Equivalent units of production: anew look at an old issue

Reinaldo Guerreiro, Edgard Bruno Cornachione andArmando Catelli

Department of Accounting and Actuarial Sciences, School of Economics,Business and Accounting, University of Sao Paulo, Sao Paulo, Brazil

Abstract

Purpose – This paper focuses on the determination of the cost completion rate used to calculate theequivalent units of production in a continuous process costing system. The paper aims at two researchquestions. What procedures do companies utilize in practical terms? How should the completion levelpercentage be calculated conceptually?

Design/methodology/approach – The study is a qualitative exploratory survey. The companiestargeted were those noted in “Melhores e Maiores,” a ranking of the best and biggest Braziliancompanies. A total of 175 questionnaires were sent to pre-selected enterprises, each with revenues ofmore than US$100 million per year, and 50 usable responses were returned.

Findings – A literature review of the theoretical procedures used for continuous process costingrevealed no indication of an objective method for determining the completion level. The empiricalresearch in the present study confirmed that, in practice, companies do not adopt the generalprocedures proposed by the theory. The best practices applied by the companies have been shown tobe an adequate alternative, because the results are identical to those obtained with the proposedmethod.

Research limitations/implications – The study bears the usual limitations of a qualitativeexploratory survey regarding its generalization to other companies.

Originality/value – The originality of the study is based on the assumption that cost accountingtheory does not offer an objective solution for the computation of the completion level percentage and,consequently, that companies in continuous process production system do not adopt the theoreticalconcepts with respect to inventory evaluation of goods-in-process and finished goods.

Keywords Cost accounting, Costs, Production management, Brazil

Paper type Research paper

IntroductionAlmost all cost accounting books present contents related to costing method in acontinuous production system. It is generally agreed in the literature that the basicprocedures involve:

. the quantification of the physical units of output;

. the determination of the number of equivalent whole units;

. the calculation of the cost per equivalent unit; and

. the evaluation of the units completed and transferred out of the department andunits in ending work-in-process inventory.

How much of a totally finished good is represented by a unit in process? The answer isprovided through the finishing level percentage of the unit in process. By using thecompletion level percentage, it is possible to make a comparison between the units in

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Managerial Auditing JournalVol. 21 No. 3, 2006

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0268-6902DOI 10.1108/02686900610653035

process and these same units considered as being fully completed. Consequently, thenumber of equivalent units of production corresponds to the number of units inworking process as converted into completed units, through the use of a definedcompletion rate. In the case of raw materials cost, which is introduced entirely at thebeginning of the production process, the completion level is 100 per cent, but whenraw materials and other resources are combined in the course of the productionprocess, the completion level should be estimated. An important aspect to be observedis that the completion level must have meaning in economic terms, and not merely inphysical terms. The completion level must represent how much a unit in workingprocess has received of the cost load that would be needed to start and finish itcompletely.

The present research arose from a review of a selected collection of classic works bycost accounting authors. This review revealed that these authors did not indicate amethod for calculating the completion level percentage. From a conceptual perspective,this represents an exciting prospect in cost accounting because this gap in theliterature implies that companies operating on a continuous process do not, in practice,use the theoretical procedures of cost accounting authors.

The proposition of the present study is that cost accounting theory does not offer anobjective solution to the problem of calculating the completion level, which is requiredfor determining the number of equivalent whole units in continuous process systemsproducing homogeneous products. This lack of an objective solution means thatenterprises in continuous production industries do not adopt the fundamental conceptsdefined by theory regarding to the finished output and work-in-process inventorymeasurement.

Calculating the completion level percentage is of primary importance because it isimpossible to calculate the equivalent whole units without this rate. In suchcircumstances, calculation of the cost per equivalent unit becomes impractical as abasis for evaluation of goods inventories and determination of profit. Consequently,whichever theoretical treatment of this subject is adopted, the approach isuseless because companies cannot adopt a methodology in practice in the absenceof any available operational procedure. So, the following research questions areestablished:

RQ1. What procedures do the companies utilize in practical terms?

RQ2. How should the completion rate be calculated conceptually?

Literature reviewCost accounting authors have not dealt with the specific question of calculatingthe completion level in a convincing way. The majority have endorsed the use of thecompletion rate, but do not indicate an objective methodology for its calculation.Bierman and Drebin (1968, p. 45) said: “one complication is the determination ofequivalent units of production”. Nelson and Miller (1977, p. 215) affirmed:

Based on estimates of percentages of completion of the goods-in-process (which probably areimprecise) estimates are made of the equivalent finished production.

