Discuss the concept of equivalent units and how that concept relates to management decision making. Be sure to include information in your discussion about the weighted-average method in comparison to the FIFO method of accounting for work residing in work-in-process units.
Process costing deals with batches of like products. For example, paint is produced in large quantities and you can’t tell one gallon of white paint from another gallon of white paint. A barrel of oil would be another example. The essence of this costing method is that costs are accumulated by process rather than by job. Accounting is very definitive, so process costing becomes a little out of the comfort zone for many accountants because we don’t have anything that is exact. At month end under job costing, we know how much in materials have been charged to a specific job. However, under process costing we only know that a certain quantity of materials has been entered into the process. As a result, we have to estimate how far along we are in the process for direct materials and direct labor. To do this we introduce the concept of equivalent units. Equivalent units is just fancy terminology for how far along we are in the process. Since accountants like to think of completed units for costing purposes, we estimate, based on where we are in the process, how many equivalent units of completed materials we would have if we combined all the partially completed units into a smaller number of completed units. For example, we might estimate that 200 units ½ complete would be equivalent to 100 fully completed units. See, that wasn’t so bad.
Here is a short video on the basics: Process Costing Part 1 – Managerial Accounting
Journal entries under process costing are also a little different than under job order costing. Materials are issued to a process, rather than a job, so materials requisitioned would be debited to WIP (some department) and credited to Materials Inventory. There are a series of five steps we use for this type of costing:
- Measure the physical flow of resources
- Compute the equivalent units of production
- Identify the product costs to be accounted for
- Compute the cost per equivalent unit: weighted average
- Assign product cost to batches of work
Here’s a problem that will demonstrate this process: Process Costing Part 2 – Managerial Accounting
One other concept that bears some additional discussion is called an Economic Order Quantity (EOQ). The idea behind the EOQ is that there is some specific quantity of materials that should be ordered each time an order is placed in order to minimize inventory holding costs and inventory ordering costs. This concept dovetails nicely with our ABC discussion in an earlier week actually.
The formula for the EOQ is:
EOQ = the square root of (2DS/H) where D=annual quantity demanded, S=flat fixed cost per order and H is the annual holding cost.