5.2: Compare and Contrast Job Order Costing and Process Costing

As you’ve learned, job order costing is the optimal accounting method when costs and production specifications are not identical for each product or customer but the direct material and direct labor costs can easily be traced to the final product.

Process costing is the optimal costing system when a standardized process is used to manufacture identical products and the direct material, direct labor, and manufacturing overhead cannot be easily or economically traced to a specific unit. Process costing is used most often when manufacturing a product in batches. Each department or production process or batch process tracks its direct material and direct labor costs as well as the number of units in production. The actual cost to produce each unit through a process costing system varies, but the average result is an adequate determination of the cost for each manufactured unit. Examples of items produced and accounted for using a form of the process costing method could be soft drinks, petroleum products, or even furniture such as chairs, assuming that the company makes batches of the same chair, instead of customizing final products for individual customers.

For example, small companies, such as David and William’s, and large companies, such as Nabisco, use similar cost-determination processes. In order to understand how much each product costs—for example, Oreo cookies—Nabisco uses process costing to track the direct materials, direct labor, and manufacturing overhead used in the manufacturing of its products. Oreo production has six distinct steps or departments: (1) make the cookie dough, (2) press the cookie dough into a molding machine, (3) bake the cookies, (4) make the filling and apply it to the cookies, (5) put the cookies together into a sandwich, and (6) and place the cookies into plastic trays and packages. Each department keeps track of its direct materials used and direct labor incurred, and manufacturing overhead applied to facilitate determining the cost of a batch of Oreo cookies.

As previously mentioned, process costing is used when similar items are produced in large quantities. As such, many individuals immediately associate process costing with assembly-line production. Process costing works best when products cannot be distinguished from each other and, in addition to obvious production line products like ice cream or paint, also works for more complex manufacturing of similar products like small engines. Conversely, products in a job order cost system are manufactured in small quantities and include custom jobs such as custom manufacturing products. They can also be legal or accounting tasks, movie production, or major projects such as construction activities.

The difference between process costing and job order costing relates to how the costs are assigned to the products. In either costing system, the ability to obtain and analyze cost data is needed. This results in the costing system selected being the one that best matches the manufacturing process.

The costing system used typically depends on whether the company can most efficiently and economically trace the costs to the job (favoring job order costing system) or to the production department or batch (favoring a process costing system).

While the costing systems are different from each other, management uses the information provided to make similar managerial decisions, such as setting the sales price. For example, in a job order cost system, each job is unique, which allows management to establish individual prices for individual projects. Management also needs to establish a sales price for a product produced with a process costing system, but this system is not designed to stop the production process and individually cost each batch of a product, so management must set a price that will work for many batches of the product.

In addition to setting the sales price, managers need to know the cost of their products in order to determine the value of inventory, plan production, determine labor needs, and make long- and short-term plans. They also need to know the costs to determine when a new product should be added or an old product removed from production.

In this chapter, you will learn when and why process costing is used. You’ll also learn the concepts of conversion costs and equivalent units of production and how to use these for calculating the unit and total cost of items produced using a process costing system.

When assigning costs to departments, it is important to separate the product costs from the period costs, which are those that are typically related with a particular time period, instead of attached to the production of an asset. Management often needs additional information to make decisions and needs the product costs further categorized as prime costs or conversion costs (Figure 5.2.1). Prime costs are costs that include the primary (or direct) product costs: direct material and direct labor. Conversion costs are the costs necessary to convert direct materials into a finished product: direct labor and manufacturing overhead, which includes other costs that are not classified as direct materials or direct labor, such as plant insurance, utilities, or property taxes. Also, note that direct labor is considered to be a component of both prime costs and conversion costs.

Figure \(\PageIndex{1}\): Prime Costs and Conversion Costs. Product costs can be categorized as prime costs (direct product costs) or conversion costs (costs incurred while converting the materials into a finished product). Direct labor is accounted for in both categories. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Job order costing tracks prime costs to assign direct material and direct labor to individual products (jobs). Process costing also tracks prime costs to assign direct material and direct labor to each production department (batch). Manufacturing overhead is another cost of production, and it is applied to products (job order) or departments (process) based on an appropriate activity base.

Equivalent Units

In a process cost system, costs are maintained by each department, and the method for determining the cost per individual unit is different than in a job order costing system. Rock City Percussion uses a process cost system because the drumsticks are produced in batches, and it is not economically feasible to trace the direct labor or direct material, like hickory, to a specific drumstick. Therefore, the costs are maintained by each department, rather than by job, as they are in job order costing.

