Case 2: Process Costing with Zero Beginning Inventory and Some Ending Work-In-Process Inventory

Learning Objective 3: Describe the five steps in process costing and calculate equivalent units

It should be noted that the estimation for % conversion for units is simply that, an estimation. Different businesses estimate differently based on the care and accuracy of the estimators/managers and the physical limitations of the business.

This % however, no matter how estimated, grants us a concept of equivalent units. These can be used to help measure the costs of our completed and incomplete units for a period. Process Costing for this type of problem follows its own process:

1. Summarize the flow of physical units of output
2. Compute output in terms of equivalent units
3. Summarize the total costs to account for
4. Compute the cost per equivalent unit
5. Assign the total costs to the units completed and to the units in ending work-in-process inventory

Summarizing the Physical Units and Equivalent Units (Steps 1 and 2)

Step 1: Summarize the flow of physical units of output

Physical units are the number of units, be it complete or incomplete. The flow is the measurement of what goes into the system and where it goes out. For example, consider a batch of 400 Simple Meals. We would record 400 simple meals started this period. However, let's say only 175 got completed, the other 225 only being partially completed. The flow then considers the 175 transferred out, and the 225 goes into Work-In-Progress.

Step 2: Compute Output in terms of equivalent units

Let's say the 225 units that are only partially completed are measured to have 100% of their materials, but only 60% converted. This would mean we have 225 physical units in our WIP, but what would this mean in Equivalent Units?

To calculate equivalent units, you multiply the amount of physical units there are by the percentage of completion. In this case, you have 225 equivalent units in Direct Materials, but only 135 equivalent units in Conversion Costs.

Note: Equivalent Units are calculated separately per input (in this case, Direct Materials and Conversion Costs)

For now, focus on quantities of units, not dollar amounts

Calculating Product Costs (Steps 3, 4, and 5)

Step 3: Summarize the Total Costs to Account For

In this case, the only costs we summarize are the ones added this period. Let's say it costs $32,000 in Direct Materials and $18,600 in Conversion Costs

Step 4: Compute the Cost Per Equivalent Unit
This is why you calculate equivalent units separately for input, by the way.

Divide the Material Cost by Equivalent Units in Direct Materials, and Conversion Costs to their Equivalent Units, to get the Cost Per Equivalent Unit.

Step 5: Assign the Total Costs to the Units Completed and to the Units in Ending WIP 

You now have the number of Equivalent Units Completed and in Progress (Steps 1 and 2), as well as the Cost Per Equivalent Units (Steps 3 and 4). Simply multiply them together to get your total costs within each inventory (Transferred out and WIP). These numbers should add up and match your recorded Total Production Costs

Journal Entries

In Process Costing, there are WIP Entries for each Process.


Why Accuracy in Conversion % is important

Inaccurate Conversion % would ultimately mean inaccurate costs being recorded, affecting the perceived performance of the manager/company.

If Conversion % is too high, this raises the apparent CoGS for the period. This is improves the performance indicators for some people in the company, meaning there's an unethical incentive to lie. The reverse is also true, where Supervisors could estimate low to help smooth over unnatural high points in productivity, which can then be used to cover up any future low points or spike future high points. Top Management should always emphasize obtaining the correct answer, regardless of how it affects reported performance.

What are the five steps in a process costing system, and how are equivalent units calculated?

1. Physical Units
2. Equivalent Units
3. Total Costs
4. Total Costs/Equivalent Units
5. Allocate Costs

Equivalent Units are calculated by measuring the amount of incomplete units in terms of both Direct Materials and Conversion Costs. So, at the end of the period if there's a WIP of 100 Units, 100% of Direct Materials are in there, but the Units are only 50% converted, that means you have 100 Equivalent Units in Direct Materials and 50 Equivalent Units in Conversion Costs. These Equivalent Units are then added to the Completed Units for the Time Period (which are treated (and defined) as 100% | 100% completed).