-value added activities.
3) To allocate the costs as per the involved activities.
4) To allocate costs, according to the negotiations done by the customer.
5) To ensure that quality products are produced.
6) To assist in the correct calculation of the cost for fixation of the selling price.
7) To provide timely information related to the different activities and
customers.
8) To concentrate on the cost activities that gives maximum value.
9) To constantly review the area for improvement in the products and reducing
the costs.
10) To set the optimum product mix, yielding the maximum level of profit.
Applications of Activity Based Costing
Following are the applications of activity-based costing:
1) Activity Costs: The basic purpose of ABC is to trace the activities so as to
ensure that the activity costs are incurred as per the industry standards. ABC
also provides the feedback to measure the cost of the services as well as to
reduce the cost.
2) Customer's Profitability: Since majority costs incurred on an individual
customer are only the product cost. However, there are also overheads that are
involved like customer service, handling of the product return and the
cooperative marketing agreements.
Under the ABC system, these costs are attributed among different activities so
that the activity gets to share the overheads and there is no unusual burden on
some of the jobs or products. This system may reduce cost of the certain jobs,
may also increase the cost of certain products. Those customers are focussed
who is bringing more profits to the company.
3) Distribution Cost: Different mediums like retail, e- commerce, distribution
network, mail order catalogues are used by a company to sell its products. So,
the costs incurred towards maintaining these networks are overhead costs and it
is important to allocate these costs in all the channels in an appropriate manner
to reap the benefits of such distribution channel.
4) Make or Buy: ABC gives an insight of all the costs that are incurred in-house
while manufacturing a product so that the activities requiring high cost can be
outsourced to outside agencies.
5) Margins: Under ABC system, proper costs are attributed towards different
jobs and services. Therefore, the actual cost can be ascertained. It now becomes
possible for a company to know their actual profit margins involved in different
products and they can further fix their product mix.
6) Minimum Price: Actual ascertainment of the cost is the base for the majority
of the selling decisions of the company. Only after a company knows its cost,
then by adding up the reasonable margin, it can quote its products in the market.
Under this, the company will be in a better position to face market competition.
ABC analysis is an efficient determinant and the distributor of the cost among
different activities.
7) Production Facility Cost: Segregation of the overhead costs of the facility-
wise level is easy and it enables the comparison among the costs of production
between different facilities.
Steps of Activity Based Costing
Following are the steps to be taken to establish an ABC system in an
organisation:
1) Identifying Major Activities: Identify the activities that share some common
characteristics of the sum total of tasks. For example, purchasing the material
which is an activity requires different tasks like. receiving a request note,
inviting tenders, selection of the supplier, placing the order and receiving the
material. In big organisations, the activity selected should be a major one which
involves a series of tasks under it.
2) Assigning Costs to Activity Cost Centres: Costs are allocated to the various
activities which are determined above. Further, total of the amount spend on
each of the activity is made. More the amount spent on a particular activity,
better will be the quality of the information generated by the system. Cost
drivers used under ABC system may also be known as the resource cost drivers.
3) Selecting Cost Drivers for Allocating Cost to Cost Directs: The accumulated
costs for each of the cost centre are apportioned among different cost objects.
This is facilitated by the use of a separate activity cost. driver. Cost driver
denotes an activity that drives the costs. Cost drivers are the key events to
derive the cost of the activities. These cost drivers may further be classified into
three categories:
i) Transaction Drivers: It comprises of the quantum of the orders processed,
orders placed, inspections done, a number of the steps undertaken, etc. They
undertake an assumption that the same quantum of resources is used at all the
time when an activity is performed. So, it can be said on the basis of this
assumption that the generated information is generally less accurate. In case, the
resources used during different transactions are same, then the transaction cost
drivers may be used.
ii) Duration Cost Drivers: These drivers are dependent on the time required by
an activity like the set-up hours, inspection hours, etc.
iii) Intensity Cost Drivers: Under this driver, an activity is charged every time
on performance. Further, direct charging is based on the actual activity costs.
4) Allocating the Cost of an Activity to Cost Objects on the Basis of Cost
Driver Rates: Rates will be calculated with the use of the selected cost drivers.
Afterwards, the rates are used to find the cost identifiable with a cost object.
Cost Driver Rates = cost driver volume. Total cost of the activity/total
Advantages of ABC
ABC system has the following advantages:
1) The nature of the overhead costs, their relation to products, services,
customers and the market segments are established by ABC system.
2) It assists in allocating the resources to the activities that result in maximum
economic benefit.
3) It establishes a bridge between the profitability analysis and the operational
decisions.
4) The non-value added items are easily identified under this system.
5) Correct information is provided on the performance as more emphasis is
given on activities instead of resources.
6) The cost drivers of each activity are understood properly and better control is
facilitated.
7) It provides correct information on the margin and correct fixation of price.
8) The organisation becomes dynamic and better strategies can be prepared.
9) It helps to prepare better strategies and thus, the organisation becomes
dynamic,
Disadvantages of ABC
ABC system has the following disadvantages:
1) It is not, the medicine for all the problems.
