Process Costing

Like the name says, Process Costing helps you figure out, well...the cost of the process. Which process? Manufacturing.

Process costing lets companies determine how much it costs them to make each individual product they manufacture. Firms use the technique to assign the expenses related to manufacturing to each of the units produced. It works best in cases of mass production. Lots and lots of identical items getting made.

If you're carving custom totem poles by hand, process costing won't really come into play. However much it costs you to make that totem pole...well, that's what it cost you. But when you're cranking out giant batches of the same product, process costing lets you know how much money to assign to the manufacture of each little unit.

You run a company that makes the eyes that go into teddy bears. You don't make the teddy bears themselves...you're actually scared of stuffed animals. It’s a long story, involving a haunted teddy that tried to kill you as a kid. Anyway, you can handle making just the eyes. So your company makes millions and millions of little black buttons that you ship off to teddy bear factories all over the world. (The further away from you the better.)

All your eyes are the same. You make 1 million per month. The only material you need is the plastic. Buying the plastic to make 1 million eyes costs you $100,000. Meanwhile, the cost of paying your workers, and the expenses associated with running the cutting, shaping, and stamping machines come to $150,000.

So the material costs for the 1 million eyes comes to ten cents per eye. The labor and machine expenses, known as your conversion costs, come to 15 cents per eye. The total cost for the process is twenty five cents per eye, a total of $250,000 for materials and conversion costs, divided by the 1 million eyes that you produced.

The simple division works, because each eye is essentially identical. You can assume that each one took an equal amount of time, an equal amount of plastic, an equal amount of machine power to produce. In a single product factory, process costing doesn’t provide much insight. But when there are multiple products, the strategy is essential to understanding margins for the various products.

You start a second business line to sell eyes for dolls. You also have a fear of dolls, because of that time your sister locked you in her closet overnight. A lot of years of therapy spent on that one. The doll eyes and the teddy eyes use the same plastic and the same machines. Under the new set-up, you are making 750,000 million teddy eyes and 500,000 doll eyes. The plastic costs you $175,000 a month. The cost of the machines and labor total $162,500.

So, in total, you’re spending $337,500 to manufacture 1.25 million eyes. Each eye costs a little over 28 cents per eye, then, right? 28.125 cents per eye, to be exact. Eh...not quite. The doll eyes require twice the plastic as the teddy eyes. However, they only need ⅔ of the time in the machines and only ⅔ of the labor to create.

Here’s where process costing earns its keep. The goal is to take these general costs and apply them to the specific products. So you’re spending $175,000 a month on plastic to make 750,000 teddy eyes and 500,000 doll eyes. But the doll eyes take twice as much plastic to make. Throw that all into the process costing mathematical blender...and you end up with 10 cents per eye for the teddy version and 20 cents per eye for the doll version.

Now, let’s do the same thing with the other costs. $162,500 total for all production. Doll eyes use ⅔ of the resources as the teddy eyes. Math blender again. We get 10 cents for the doll eyes and 15 cents for the teddy eyes. Total costs for the two products: 25 cents for the teddy eyes, and 35 cents for the doll eyes. So process costing shows us that the doll eyes cost more to make than the teddy eyes.

Time for the annual board meeting. You have money for a marketing push and the board wants you to recommend which product to push more: teddy eyes or doll eyes? Process costing helps you make that decision. The teddy eyes sell for 35 cents each. Meanwhile, the doll eyes sell for 51 cents each.

The process costing we did shows us that the teddy product costs 25 cents to make. So gross margins on those come in at 40%. The doll product cost 35 cents to make. But with the 51 cent sale price, the gross margin is just under 46%. So the doll eyes, while more expensive to make...are a higher margin product.

You recommend a marking push for the doll eyes, information you wouldn’t have had if you didn’t go through the process costing rigmarole. It makes process costing a very useful tool when you’re mass producing multiple products. You can't say the same for the totem pole subsidiary you're thinking about getting off the ground. Each totem pole takes a different amount of time and a different amount of materials, and each has different machine costs associated with its production.

But, at least when you carve out the animal faces, you'll have the eyes all ready to go...