Cost Accounting (14th Edition)

17
Process Costing
Learning Objectives
1. Identify the situations in which
process-costing systems are
appropriate
2. Understand the basic concepts of
process-costing and compute
average unit costs
3. Describe the five steps in
process costing and calculate
equivalent units
4. Use the weighted-average method
and first-in, first-out (FIFO) method
of process costing
5. Apply process-costing methods to
situations with transferred-in costs
6. Understand the need for hybridcosting
systems such as operationcosting
Companies that produce identical or similar units of a
product or service (for example, an oil-refining
company) often use process costing.
A key part of process costing is valuing inventory, which entails
determining how many units of the product the firm has on hand at
the end of an accounting reporting period, evaluating the units’
stages of completion, and assigning costs to the units. There are
different methods for doing this, each of which can result in different
profits. At times, variations in international rules and customs make it
difficult to compare inventory costs across competitors. In the case
of ExxonMobil, differences in accounting rules between the United
States and Europe also reduce the company’s profits and tax liability.
ExxonMobil and Accounting Differences in the
Oil Patch 1
In 2010, ExxonMobil was number two on the Fortune 500 annual ranking
of the largest U.S. companies. In 2009, the company had $284 billion
dollars in revenue with more than $19 billion in profits. Believe it or not,
however, by one measure ExxonMobil’s profits are understated.
ExxonMobil, like most U.S. energy companies, uses last-in, firstout
(LIFO) accounting. Under this treatment, ExxonMobil records its
cost of inventory at the latest price paid for crude oil in the open
market, even though it is often selling oil produced at a much lower
cost. This increases the company’s cost of goods sold, which in turn
reduces profit. The benefit of using LIFO accounting for financial
reporting is that ExxonMobil is then permitted to use LIFO for tax
purposes as well, thereby lowering its payments to the tax authorities.
In contrast, International Financial Reporting Standards (IFRS) do
not permit the use of LIFO accounting. European oil companies such
as Royal Dutch Shell and British Petroleum use the first-in, first-out
(FIFO) methodology instead when accounting for inventory. Under
FIFO, oil companies use the cost of the oldest crude in their inventory
to calculate the cost of barrels of oil sold. This reduces costs on the
income statement, therefore increasing gross margins.
Assigning costs to inventory is a critical part of process costing,
and a company’s choice of method can result in substantially different
1 Source: Exxon Mobil Corporation. 2010. 2009 Annual Report. Irving, TX: Exxon Mobil Corporation;
Kaminska, Izabella. 2010. Shell, BP, and the increasing cost of inventory. Financial Times. “FT Alphaville”
blog, April 29; Reilly, David. 2006. Big oil’s accounting methods fuel criticism. Wall Street Journal, August 8.
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