Cost Accounting Methods: Inter-process Profit and Inventory Valuation

Posted on Dec 29, 2025 in Other subjects

Inter-process Profit and Its Treatment

Process costing is used in industries where production is continuous and passes through successive processes such as chemicals, textiles, petroleum, paper, or food processing. In such industries, the output of one process becomes the input of the next process. When this transfer of output takes place at a price above cost, the difference is called Inter-process Profit.

Meaning of Inter-process Profit

Inter-process profit refers to the practice of charging the output of one process to the next process at a price that includes a profit margin rather than at actual cost.

For example:

• Cost of output of Process A = Rs. 100
• Profit added = 20 percent
• Transfer price to Process B = 100 + 20 = Rs. 120.

This profit is not realized because the goods are still inside the organization. Hence, it is a purely internal accounting adjustment used primarily for managerial control.

Objectives of Charging Inter-process Profit

Inter-process profit is used by management for several specific control and evaluation purposes:

• Evaluate Performance: Each process becomes a profit center, allowing managers to be evaluated based on the profit earned by their process.
• Improve Cost Control: Treating processes as separate units encourages them to minimize their own costs and improve efficiency.
• Measure Value Addition: Inter-process profit shows how much value is added at each stage of production.
• Support Internal Transfer Pricing: Helps internal decision-making regarding whether to produce internally or buy from outside sources.
• Increase Transparency: Distinguishes the performance of various stages in multi-process manufacturing.

Structure and Calculation

Transfer price = Cost of production of process + Profit Margin

The profit margin may be calculated as:

• A percentage of cost.
• A percentage of the transfer price.
• A predetermined mark-up decided by management.

Accounting Treatment of Inter-process Profit

Since the profit included in the transfer price is unrealized, special adjustments are required. The treatment involves three main stages:

1. Recording Transfer at Loaded Price

The receiving process records the transferred units at the loaded (enhanced) transfer price.

Example: Process B Account shows: To Process A Account ………. Rs. 120. This amount includes both cost and profit.

2. Elimination of Unrealized Profit from Closing Stock

Closing stock (Work-in-Progress or finished goods) of the receiving process contains profit that is not yet realized, as the goods have not been sold to external customers. This unrealized profit must be removed for proper valuation.

Calculation of Unrealized Profit

Unrealized Profit = Value of closing stock × Profit percentage (adjusted for cost/transfer price basis).

This amount is transferred to the Provision for Unrealized Profit Account.

Journal Entry for Provision:

Provision for Unrealized Profit A/c … Dr
To Process Account

This ensures stock is valued at actual cost, not at the loaded price.

3. Treatment in Next Accounting Period

When the closing stock is sold in the next period, the unrealized profit becomes realized, and the provision is reversed.

Journal Entry for Reversal:

Process Account … Dr
To Provision for Unrealized Profit A/c

This ensures the matching of revenue and cost.

Conceptual Illustration

Suppose:

• Cost from Process 1 = Rs. 10,000
• Profit charged = 25 percent on cost
• Transfer price = Rs. 12,500
• Closing stock in Process 2 = Rs. 5,000 (loaded price)

Profit included in closing stock:

Profit percentage on transfer price = 25 / (100 + 25) = 25/125

Unrealized profit = 5,000 × (25/125) = Rs. 1,000

This Rs. 1,000 is deducted by creating a provision for unrealized profit.

Advantages and Limitations

Advantages

• Enhances Accountability: Each process manager is responsible for both cost and profitability.
• Encourages Cost Reduction: Managers strive to reduce costs to increase their process profit.
• Aids Decision-making: Provides insight for decisions like outsourcing or process investment.
• Shows Value Addition: Value created by each stage becomes visible.

Limitations

• Complicates Accounting: Multiple adjustments are required for unrealized profit.
• Overstates Inventory: If unrealized profit is ignored, stock may be overvalued.
• Inflates Internal Profits: Process-level profits may not reflect actual company profits.
• Difficult for External Reporting: Adjustments are mandatory for financial statements.

Inter-process profit is a valuable costing and control tool for multi-process industries. It requires careful accounting treatment to eliminate unrealized profit from closing stock to avoid inflation of cost and profit.

Job Costing: Features and Procedure

Job costing is a fundamental method of costing used in industries where production is carried out based on specific customer orders. Each job is treated as a distinct cost unit, and costs are accumulated separately for every job. This method is widely used where products are non-standardized and vary from one order to another.

