Imagine this: You’re baking a massive batch of cookies for a fundraiser. You mix all the ingredients in one large bowl, scoop out dozens of cookies, and bake them to golden perfection. At the end, someone asks, “How much did each cookie cost to make?” You know the total cost of flour, sugar, and butter, but breaking it down per cookie is a little trickier.
Now, scale that challenge up to a business producing hundreds, thousands, or even millions of identical products. How do you track costs accurately when the production process blends everything together?
Enter process costing — a systematic way to assign costs to products in industries where goods are mass-produced in a continuous flow. Whether you’re creating batches of shampoo, refining crude oil, or producing cans of soda, process costing ensures you’re accounting for every unit’s cost across production.
What is process costing?
Companies that produce large quantities of identical or very similar products use this costing method for manufacturing. Instead of tracking costs for each individual item, process costing allocates total production costs — direct materials, direct labor, and overhead — to all units produced when they’re completed. You can also use weighed averages to account for works-in-process (WIP). By dividing total production costs by the number of finished goods and WIPs, manufacturers can calculate the average cost of each unit. It’s perfect for industries using process manufacturing or working with very standardized processes, like food production, chemicals, or textiles.
Here are the three key elements of process costing:
Direct materials
These are the physical materials used in production, such as fabric in a clothing factory or chemicals in a paint manufacturing plant. In process costing, the cost of raw materials is allocated evenly across all units produced. For instance, in a batch of paint, every gallon “shares” the total cost of materials used in production.
Direct labor
This covers the wages paid to workers directly involved in the manufacturing process. Whether they’re operating machines or assembling products by hand, the direct labor costs incurred are spread evenly across all units.
Manufacturing overhead
This includes all the indirect costs associated with production, like factory rent, machinery maintenance, and utility bills. These overhead costs are accumulated and then allocated to all units manufactured during production.
The result is a reliable calculation for each unit produced to determine production costs for WIPs and finished goods.
Process costing examples
Process costing is a costing method where products undergo standardized production stages. Here are a few examples of process costing in action.
Food production
Companies producing items like bottled drinks or packaged snacks rely on process costing to proportionately distribute production costs such as raw materials, direct labor, and overhead across thousands of identical products. This approach simplifies pricing and profitability analysis.
Textiles
Textile mills’ fabrication involves stages like spinning, dyeing, and finishing. Process costing assigns costs to each step, making it easier to track production costs and calculate the value of large fabric batches.
Chemical manufacturing
Manufacturers of paints, cleaning supplies, or pharmaceuticals benefit from process costing by dividing total production costs across each gallon, liter, or tablet produced.
Steel and cement industries
These industries produce massive quantities of standardized products, like sheets of metal or bags of cement. Process costing splits expenses like energy, labor, and direct materials into manageable costs per ton, allowing for transparency in pricing and profitability assessment.
Process costing vs. job costing
Both process and job costing help you answer questions about how much an item costs to produce. But unlike job costing, which tracks costs for custom or unique products, process costing spreads expenses evenly across all units.
Here are the major differences in these costing methods to help you decide which is best for you.
Production style
- Process costing works best for businesses that produce identical items through a standardized process — like bottles of soda or packages of paper. It distributes the total cost uniformly across all units.
- Job costing focuses on unique, custom items. Businesses use it to track the cost of specific jobs or batches, making it ideal for industries producing items with more variation, like construction projects or custom furniture.
Tracking costs
- In process costing, you group costs by departments or processes, then average them across all units to determine the unit cost.
- In job costing, you assign direct materials, direct labor, and overhead to each job for a detailed breakdown.
Handling unfinished work
- Process costing accounts for partially completed products and uses methods like the weighted average to calculate costs at different stages of the production process.
- Job costing focuses on individual projects, so you can only calculate costs when you finish the job.
Types of process costing
Businesses use different methods of process costing to match production needs. Here are three common types and how they work.
Weighted average method
The weighted average method combines costs from current and previous production periods. It averages the total cost of direct materials, labor costs, and manufacturing overhead over all units — whether they’re completed or still in process. This method is simple and works best for standardized processes with a steady production flow.
FIFO (First-In, First-Out) method
The FIFO method assumes the earliest costs are assigned to the first units completed. It separates costs of production from different periods, focusing on the current period’s expenses. This approach gives a more precise picture of production costs during a specific timeframe, which is especially useful when tracking changes in costs incurred.
Standard costing
Instead of tracking actual costs, the standard costing method uses predetermined estimates for raw materials, labor, and overhead costs. Businesses often rely on this method to identify variances between expected and actual costs, helping them improve efficiency and maintain profitability in their production processes.
Benefits of process costing
Process costing is more than just a way to track expenses — it’s a valuable tool for businesses that rely on standardized processes. Here’s how it can make a difference:
- Simplifies cost allocation: Instead of calculating costs for individual items, process costing evenly distributes them across all units. This saves time and improves tracking accuracy.
- Improves cost control: By analyzing expenses at each stage of production, companies can spot inefficiencies in the use of raw materials, labor hours, or overhead to reduce waste.
- Ensures accurate pricing: Precise unit cost data enables businesses to price products effectively, covering their expenses and protecting their profitability. With clear insights into the cost of production, companies set prices that reflect their value.
- Supports strategic decision making: Detailed production information and average costs aid in planning future budgets, managing resources, and evaluating manufacturing productivity. Accurate data on total costs and output equips businesses to make informed decisions that drive growth.
How to use the process costing method
Using the process costing method effectively allows businesses to track production costs with clarity and accuracy. Here’s a step-by-step guide:
- Map out your production stages: Break your manufacturing process into stages or departments, then highlight each step where products move and incur costs.
- Track costs as they happen: Monitor all the costs involved — from direct materials and labor to overhead costs. These are the core elements contributing to production expenses.
- Calculate equivalent units: For partially completed units, determine how much work has been done on them. Use finished units as a gauge to quantify the progress.
- Allocate costs to each stage: After determining the total cost, allocate them to each production stage based on the resources used in that particular phase.
- Determine cost per unit: To find the unit cost, divide the total costs for each stage by the number of equivalent units produced. This gives you a clear idea of how much each unit costs to produce.
- Assign costs to finished goods and WIPs: Allocate the unit cost to both the completed products and any unfinished goods in the production pipeline.
- Summarize and review: Finally, summarize the costs at each stage and compare them to the budgeted amounts or past performance. Doing this gives you data to evaluate cost control and operational efficiency.
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Don’t leave your profitability to chance. Book a demo today to discover how Fishbowl can help you streamline manufacturing.