Process costing is a popular method used in the manufacturing industry to calculate the cost of producing a product. This method is used for companies that produce large quantities of similar items, such as food products or electronic components. Process costing allows the manufacturer to calculate the cost per unit of the product by allocating costs across each step of the production process.
In process costing, manufacturing costs are categorized into three main categories: direct materials, direct labor, and factory overhead. Direct materials and direct labor costs are usually easy to track since they are associated with a specific unit of product. However, factory overhead costs are a bit trickier since they cannot be traced to a specific unit of production.
To account for factory overhead costs, process costing relies on a predetermined overhead rate. The predetermined overhead rate is calculated at the beginning of the period by estimating the total amount of factory overhead costs expected to be incurred during that period and dividing it by the estimated amount of activity that will occur during the period. This activity is usually measured in terms of direct labor hours, machine hours, or some other relevant measure of activity.
Once the predetermined overhead rate is established, the manufacturer can apply it to each unit of product as it passes through each step of the production process. For example, if the predetermined overhead rate is $5 per direct labor hour and a unit of product requires 2 hours of direct labor, then the overhead cost allocated to that unit of product would be $10.
For more about determining a single plantwide factory overhead rate, go here: https://accountinghowto.com/how-do-you-calculate-single-plantwide-factory-overhead-rate/
For more methods of calculating factory overhead rates, go here: https://accountinghowto.com/what-are-the-three-methods-of-allocating-manufacturing-overhead-to-products/
As the product moves through each stage of production, the costs of direct materials, direct labor, and overhead are accumulated until the product is completed. At the end of the production process, the total cost of the product is divided by the number of units produced to determine the cost per unit.
Overall, process costing is a useful tool for manufacturers who produce large quantities of similar items. By using this method, they can accurately determine the cost of producing each unit of product and make informed decisions about pricing and production volume.