Meaning of Job Costing

Job costing is a system in which manufacturing costs are collected and assigned to individual jobs, orders, or contracts. Each job differs from others in terms of material, labor, and overhead requirements, necessitating separate cost recording.

Industries using job costing include printing presses, furniture making, construction projects, engineering workshops, repair shops, interior design, and custom manufacturing.

Key Features of Job Costing

• Customer Orders: Production is initiated only after receiving a customer’s order and specifications.
• Distinct Cost Unit: Every job is assigned a unique job number, and costs are tracked job-wise.
• Heterogeneous Output: Products are not identical; they vary in size, quality, materials, and processes.
• Job Cost Sheet: A comprehensive sheet records all materials, labor, overheads, and total cost, serving as the basis for pricing.
• Identifiable Direct Costs: Materials, labor, and direct expenses can be clearly traced to a specific job.
• Overhead Allocation: Indirect costs are absorbed using suitable bases (e.g., machine hours, labor hours).
• Cost Control Focus: Helps compare actual costs with estimated costs to analyze variances.
• Customization: Suitable for flexible production systems catering to specific customer needs.

Procedure of Job Costing

1. Receiving the Order: Customer order specifying quantity, design, and schedule is reviewed and accepted.
2. Assigning a Job Number: A unique number is assigned for reference across all cost records.
3. Preparation of Job Cost Sheet: A sheet is prepared to record all costs, including material requisition slips, labor time sheets, and overhead allocation.
4. Materials Requisition: Materials are drawn from stores using a Material Requisition Note referencing the job number, and costs are charged directly.
5. Labor Time Recording: Workers record time spent using Job Cards or Time Sheets. Labor cost is traced directly using hourly or piece rates.
6. Allocation of Direct Expenses: Special expenses (e.g., tools, design charges) are added to the job cost.
7. Absorption of Overheads: Indirect costs are absorbed using predetermined rates (e.g., labor hour rate, machine hour rate).
8. Completion of the Job: A Job Completion Report is prepared, and goods are sent to finished goods.
9. Determination of Job Cost and Profit: Total cost (Prime Cost + Overheads) is computed, and profit is calculated (Selling price – Total cost).
10. Analysis and Feedback: Actual costs are compared with estimates to identify variances and improve future quotations.

Advantages of Job Costing

• Accurate job-wise costing.
• Helps in tendering and quotation preparation.
• Useful for detailed cost control.
• Facilitates performance evaluation.

Limitations of Job Costing

• Expensive and time-consuming due to high clerical load.
• Overhead allocation may be subjective.
• Cost information is available only after job completion.

Contract Costing: Features and Profit Recognition

Contract costing refers to the costing method used for large, long-term projects such as the construction of buildings, bridges, dams, and roads. Each contract is treated as a cost unit, and costs are accumulated over the contract life.

Features of Contract Costing

• Cost Unit: Costs are recorded separately for each contract.
• Long Duration: Contracts typically extend over several months or years.
• Site Work: Production takes place at the customer’s site, unlike factory costing.
• Direct Costs: Most costs (materials, labor, equipment) are direct and traceable.
• Architect Certificates: Completion is certified periodically for payment purposes.
• Work-in-Progress (WIP): Unfinished work at period end is shown as WIP.
• Retention Money: A percentage of payment is withheld by the contractee to ensure quality completion.
• Plant and Subcontractors: Heavy machinery use and subcontract work are common.

Elements of Contract Cost

Contract costs typically include:

• Direct material and direct labor
• Direct expenses
• Plant and machinery cost (depreciation/hire charges)
• Overheads apportioned to the site
• Subcontract charges and architect’s fees

Advantages of Contract Costing

• Accurate cost tracking for large projects.
• Effective cost control over materials, labor, and plant.
• Easy determination of profitability per contract.
• Supports management decisions regarding tendering and pricing.

Profit Recognition in Contract Costing

Due to the long duration of contracts, profit must be recognized periodically based on the stage of completion.

1. Completed Contract Method

Profit is recognized only when the contract is fully completed.

Suitable for: Short-term contracts or when risks are high.

2. Percentage of Completion Method (POCM)

Used when contracts span multiple years and the outcome can be reliably estimated.