How does an organization determine the cost of each unit in a process costing environment? The costs in each department are allocated to the number of units produced in a given period. This requires determination of the number of units produced, but this is not always an easy process. At the end of the accounting period, there typically are always units still in production, and these units are only partially complete. Think of it this way: At midnight on the last day of the month, all accounting numbers need to be determined in order to process the financial statements for that month, but the production process does not stop at the end of each accounting period. However, the number of units produced must be calculated at the end of the accounting period to determine the number of equivalent units, or the number of units that would have been produced if the units were produced sequentially and in their entirety in a particular time period. The number of equivalent units is different from the number of actual units and represents the number of full or whole units that could have been produced given the amount of effort applied. To illustrate, consider this analogy. You have five large pizzas that each contained eight slices. Your friends served themselves, and when they were finished eating, there were several partial pizzas left. In equivalent units, determine how many whole pizzas are left if the remaining slices are divided as shown in Figure 5.2.2.

• Pie 1 had one slice

• Pie 2 had two slices

• Pie 3 had two slices

• Pie 4 had three slices

• Pie 5 had eight slices

Together, there are sixteen slices left. Since there are eight slices per pizza, the leftover pizza would be considered two full equivalent units of pizzas. The equivalent unit is determined separately for direct materials and for conversion costs as part of the computation of the per-unit cost for both material and conversion costs.

Figure \(\PageIndex{2}\): Equivalent Units. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Major Characteristics of Process Costing

Process costing is the optimal system for a company to use when the production process results in many similar units. It is used when production is continuous or occurs in large batches and it is difficult to trace a particular input cost to a specific individual product.

For example, before David and William found ways to make five large cookies per batch, their family always made one large cookie per batch. In order to make five cookies at a time, they had to gather the ingredients and baking materials, including five bowls and five cookie sheets. The exact amount of ingredients for one large cookie was mixed in each separate bowl and then placed on the cookie sheet. When this method was used, it was easy to establish that exactly one egg, two cups of flour, three-quarter cup of chocolate chips, three-quarter cup of sugar, one-quarter teaspoon salt, and so forth, were in each cookie. This made it easy to determine the exact cost of each cookie. But if David and William used one bowl instead of five bowls, measured the ingredients into it and then divided the dough into five large cookies, they could not know for certain that each cookie has exactly two cups of flour. One cookie may have 1 7/8 cups and another may have 1 15/16 cups, and one cookie may have a few more chocolate chips than another. It is also impossible to trace the chocolate chips from each bag to each cookie because the chips were mixed together. These variations do not affect the taste and are not important in this type of accounting. Process costing is optimal when the products are relatively homogenous or indistinguishable from one another, such as bottles of vegetable oil or boxes of cereal.

Often, process costing makes sense if the individual costs or values of each unit are not significant. For example, it would not be cost-effective for a restaurant to make each cup of iced tea separately or to track the direct material and direct labor used to make each eight-ounce glass of iced tea served to a customer. In this scenario, job order costing is a less efficient accounting method because it costs more to track the costs per eight ounces of iced tea than the cost of a batch of tea. Overall, when it is difficult or not economically feasible to track the costs of a product individually, process costing is typically the best cost system to use.

Process costing can also accommodate increasingly complex business scenarios. While making drumsticks may sound simple, an immense amount of technology is involved. Rock City Percussion makes 8,000 hickory sticks per day, four days each week. The sticks made of maple and birch are manufactured on the fifth day of the week. It is difficult to tell the first drumstick made on Monday from the 32,000th one made on Thursday, so a computer matches the sticks in pairs based on the tone produced.

Process costing measures and assigns the costs to the associated department. The basic 5A hickory stick consists only of hickory as direct material. The rest of the manufacturing process involves direct labor and manufacturing overhead, so the focus is on properly assigning those costs. Thus, process costing works well for simple production processes such as cereal, rubber, and steel, and for more complicated production processes such as the manufacturing of electronics and watches, if there is a degree of similarity in the production process.

In a process cost system, each department accumulates its costs to compute the value of work in process inventory, so there will be a work in process inventory for each manufacturing or production department as well as an inventory cost for finished goods inventory. Manufacturing departments are often organized by the various stages of the production process. For example, blending, baking, and packaging could each be categorized as manufacturing or production departments for the cookie producer, while cutting, assembly, and finishing could be manufacturing or production departments with accompanying costs for a furniture manufacturer. Each department, or process, will have its own work-in-process inventory account, but there will only be one finished goods inventory account.

There are two methods used to compute the values in the work in process and finished goods inventories. The first method is the weighted-average method, which includes all costs (costs incurred during the current period and costs incurred during the prior period and carried over to the current period). This method is often favored, because in the process cost production method there often is little product left at the end of the period and most has been transferred out. The second method is the first-in, first-out (FIFO) method, which calculates the unit costs based on the assumption that the first units sold come from the prior period’s work in process that was carried over into the current period and completed. After these units are sold, the newer completed units can then be sold. The theory is similar to the FIFO inventory valuation process that you learned about in an earlier chapter. (Since the FIFO process costing method is more complicated than the weighted-average method, the FIFO method is typically covered in more advanced accounting courses.) We will focus on the weighted average method in this course.

With processing, it is difficult to establish how much of each material, and exactly how much time is in each unit of finished product. This will require the use of the equivalent unit computation.