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## Friday, July 13, 2012

### Process Costing - Theory

Introduction: Process costing is a method of operation costing which is used to ascertain the cost of production at each process, operation or stage of manufacture, where processes are carried in having one or more of the following features:
a)      Where the product of one process becomes the material of another process or operation
b)      Where there is simultaneous production at one or more process of different products, with or without by product,
c)       Where, during one or more processes or operations of a series, the products or materials are not distinguishable from one another, as for instance when finished products differ finally only in shape or form’.

Definition: Process costing is defined by Kohler as:
“A method of accounting whereby costs are charged to processes or operations and averaged over units produced; it is employed principally where a finished product is the result of a more or less continuous operation, as in paper mills, refineries, canneries and chemical plants; distinguished from job costing, where costs are assigned to specific orders, lots or units.

Features/Characteristics of Process Costing: The following are the features of Process costing:
a)      Process Costing Method is applicable where the output results from a continuous or repetitive operations or processes.
b)      Products are identical and cannot be segregated.
c)       It enables the ascertainment of cost of the product at each process or stage of manufacture.
d)      The output consists of products, which are homogenous.
e)      Production is carried on in different stages (each of which is called a process) having a continuous flow.
f)       The input will pass through two or more processes before it takes the shape of the output. The output of each process becomes the input for the next process until the final product is obtained, with the last process giving the final product.
g)      The output of a process except the last may also be saleable in which case the process may generate some profit.
h)      The input of a process except the first may be capable of being acquired from the outside sources.
i)        The output of a process is transferred to the next process generally at cost to the process. It may also be transferred at market price to enable checking efficiency of operations in comparison to the market conditions.
j)        Normal and abnormal losses may arise in the processes

Application of Process Costing: There are number of industries where Process costing system can be used except where job, Batch or Unit Operation Costing is necessary. The following are examples of industries where process costing is applied:
a)   Where the final product merges only after two or more process such as paper-the raw material, bamboo is made into pulp; pulp is a made into paper and then it is finished, glazed etc. for sale;
b)   The product of one process becomes the raw material of another process or operation e.g. refined groundnut oil is the material for making vegetable ghee and
c)    Different products may have a common prior process e.g. brass goods will require melting of brass commonly for all goods. Another example is petroleum products by the same refinery.
Some other industries where Process Costing is applied are:
Chemical works                                                                Textiles, weaving, spinning etc.
Soap making                                                                      Food products
Box making                                                                         Canning factory
Coke works                                                                        Paint, ink and varnishing etc.

Difference between Job costing and Process Costing:

 Basis of distinction Job Costing Process Costing Basic Production Cost Determination Cost Calculation Transfer Forms and Details Inventory Mechanization Job costing is used when the cost object is an individual (or a lot/batch) unit or a distinct product or service Costs can be accumulated by each individual product or service Job costing is done against a specific order being produced. Costs are calculated when a job is over. There are usually no transfers of costs from one job to another.  There is more paper work. There is little or no inventory.    It is less amenable to mechanization & automation. Process Costing is generally used for a mass of identical product or service. The Costs are accumulated in a period. The total costs in a period are divided over the number of units to get an average unit cost. Costs are compiled for each process over a period of time. Costs are calculated at the end of a cost period like an accounting year. Transfer of costs from one process to another is made as the product moves from one process to the other. It has lesser paper work. There is regular and significant inventory. It is more amenable to mechanization & automation.

Advantages of Process Costing: The following are the main advantages of Process Costing:
a)      It is possible to determine process costs periodically at short intervals. Average unit cost can be computed weekly or even daily.
b)      It is simple and less expensive to find out the process costs.
c)       It is possible to have managerial control by evaluating the performance of each process.
d)      It is easy to allocate the expenses to processes in order to have accurate costs.
e)      It is easy to quote the prices with standardization of process. Standard costing can be established easily in process type of manufacture.

Disadvantages of Process Costing: The following are the main disadvantages of Process Costing:
a)      Cost obtained at the end of the accounting period are only of historical value and are not very useful for effective control.
b)      Valuation of work-in-progress is generally done of estimated basis which introduces further inaccuracies in total cost.
c)       Where different products arise in the same process, it is not possible to exactly ascertain the total cost of the products.
d)      If any error occurs while calculating average costs, it will be carried through all the processes to the valuation of work in process and finished goods.
e)      The computation of average cost is more difficult in those cases where more than one type of product is manufactured and a division of the cost element is necessary.

Fundamental Principles of Process Costing: The following are the fundamental principles of process costing:
a)      Cost of material, wages and overheads expenses are collected for each process or operation in a period.
b)      Adequate records in respect of output and scrap of each processes or operation during the period are kept.
c)       The cost per unit of each process is obtained by dividing the total cost incurred during a period by the number of units produced during that period after taking into consideration the losses and amount realized from sale of scrap.
d)      The finished product of one process is transferred as a raw material to the next process.

Elements/Components of Cost
For the purpose of cost accounting, the process industry is divided into separate departments with each department representing a specific process. The Direct Material and Direct Labour Costs are collected for each department separately and the overheads, which are collected over all the departments/processes, are apportioned over the various departments/processes on some rational basis
The following are the main elements/components of costs involved in the manufacturing process where process costing is adopted.
a)      Direct Materials There are two types of materials that we come across in process costing.
Primary Material Materials that are introduced in the initial process, which is passed on to the next process after completion of processing.
Secondary Material Materials, which are introduced in the first or subsequent processes in addition to, the main material introduced in the initial process. This gets mixed up with the main material and is passed on to the subsequent processes as a part of the output.
b)      Direct Labour the direct labour cost is incurred in every process. Identification of direct Labour cost is also relatively easy in process costing industry.
c)       Direct Expenses in addition to Direct Material and Labor, which can be directly attributable to a particular process. These are costs relevant to specific processes.
d)      Production Overheads The overhead expenses are generally expended over all the processes involved in production. These are to be apportioned over the various processes in an amicable manner.