In a process costing system when items are sold the cost of the item is moved from

What Is Flow of Costs?

Flow of costs refers to the manner or path in which costs move through a firm. Typically, the flow of costs is relevant with manufacturing companies whereby accountants must quantify what costs are in raw materials, work in process, finished goods inventory, and cost of goods sold.

Flow of costs applies not only to inventory but also to factors in other processes to which a cost is attached, such as labor and overhead.

Understanding Flow of Costs

The process of the flow of costs begins with valuing the raw materials used in manufacturing. The flow of costs then moves to the work-in-process inventory. The cost of the machinery and labor involved in production are added as well as any overhead costs. The flow of costs next moves to the inventory stage where the finished goods are stored until they're sold. Following the sale of the goods, the flow of costs finally moves to cost of goods sold.

There are several methods for accounting for the flow of costs. These include LIFO (last in, first out), FIFO (first in, first out), specific identification, and weighted-average cost. For example, the costs of raw materials might vary over time, whereby some are higher in price than others. After the goods are sold, the company must account for the cost of goods sold by removing the items from inventory to COGS.

Under the FIFO method, the first raw material purchased would be moved from inventory and charged to COGS as an expense. Conversely, if the company used the LIFO method, the last unit of raw materials purchased would be moved from inventory and charged to COGS as an expense.

In other words, with the LIFO method, the oldest raw materials are kept or recorded in inventory longer while FIFO leaves the recently purchased materials in inventory. Companies must use the same cost flow calculations and assumptions.

U.S. GAAP (generally accepted accounting principles) financial reporting standards require that companies that use the LIFO method report the difference between that method and FIFO in a line item called LIFO reserve. This allows analysts to readily compare firms using different cost flow assumptions.

Example of Flow of Costs

For example, Ford Motor Company produces cars and trucks. The company has to purchase raw goods to manufacture the cars it sells, which marks the start of the cost of auto production. Next, there are the costs to pay employees to run the assembly line, which adds on to the cost of the raw materials. The cost to operate the machines and the costs associated with the building where the machines are located are also accounted for in the flow of costs.

What is Process Costing?

Process costing is used when there is mass production of similar products, where the costs associated with individual units of output cannot be differentiated from each other. In other words, the cost of each product produced is assumed to be the same as the cost of every other product. Under this concept, costs are accumulated over a fixed period of time, summarized, and then allocated to all of the units produced during that period of time on a consistent basis. When products are instead being manufactured on an individual basis, job costing is used to accumulate costs and assign the costs to products. When a production process contains some mass manufacturing and some customized elements, then a hybrid costing system is used.

Examples of the industries where this type of production occurs include oil refining, food production, and chemical processing. For example, how would you determine the precise cost required to create one gallon of aviation fuel, when thousands of gallons of the same fuel are gushing out of a refinery every hour? The cost accounting methodology used for this scenario is process costing.

Process costing is the only reasonable approach to determining product costs in many industries.   It uses most of the same journal entries found in a job costing environment, so there is no need to restructure the chart of accounts to any significant degree.  This makes it easy to switch over to a job costing system from a process costing one if the need arises, or to adopt a hybrid approach that uses portions of both systems.

Example of Process Cost Accounting

As a process costing example, ABC International produces purple widgets, which require processing through multiple production departments. The first department in the process is the casting department, where the widgets are initially created. During the month of March, the casting department incurs $50,000 of direct material costs and $120,000 of conversion costs (comprised of direct labor and factory overhead). The department processes 10,000 widgets during March, so this means that the per unit cost of the widgets passing through the casting department during that time period is $5.00 for direct materials and $12.00 for conversion costs. The widgets then move to the trimming department for further work, and these per-unit costs will be carried along with the widgets into that department, where additional costs will be added.

Types of Process Costing

There are three types of process costing, which are as follows:

1. Weighted average costs. This version assumes that all costs, whether from a preceding period or the current one, are lumped together and assigned to produced units. It is the simplest version to calculate.

2. Standard costs. This version is based on standard costs. Its calculation is similar to weighted average costing, but standard costs are assigned to production units, rather than actual costs; after total costs are accumulated based on standard costs, these totals are compared to actual accumulated costs, and the difference is charged to a variance account.

3. First-in first-out costing (FIFO). FIFO is a more complex calculation that creates layers of costs, one for any units of production that were started in the previous production period but not completed, and another layer for any production that is started in the current period.

There is no last in, first out (LIFO) costing method used in process costing, since the underlying assumption of process costing is that the first unit produced is, in fact, the first unit used, which is the FIFO concept.

Why have three different cost calculation methods for process costing, and why use one version instead of another?  The different calculations are required for different cost accounting needs.  The weighted average method is used in situations where there is no standard costing system, or where the fluctuations in costs from period to period are so slight that the management team has no need for the slight improvement in costing accuracy that can be obtained with the FIFO costing method.  Alternatively, process costing that is based on standard costs is required for costing systems that use standard costs.  It is also useful in situations where companies manufacture such a broad mix of products that they have difficulty accurately assigning actual costs to each type of product; under the other process costing methodologies, which both use actual costs, there is a strong chance that costs for different products will become mixed together.  Finally, FIFO costing is used when there are ongoing and significant changes in product costs from period to period – to such an extent that the management team needs to know the new costing levels so that it can re-price products appropriately, determine if there are internal costing problems requiring resolution, or perhaps to change manager performance-based compensation.  In general, the simplest costing approach is the weighted average method, with FIFO costing being the most difficult.

Cost Flow in Process Costing

The typical manner in which costs flow in process costing is that direct material costs are added at the beginning of the process, while all other costs (both direct labor and overhead) are gradually added over the  course of the production process. For example, in a food processing operation, the direct material (such as a cow) is added at the beginning of the operation, and then various rendering operations gradually convert the direct material into finished products (such as steaks).

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