Question

Question #1: Compare and contrast a job order costing system and a process costing system - include an example of when each might be used

Question #2: Explain in detail what the term "equivalent units" means. How is it used in Accounting and/or what is its purpose

Answer 1

Question 1)

Job Order Costing

As you’ve learned, job order costing is the optimal accounting method when costs and production specifications are not identical for each product or customer but the direct material and direct labor costs can easily be traced to the final product. Job order costing is often a more complex system and is appropriate when the level of detail is necessary, as discussed in Job Order Costing. Examples of products manufactured using the job order costing method include tax returns or audits conducted by a public accounting firm, custom furniture, or, in a comprehensive example, semitrucks. At the Peterbilt factory in Denton, Texas, the company can build over 100,000 unique versions of their semitrucks without making the same truck twice.

Process Costing

Process costing is the optimal costing system when a standardized process is used to manufacture identical products and the direct material, direct labor, and manufacturing overhead cannot be easily or economically traced to a specific unit. Process costing is used most often when manufacturing a product in batches. Each department or production process or batch process tracks its direct material and direct labor costs as well as the number of units in production. The actual cost to produce each unit through a process costing system varies, but the average result is an adequate determination of the cost for each manufactured unit. Examples of items produced and accounted for using a form of the process costing method could be soft drinks, petroleum products, or even furniture such as chairs, assuming that the company makes batches of the same chair, instead of customizing final products for individual customers.

For example, small companies, such as David and William’s, and large companies, such as Nabisco, use similar cost-determination processes. In order to understand how much each product costs—for example, Oreo cookies—Nabisco uses process costing to track the direct materials, direct labor, and manufacturing overhead used in the manufacturing of its products. Oreo production has six distinct steps or departments: (1) make the cookie dough, (2) press the cookie dough into a molding machine, (3) bake the cookies, (4) make the filling and apply it to the cookies, (5) put the cookies together into a sandwich, and (6) and place the cookies into plastic trays and packages. Each department keeps track of its direct materials used and direct labor incurred, and manufacturing overhead applied to facilitate determining the cost of a batch of Oreo cookies.

As previously mentioned, process costing is used when similar items are produced in large quantities. As such, many individuals immediately associate process costing with assembly line production. Process costing works best when products cannot be distinguished from each other and, in addition to obvious production line products like ice cream or paint, also works for more complex manufacturing of similar products like small engines. Conversely, products in a job order cost system are manufactured in small quantities and include custom jobs such as custom manufacturing products. They can also be legal or accounting tasks, movie production, or major projects such as construction activities.

Contrast between Job Order Costing and Process Costing

The difference between process costing and job order costing relates to how the costs are assigned to the products. In either costing system, the ability to obtain and analyze cost data is needed. This results in the costing system selected being the one that best matches the manufacturing process.

A job order cost system is often more expensive to maintain than a basic process costing system, since there is a cost associated with assigning the individual material and labor to the product. Thus, a job order cost system is used for custom jobs when it is easy to determine the cost of materials and labor used for each job. A process cost system is often less expensive to maintain and works best when items are identical and it is difficult to trace the exact cost of materials and labor to the final product. For example, assume that your company uses three production processes to make jigsaw puzzles. The first process glues the picture on the cardboard backing, the second process cuts the puzzle into pieces, and the final process loads the pieces into the boxes and seals them. Tracing the complete costs for the batch of similar puzzles would likely entail three steps, with three separate costing system components. In this environment, it would be difficult and not economically feasible to trace the exact materials and the exact labor to each individual puzzle; rather, it would be more efficient to trace the costs per batch of puzzles.

The costing system used typically depends on whether the company can most efficiently and economically trace the costs to the job (favoring job order costing system) or to the production department or batch (favoring a process costing system).

While the costing systems are different from each other, management uses the information provided to make similar managerial decisions, such as setting the sales price. For example, in a job order cost system, each job is unique, which allows management to establish individual prices for individual projects. Management also needs to establish a sales price for a product produced with a process costing system, but this system is not designed to stop the production process and individually cost each batch of a product, so management must set a price that will work for many batches of the product.

In addition to setting the sales price, managers need to know the cost of their products in order to determine the value of inventory, plan production, determine labor needs, and make long- and short-term plans. They also need to know the costs to determine when a new product should be added or an old product removed from production.

Question 2)

Equivalent Units
Equivalent units of production is a term applied to the work-in-process inventory at the end of an accounting period. It is the number of completed units of an item that a company could theoretically have produced, given the amount of direct materials, direct labor, and manufacturing overhead costs incurred during that period for the items not yet completed. In short, if 100 units are in process but you have only expended 40% of the processing costs on them, then you are considered to have 40 equivalent units of production.

Equivalent units is a cost accounting concept that is used in process costing for cost calculations. It has no relevance from an operational perspective, nor is it useful for any other type of cost derivation other than process costing.

Equivalent units of production are usually stated separately for direct materials and all other manufacturing expenses, because direct materials are typically added at the beginning of the production process, while all other costs are incurred as the materials gradually work their way through the production process. Thus, the equivalent units for direct materials are generally higher than for other manufacturing expenses.

When assigning a cost to equivalent units of production, you typically assign either the weighted average cost of the beginning inventory plus new purchases to the direct materials, or the cost of the oldest inventory in stock (known as the first in, first out, or FIFO, method). The simpler of the two methods is the weighted average method. The FIFO method is more accurate, but the additional calculations do not represent a good cost-benefit trade off. Only consider using the FIFO method when costs vary substantially from period to period, so that management can see the trends in costs.

Example of Equivalent Units of Production

ABC International has a manufacturing line that produces large amounts of green widgets. At the end of the most recent accounting period, ABC had 1,000 green widgets still under construction. The manufacturing process for a green widget requires that all materials be sent to the shop floor at the start of the process, and then a variety of processing steps are added before the widgets are considered complete. At the end of the period, ABC had incurred 35% of the labor and manufacturing overhead costs required to complete the 1,000 green widgets. Consequently, there were 1,000 equivalent units for materials and 350 equivalent units for direct labor and manufacturing overhead.