Steps for Profit Calculation:

1. Determine the value of work certified by the architect.
2. Compute Notional Profit = (Value of work certified + uncertified) – Cost incurred to date.
3. Calculate profit to be transferred to the Profit & Loss (P&L) Account based on the percentage of completion:

Profit Transfer Rules (Based on Work Certified)

• Less than 25%: No profit recorded.
• 25% to 50%: Profit to P&L = Notional profit × 1/3 × (Cash received / Work certified)
• More than 50%: Profit to P&L = Notional profit × 2/3 × (Cash received / Work certified)
• Nearly Complete: Profit to P&L = Estimated total profit × (Work certified / Contract price)

Process Costing: Features and Account Preparation

Process costing is a technique where costs are collected for each stage or process of production. The total cost of the process is divided by the total units produced to determine the average cost per unit.

Under this method, production is continuous, units lose identity as they merge into a uniform product, and cost is accumulated process-wise, not job-wise.

Features of Process Costing

• Continuous Flow: Production occurs steadily, passing through several processes.
• Homogeneous Products: Every unit produced is identical, making average costing appropriate.
• Cost Centers: Each stage of production is treated as a separate cost center (e.g., Mixing, Boiling, Finishing).
• Average Costing: Cost per unit is computed by dividing total process cost by output units.
• Loss Accounting: Normal and abnormal losses are accounted for separately.
• Work-in-Progress (WIP): The concept of equivalent production is used to value incomplete units.
• Transfer of Costs: Output of one process is transferred to the next process at cost (or cost plus profit).

Advantages of Process Costing

• Simple and systematic cost accumulation due to standardized production.
• Facilitates accurate average cost per unit.
• Ideal for mass production industries.
• Helps in cost control by identifying process inefficiencies.
• Supports managerial decisions like pricing and budgeting.

Preparation of Process Accounts

A Process Account is prepared for each process, showing the total cost incurred and how it is assigned to completed output, WIP, and losses.

Format of a Process Account

Debit Side Includes:

• Cost of materials introduced
• Direct labor and direct expenses
• Factory overheads
• Opening WIP (if any)
• Cost transferred from previous process

Credit Side Includes:

• Normal loss (at scrap value)
• Abnormal loss
• Units transferred to next process or finished stock
• Closing WIP

Step-by-Step Preparation

1. Determine the physical flow of units.
2. Identify and record process costs (debit side).
3. Account for Normal Loss (credit side at scrap value).
4. Identify and value Abnormal Loss or Abnormal Gain.
5. Calculate Equivalent Production (if WIP exists) to find cost per equivalent unit.
6. Value Completed Units and Closing WIP based on equivalent units.
7. Transfer completed units to the next process or finished stock.

Equivalent Production in Process Costing

Process industries frequently have partially completed units (WIP) at the end of the accounting period. To value these incomplete units scientifically, the concept of Equivalent Production is used.

Meaning of Equivalent Production

Equivalent production means expressing incomplete units in terms of their equivalent number of fully completed units. It standardizes the amount of work done on WIP into a comparable output form.

Example: 200 units 50 percent complete = 100 equivalent units.

Need for Equivalent Production

• Closing WIP is unavoidable in continuous production.
• Materials, labor, and overhead may be added at different stages.
• It ensures accurate cost per unit calculation by bringing all units to a common denominator.

Elements Considered

Equivalent units are calculated separately for each cost element, as WIP may be at different stages of completion for:

1. Materials
2. Labor
3. Factory Overheads

Steps in Calculation

1. Determine physical flow of units.
2. Identify the degree of completion for each cost element.
3. Compute equivalent units (Units × Degree of completion).
4. Calculate cost per equivalent unit (Total cost / Equivalent units).
5. Allocate costs to completed units, closing WIP, and abnormal losses/gains.

Methods of Calculation

• FIFO Method: Opening WIP is treated separately; only work done in the current period is considered. Best when cost fluctuations are high.
• Weighted Average Method: Opening WIP cost is merged with current cost; simpler and widely used.
• Standard Cost Method: Used in automated industries where variances are analyzed separately.

Significance of Equivalent Production

• Scientific valuation of WIP, avoiding over or understatement.
• Accurate product costing by reflecting actual work done.
• Facilitates cost control by identifying wastage and abnormal loss.
• Essential for process costing functionality.
• Improves inter-period comparability of output.

Distinction Between Job Costing and Process Costing

Job costing and process costing are two fundamental techniques used for product costing in different manufacturing environments. Understanding the distinction is essential for selecting the appropriate costing method.

1. Meaning

• Job Costing: Used for customized, non-repetitive jobs where each order is unique.
• Process Costing: Used where production is continuous and units are identical.

2. Key Differences