Process Costing, Joint Products and By-Products
Weightage: Chapter 7 of ICAI's Paper 4 syllabus, roughly 14 marks. One of the three heaviest chapters in the paper, and the one whose single governing idea — equivalent units — is worth understanding thoroughly before attempting extended computation.
Why process costing exists as a distinct method
Where production is continuous and output is homogeneous, passing through a sequence of processing stages, there is no individual job or batch to attach cost to. Cost is instead ascertained for each process as a whole, for a period, and then spread across the units that emerged from that process during the period — but a period virtually never ends exactly when a batch of units is exactly complete. Some units are typically partly through the process at the period end, and this is the problem equivalent units exists to solve.
Equivalent units — the governing idea
A unit that is 60% complete is not worth 60% of a completed unit's selling price, but for costing purposes, it has absorbed roughly 60% of the cost a fully completed unit would carry (assuming cost is incurred evenly through the process, or adjusted for the specific pattern in which it is actually incurred). Equivalent units convert partly completed output into an equivalent number of fully completed units, so that cost per unit can be computed on a consistent basis.
Materials, labour and overheads are frequently completed to different degrees, and this is where most of the computational care in this chapter lives: material is very often added fully at the start of a process (100% complete for material from the moment a unit enters the process), while labour and overhead (conversion cost) accrue gradually through the process and are only partly complete for a unit still in progress. A candidate must compute separate equivalent unit figures for material and for conversion cost wherever their completion percentages differ, rather than applying a single blended completion percentage to the whole cost.
FIFO versus weighted average in process costing
Two methods exist for dealing with opening work-in-progress when computing equivalent units, and they differ in how they treat the work already done on opening WIP in a prior period:
Weighted average method — treats opening WIP as though all its work, prior period's and current period's combined, were done in the current period; equivalent units = units completed and transferred out + equivalent units in closing WIP (opening WIP's prior-period-completed work is not separated out).
FIFO method — separates the work needed to complete opening WIP (only the incremental work done this period on units that were already partly done) from the work on units started and completed entirely within the current period, and from closing WIP; equivalent units = (equivalent units to complete opening WIP) + (units started and completed this period) + (equivalent units in closing WIP).
The FIFO method is more precise about which period's cost applies to which portion of work, but is correspondingly more computational; the weighted average method is simpler but blends prior and current period costs together. Both remain examinable, and a question will generally specify which method to apply.
Normal loss, abnormal loss and abnormal gain
The same normal/abnormal principle from material and labour costing applies here, with process-specific accounts:
Normal loss is expected, inherent in the process (evaporation, unavoidable scrap), and its cost is absorbed by the good units that survive — the normal loss units are simply removed from the quantity used to compute cost per unit, so the same total process cost is spread over fewer good units, effectively raising cost per good unit.
Abnormal loss — actual loss exceeding the normal expected loss — is valued at the same rate as good units (the process's cost per unit) and is debited to an Abnormal Loss Account, then further transferred to the costing profit and loss account, keeping it entirely separate from the cost of good output.
Abnormal gain — actual loss less than the normal expected loss (fewer units lost than anticipated) — is valued similarly at the process cost per unit rate and is credited to an Abnormal Gain Account, then transferred to the costing profit and loss account as a gain, since fewer resources were consumed per good unit produced than the normal allowance anticipated.
Scrap value, where normal loss units have some residual sale value, is credited to the process account, reducing the net cost to be absorbed by good units — the normal loss's cost absorption is therefore net of whatever the scrap itself can be sold for, not its gross cost.
Inter-process profit
Where a company organises its processes as if each were a separate profit centre, output of one process may be transferred to the next at a price above cost (including a profit margin) rather than at cost — this is done for internal performance evaluation purposes (to assess whether each process, viewed as a quasi-independent unit, is genuinely adding value), but it introduces unrealised profit into the closing stock of work-in-progress and finished goods, exactly analogous to unrealised profit on intra-group transactions in consolidation (Paper 1) or on branch stock transfers invoiced above cost (also Paper 1).
Stock reserve for unrealised profit is computed and adjusted in exactly the same conceptual way as the branch accounting stock reserve: the profit loading embedded in closing stock that has not left the entity (has not been sold to an outside party) must be eliminated before the entity's true, realised profit is stated.
Joint Products and By-Products
The classification that governs everything
Joint products are two or more products of significant, comparable value, produced simultaneously from the same process and the same input, up to a split-off point beyond which they are processed separately (or sold as is) — crude oil refining into petrol, diesel and kerosene is the standard illustration.
By-products are products of relatively minor value, incidentally produced alongside a main product from the same process — sawdust from a sawmill producing timber as its main product.
The distinction matters because it determines the accounting approach: joint products require the joint cost itself to be apportioned among them (since each is significant enough to need its own cost figure for inventory valuation and profitability assessment), while by-products, being minor, are typically accounted for by crediting their net realisable value against the main product's cost, without attempting to apportion joint cost to them at all.
Apportioning joint cost among joint products
Costs incurred up to the split-off point are common to all the joint products and must be apportioned by some reasonable method; costs incurred after split-off (further processing costs specific to one product) are not joint costs and are charged directly to the specific product that incurs them.
Physical unit method — apportions joint cost in proportion to the physical quantity (weight, volume) of each joint product, simple but can produce anomalous results where products differ greatly in value per physical unit.
Sales value at split-off method — apportions joint cost in proportion to each product's sales value at the split-off point, which better reflects each product's relative ability to bear cost, but requires an ascertainable market at the split-off point itself.
Net realisable value (NRV) method — used where products are not saleable at split-off and require further processing before sale; joint cost is apportioned based on each product's final sales value less its own further processing cost (working backward from final value to an imputed value at split-off).
Constant gross margin percentage method — apportions joint cost so that every joint product earns the same gross profit percentage on its final sales value, a method sometimes used where management wants a uniform profitability picture across products regardless of the underlying joint cost apportionment mechanics.
By-product valuation
Where a by-product is sold as is at split-off, its net realisable value (sale value less any selling cost) is credited against the main product's process cost. Where a by-product requires further processing before sale, its cost credited is its final sales value less both selling cost and further processing cost — the same working-backward logic used in the NRV method for joint products, applied here to a single minor product rather than to an apportionment across several significant ones.
