Types of Process Costing

There are three types of process costing, which are:

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).