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Process Costing is the method of accumulating costs over a period of time and averaging the accrued costs over all the units produced during the period. This technique is best suited to determine product costs for homogeneous and standardized products, the manufacture of which results from a sequence of continuous or repetitive operations or processes. This costing method usually finds application in manufacturing industries such as chemicals, petroleum, gas, cement, and coal where both the product and production process are uniform with no scope for variations.
Image Credit: Wikimedia Commons/Rundvald
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Some criticisms of the process costing method is that it fails to estimate the exact cost of specific products. Process costing fails to provide an accurate estimate of product cost when a single process produces many items or different versions of a same item.
Manufacturing plants or service providers rarely make identical and homogeneous products, and usually produce different versions of the same product, even if the product remains the same. By accruing all costs and dividing such costs on an average, it becomes difficult to determine the actual cost accrued to manufacture a specific variant.
For instance, oil refineries that product crude oil usually have a standardized process and deal only with crude oil, making it best suited to apply process costing. Most oil refineries, however, produce different varieties of fuel, such as gasoline, aviation fuel, kerosene, and others, and process costing can only assign an approximate cost to each different product.
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Suitable Only for Mass Production
Another major criticism of the process costing method is that it remains suitable only for mass production of standardized goods. The process costing method does not cater to customization of a product or individual orders, or providing optional value added services on top of a standard product, for it may cause irrational pricing decisions in such cases.
Process costing also makes it difficult to determine the price of partially completed goods, or goods whose production spans over two accounting periods.
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Process costing makes the evaluation of the efficiency of individual processes or productivity of an individual worker difficult. Process costing, by accumulating all costs and transferring them to units as average costs, may conceal inefficiencies in processes.
If nine workers produce 100 units a day and the tenth worker produces 50 units a day, that might mean there are inefficiencies in the tenth worker's output. Process costing only considers that 10 workers produce 950 units, or an average of 95 units per worker.
Again, if the dyeing plant in a textile manufacturing plant is inefficient and costs more than the value added, process costing, by averaging the costs hide this inefficiency, whereas activity based costing would reveal the inefficiency and prompt the company to outsource this function.
Process costing may include costs not necessarily related to the manufacturing process.
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Limitations for Managerial Decision Making
Finally, process costing, by dividing actual costs after they occur, depicts historical costs rather than current costs. This reactive process helps in budgeting and accounting, but serves a limited purpose for managerial decision-making in a fast changing world where prices and conditions change fast, and remains a major disadvantage of process costing.
For instance, process costing helps determine the price of a bag of cement. In a world where raw material prices and technology changes by the minute, such historical costs have little bearing on future production costs. Activity based costing that identifies all activities in an organization and assigns the cost of each activity resource to products based on actual consumption by the product allows for better analysis on the impact of changes to any particular activity on products.
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- Thompson, Tim. Management Accounting Decision Management. Retrieved from http://www.cimaglobal.com/Documents/ImportedDocuments/fm_feb06_p37-43.pdf on 14 December 2010
- Walther, Larry. "Process costing and activity-based costing." Retrieved from http://www.principlesofaccounting.com on 14 December 2010.
- Accounting for Management.com, "Product Cost vs. Period Cost." http://www.accountingformanagement.com/product_costs_and_period_costs.htm. Retrieved on 14 December 2010.