2) A number of resources are required.
3) For providing the products at a competitive rate, too much attention is given
to the customers. Therefore, other key areas are ignored.
4) Customs segmentation may lose its roots.
5) Opportunity cost is not considered.
TARGET COSTING
Meaning and Definition of Target Costing
It is a pricing method and has been defined as "a cost management tool for
reducing the overall cost of a product over its entire life-cycle with the help of
production, engineering, research and design".
According to Cooper, "Target Costing is a disciplined process for determining
and realizing a total cost at which a proposed product with specified
functionality must be produced to generate the desired profitability at its
anticipated selling price in the future".
According to CIMA, target cost is "a product cost estimate derived from a
competitive market price". In the context of pricing in competitive environment,
it is used to reduce cost through continuous improvement and replacement of
technologies and processes.
This is what according to management; the cost should be viewing the
competitive market prices. These costs are generated externally based on
analysis of the cost structure of the leading competitors in the industry".
It is a strategic cost-management process. It can be used for reducing total costs
at the various stages of planning and design.
It also encompasses all the relevant departments such as engineering, marketing,
accounting and production. The process sets target costs as well as the required
rate of return on investment.
Features of Target Costing
Following are the main features of target costing:
1) Target costing is a market driven process.
2) It is calculated by subtracting the desired profit margin from the target price.
3) The target cost is an independent variable and should not be affected by
design decisions.
4) It is a simple yet powerful process to affect the profitability of the business.
5) It can be easily embedded in current processes.
6) It is a logical process for achieving targets.
7) Target costing integrates economic objectives and technical knowledge.
Objectives of Target Costing
Following are the main objectives of target costing:
1) The fundamental objective of the process is to promote proactive cost
management, planning and cost reduction.
2) It helps in identifying the costs, which the product must be manufactured as
if it is to earn its profit margin at its expected target selling price.
3) Target costing breaks down the target cost down to its component level and
determining the efficient way to supply them.
4) It helps managers to make comprehensive plans regarding product costs and
decisions, implementation well ahead in time.
5) It is a comprehensive process to plan, manage and reduce costs.
6) Target costing helps to understand the markets and its competition. It also
helps in making trade-off analysis.
Target costing gives attention to the needs of customers with regard to quality,
cost and quantity which results in increased in profit margin.
Steps of Target Costing
Following are the main ten steps to be followed in this process:
1) Reorient Culture and Attitudes: The basic step is to recondition thinking
process towards market driven pricing. It also deals with prioritizing customer
needs over technical requirements as a basis for product development. This
fundamental change of the prevailing attitude of cost being the result of the
design rather than being the other way round.
2) Establish a Market Driven Target Price: A target price is established after
analyzing market factors such as market share, business penetration strategy and
competition. The target price is based on analysis of the price to win
considering customer affordability and competitive analysis, in the case of
quotation request.
3) Determining the Target Cost: After establishing target price, a worksheet is
used for calculating the target cost. This is done by subtracting the standard
profit margin, warranty reserves, and any uncontrollable corporate allocations.
Non- recurring development costs are also subtracted. The target cost is then
allocated to lower level assemblies of sub- systems based on individual designer
responsibilities or the structure of teams.
4) Balance Target Cost with Requirements: Proper setting of requirements or
specifications offers the greatest opportunity to control a product's cost. The
various factors which need to be considered for this process are customer's
requirements and other related aspects. Techniques such as quality function
deployment are used for managing trade-offs between quality and costs.
5) Establish a Target Costing Process and a Team- Based Organization: A
defined process is used for integrating various tasks and activities to support
target. This process should be carried out early in the process. A team-based
organization may require various departments such as marketing and finance to
integrate their plans to support targets.
6) Brainstorm and Analyze Alternatives: It is important to consider multiple and
design alternatives for the product and the manufacturing process for effective
achievement of cost reduction. This can be done by combining out of the box
thinking with structured analysis.
7) Establish Product Cost Models to Support Decision-Making:
Product cost and cost tables are used to analyze different design alternatives and
concepts. In the early stages of development, parametric estimating or analogy
techniques are used to develop models.In the later stages, these models are
based on bottom up estimating techniques or industrial engineering. These
models should be comprehensive to fully address validation of fabrication,
assembly and material used. Various elements of product costs are recorded
using a target cost worksheet. These elements can be compared for better
understanding of processes. Change in estimates should also be tracked.
8) Use Tools to Reduce Costs: Methodologies consisting of training, databases,
guidelines, supporting analysis tools and procedures should be used for
inspection and test design for manufacturing and assembly.
9) Reduce Indirect Cost Application: Indirect costs from 30 to 50 percent of
total costs. The firm should examine these costs and should try to reduce those
costs which do not add value. An effort should be made to understand the
relationship between these costs and the products. Activity- based costing and
cost drivers study should be undertaken for this purpose.
10) Measure Results and Maintain Management Focus: Current estimated costs
should be matched against target costs. Management should pay attention to
target costs during review processes and phase-gate reviews.