How Are Costs Recorded?
In process costing, the accumulation of costs needs to reflect the flow of the product as it moves from department to department. In the managerial accounting records, the total work in process (WIP) amount will reflect the totals of the work in process recorded in each department. The accountant builds a document called a general ledger to reflect the flow of costs through the various departments, with the department totals equal to the overall work in process total. A general ledger is a way to record a company's complete financial accounts, including expenses, income, money generated, and more.
This is needed in order to keep costs and all financial information aligned to the flow of product and provide checks and balances to improve accuracy. Managers update and maintain process costing information by using cost of production reports. The cost of production report shows how much the company manufactured and spent during a specific reporting period.
The cost of production report supports the information in the general ledger. Because the general ledger contains the financial transaction information that the accountant uses to complete the financial statements, this is a point where cost accounting information is tied to financial information. Each individual department will have a general ledger number that reflects the inventory in that department. The accountant will add together the inventory in each department to get the company's total work in process inventory amount. Managers will use the department information for internal analysis and to decide on prices for products. Only the total work in process inventory number is reported in financial statements and available to external parties.
Some companies make products that do not entirely fit with process costing. When working with products that are mostly similar but have some unusual or unique features, companies may want to use operation costing. Operation costing is a hybrid of process costing and job-order costing. With operation costing, the accountant accumulates most costs through process costing but adds unique features through job-order costing. The use of job-order costing provides the ability to add product-specific costs. Accountants who use operation costing need to make sure the recording of costs follows the requirements for the type of costing that relates to the work in process status of the product.Companies gather financial data not only to make better decisions (a process called managerial accounting) but also to report required information to the government and the public (a process called financial accounting). These two types of accounting use data from the same organization in different ways.
Managerial Accounting versus Financial Accounting
Examples of Cost Entries
Companies using process costing need to account for direct material, direct labor, and overhead costs, just as they would with other costing systems. Direct labor is hours spent producing a product or providing a service that can easily be traced to the product or service; for example, hours operating a machine on a candy bar production line. A company can assign these hours to a specific product or cost center. By recording these three types of costs to the product, the company accounts for all costs necessary to produce the product. In this way, management can assign a price to the product that will cover costs and create a desired profit.
Journal entries for direct material costs will move costs from raw material to the specific work in process (WIP) account for the department or process. In the case of the production of a candy bar, the accountant would move the cost of the cacao beans from raw material inventory to the work in process of the first production department: roasting. The accountant would credit raw material and debit work in process to reduce the cost of raw materials and increase the cost of the appropriate work in process inventory.
The accountant records journal entries for direct labor costs. These journal entries move the cost of labor from an expense to an inventory account. Direct labor is considered a conversion cost, or an expense necessary to move the product from raw material to its finished state. This entry decreases expenses (salary expenses) and increases assets (work in process inventory). As with direct materials, the accountant debits direct labor expenses to the specific work in process inventory.
Overhead refers to operating costs or expenses, such as rent, electricity, and taxes. These costs are part of just about every business. The accountant applies overhead to the work in process inventory in process costing. The accountant usually applies overhead by using a selected allocation base, a standard unit that provides the system for the way overhead costs of a product or service are divided. The accountant uses the allocation base to create a predetermined overhead rate.
The predetermined overhead rate is an estimated ratio established before an accounting period begins and is used to allocate costs involved in producing goods or services. It is calculated by dividing the estimated manufacturing overhead costs for the accounting period by the allocation base. For example, if the accountant selects direct labor hours as the allocation base, then they would allocate overhead to the department or process based on the number of direct labor hours that department or process takes to complete a task. The journal entry to move overhead to the department or process would be a debit to the specific work in process inventory account and a credit to manufacturing overhead. Similar to the direct labor entry, this would reduce expenses (manufacturing overhead) and increase assets (work in process inventory).Journal entries are used to move raw materials, salary (labor), and overhead into WIP. As the product is completed in each department, an entry moves the costs from one department WIP to the next department WIP. Additional materials, labor, and overhead are also added in each subsequent department.