Material Costs as a Direct Cost Center
If a business makes each order by hand to custom specifications, then it is easier to figure out which materials went into each unit. However, most businesses do not work this way anymore. Manufacturers make huge quantities of goods to the same specifications, and the materials to make those goods flow in month after month.
To get a better idea of how much each item that their company produces actually costs, most manufacturers use process costing. Process costing makes it possible to track expenditures when a company makes huge amounts of similar products; it is a method used when large quantities of similar products are manufactured and expenses are applied to a series of actions instead of an individual product. Instead of trying to measure the individual cost of each unit, accountants use process costing to track how much each part of the manufacturing process costs, on average.
Manufacturers need to keep track of the costs of their materials. Direct materials are raw goods that can be traced directly to or easily identified with a specific product. For instance, nuts and cacao beans would be direct materials for a candy bar maker. In process costing, direct materials become associated with the process being performed instead of with a single product. For a candy bar producer, the cocoa (direct material) is related to the first process (roasting), not to each individual candy bar.
The relationship of a material to a process rather than a product makes the costing approach a bit more complex. An accountant can look at raw materials, the items a manufacturer uses as the basic parts to create a product, from both the company and process perspective. Raw materials from the company perspective would be items that the company buys from vendors. Raw materials from the process perspective would include the product that is completed by any prior internal process. As a product completes one process, it becomes raw material to the next process.
Following the movement of cocoa in the making of a candy bar provides an example of the flow of direct materials in process costing. The company buys cacao beans from an external source, and those become raw materials to the company. The company then moves the cacao beans from raw materials inventory to the roasting process. After roasting, the roasted cacao beans become a raw material for a process called winnowing, which strains and sorts the beans. A chocolate crumb process uses the winnowed beans along with the additional raw materials of milk and sugar. The chocolate crumb becomes the raw material for a process called conching. The finished product from the conch process goes into the tempering process, which produces the melted chocolate for the candy bar. This example completes the production of the chocolate, but creating an actual candy bar goes through multiple additional processes, including cooling and wrapping.The candy bar example demonstrates how accountants apply direct materials to processes instead of products. In the basic development of a chocolate bar, cacao beans go through many different processes. During these different processes, the product is part of the company's work in process (WIP) inventory, which is a way of keeping track of products that have started through the manufacturing process but are not yet complete. While the materials in this example aren't finished products, the accountant measures processes rather than products. Each process is complete at its end, when the product moves on to the next process.
Flow of Direct Materials in Process Costing
How Process Costing Flows Work
In process costing, the accountant allocates each cost to a processing department, which is an area of operation that moves material or data through a series of actions that bring the company closer to a stated goal. For instance, a processing department might perform product assembly, quality assurance, or billing. This is only part of the cost analysis, as the final calculation needs to determine the cost of the finished manufactured product. The most common flow of costs is the addition of direct materials at the beginning of the manufacturing process and the addition of labor and overhead in later departments.
However, companies are not restricted to entering direct material at the beginning of the manufacturing process. In the production process of a candy bar, for instance, the manufacturer adds milk and sugar to the cacao beans midway through production. This shows that it is possible to add direct materials during the production process instead of just at the beginning of the process.
Even with all these additions and processes, an accountant must accurately collect all costs for a product. The accountant subdivides the work in process (WIP) inventory account to reflect the different processes or departments. Using the candy bar example, the accountant would include work in process inventory subtotals under roasting, winnowing, chocolate crumb, conching, and tempering. The unprocessed cacao beans will be part of raw material inventory.
To accurately determine the total costs of the candy bar, all costs need to move from processing department to processing department as processes are completed. At this point of collecting costs, the company has not yet determined the cost of a single unit. To calculate the unit cost, the accountant makes sure that all costs are accumulated and flow with the product as each process is completed.The manufacturing process is a continuous flow of product, so the accountant will have to determine mathematically how to assign costs for finished processes. The accountant uses an equivalent units calculation, which is a method of valuation that helps companies determine inventory value for partially finished units. The accountant gives partially completed items a cost equivalent to fully completed units for inventory valuation purposes.