What Are Equivalent Units?
In a manufacturing environment that uses process costing, the production process is continuous. In other words, it doesn't stop when an accounting period ends and then start up again when the new accounting period begins. The production process goes on and on, speeding up or slowing down depending on many factors, and uses direct materials all the time. The process of production is evaluated on a completion basis rather than in a time frame.
Accountants need to value inventory as part of generating financial statements. The challenge in a process costing environment is inventory that is in various stages of completion. In order to be able to arrive at a value for inventory, the accountant makes a calculation to convert the partially completed units to a comparable amount of completed units. Accountants call the conversion of partial units to comparative completed units the equivalent units of production.
The equivalent units calculation determines the completed units on a processing department basis. Each processing department that the accountant collects costs for will have its partially completed inventory converted to a comparative number of completed units. The term completed unit refers to an item that has been finished within the related processing department. Completed units are not the same as finished goods, but they are still part of work in process (WIP) until the product is ready to sell.
The equivalent units calculation is necessary to figure out the value of work in process remaining in the department and the completed units being transferred out of the department. Because the company applies costs to the processing department rather than the product—and production is continuous—it is not possible to determine the cost for the product without a calculation. Products will be at various stages of completion within a department. Trying to determine each step of the production process, the related cost at each stage, and the number at each stage to calculate work in process inventory costs would not be possible. Instead, the accountant looks at the units the department is working on and figures out the percentage of completion. From this evaluation, the accountant calculates the number of equivalent units. Based on the costs that have accumulated in the processing department, the accountant determines the value of one completed unit. These figures allow the company to keep track of work in process inventory and inventory that is being transferred out of the department at the end of the accounting period.
How Does an Accountant Calculate Equivalent Units?
To complete the equivalent units calculation, the accountant considers the direct material separately from direct labor and manufacturing overhead. In some cases, the accountant will add 100% of direct material at the beginning of the process, before any labor or overhead costs. In other cases, the accountant adds direct material during the process, but at a rate different from labor or overhead costs. To capture the correct costs, the accountant will make two different equivalent unit calculations: one for direct labor, and one for labor and overhead.
An accountant calculates equivalent units based only on the processing department where the product is currently located. Consider the production of chocolate for a candy bar that goes from raw material to roasting to winnowing to chocolate crumb (raw material with milk and sugar added) to conching to tempering. If the candy has entered the winnowing process, the percentage completed for direct material is 100%. All direct material related to winnowing was added at the beginning of the roasting process. This does not mean that all direct material related to the final product has been added. In the chocolate crumb process, the direct material will not be 100% until the milk and sugar have been added.Direct labor and manufacturing overhead are considered conversion costs. These costs represent the actions necessary to change the raw material into finished products. The accountant adds overhead to the cost of the product by using a predetermined overhead rate. This rate is the estimated amount paid for fixed costs. The accountant calculates it by dividing the estimated manufacturing fixed costs for the accounting period by the allocation base. Typically the allocation base is direct labor hours or direct labor cost. The relationships that exist between direct labor and manufacturing overhead allow the accountant to calculate the percentage completion for these two cost centers together in determining equivalent units.