Dearden (1976, p. 27), focusing on the process cost accumulation, emphasized that themajor problem consists in determining the goods in work-in-process inventory

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in equivalent units terms (two units, half finished, are equal to one finished unit).Li (1966, p. 107) claimed that the completion level for direct labor and manufacturingoverheads must always be 50 per cent, unless there are indications to the contrary.He justified this proposition in the following terms:

For an enterprise using continuous processing techniques, the amount of labor andmanufacturing overhead added to materials increases at a fixed increment. At any givenmoment, the amount of labor and manufacturing overhead added ranges from 1 per cent(for the item just introduced into the process) to 99 per cent (for the item just about to betransferred to the subsequent process). Together with all other items in the process, theyform an arithmetic series (1, 2, 3, . . . , 97, 98, 99 per cent) for an average completion rate of50 per cent. This is known as the 50 per cent completion assumption.

The present authors believe that Li’s (1966) justification represents more of a valuejudgment than a scientific proof. The present authors agree with Horngren’s (1972)opinion that the assumption that all conversion costs are incurred uniformly inproportion to the degree of product completion is difficult to justify on theoreticalgrounds. Although Horngren (1972) did not present a method for calculating thecompletion level, he did begin to develop a possible solution, observing that theconversion costs sequence usually consists of a number of standard operations or astandard number of hours, days, weeks, or months for mixing, heating, cooling, aging,curing, and so forth. Thus, the degree of completion for conversion costs depends onwhat proportion of the total effort needed to complete one unit or one batch has beendevoted to units still in process. Similarly, Morse (1981), without presenting a solutionfor the problem, did indicate a conceptual approach, when he affirmed that standardcost systems are most frequently used when identical units are produced on acontinuous basis. The use of standard costs eliminates the need to compute the cost perequivalent unit. The equivalent unit cost is the standard cost. Additionally, the coststransferred out are equal to the number of units completed times the standard cost perequivalent unit.

Black and Edwards (1979) focused on the equivalent production unit (EPU) insaying that, if either of these assumptions is changed different EPU computations willbe required. These authors did not provide any indication of how to obtain thecompletion level for the EPU calculation. Moore and Jaedicke (1976, p. 292) affirmedthat in process cost accounting, the problem of determining unit costs is resolved byusing equivalent units. After determining carefully what the equivalent units ofproduction are, the authors presented examples in which the completion level conceptwas used to calculate the equivalent units of production, but without any indication ofthe procedures followed in obtaining it. Leone (1980, p. 195) gave an example that at thebeginning of the month, in a determined production stage, there were 12 pool ballswhich were 50 per cent completed, i.e. only the halves were completed. However,throughout his explanations, Leone (1980) did not address the issue of the calculationof the completion level.

Backer and Jacobsen (1978, p. 288), in commenting on the calculation of theequivalent units of production, noted that the completion level of work-in-process unitsmust be estimated by qualified technical staff. These authors thus transferred theproblem to “qualified technical personnel”. But who are these “qualified technicalpersonnel”? It is likely that the authors were referring to engineering, process control,or production control technicians. The problem with this approach is that, although

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technical personnel might well be qualified to calculate the physical completion rate,they are less likely to be qualified to calculate the completion level in terms of costs.The completion level that must be used to calculate the equivalent units of productionis the cost completion rate. In this sense, the present authors agree with Horngren(1972, p. 597) when he observed that unit cost is not calculated on the basis of physicalunits. It is calculated on the basis of cost equivalent unit performance – i.e. on the basisof charges or doses of cost needed to complete a given unit.

The research carried out into the important cost accounting books of the latetwentieth century did not give any indication of how to calculate the completion rate.The books analyzed were: Bierman and Drebin (1968), Howard (1966), Horngren (1972),Dopuch et al. (1974), Dearden (1976), Moore and Jaedicke (1976), Corcoran (1977),Nelson and Miller (1977), Backer and Jacobsen (1978), Matz et al. (1978), Black andEdwards (1979), Leone (1980), Morse (1981), Maher and Deakin (1994), Maher et al.(1997), Hansen and Mowen (1997) and Cooper and Kaplan (1999).

A consideration of more recent literature indicates that new cost accounting booksand new editions of earlier books still fail to present a method for determining thecompletion level of work-in-process units. These newer works are Morse et al. (2000),Anthony and Govindarajan (2000), Atkinson et al. (2000), Garrison and Noreen (2001),Jiambalvo (2001), Warren et al. (2001), Willson et al. (2001), Martins (2003) andHorngren et al. (2004a, b). The research findings in cost accounting papers, as indicatedby the literature review, have not resolved this problem.

Exploratory studyAn exploratory study was conducted to obtain a general understanding of the practicalprocedures used by companies related to the costing of goods-in-process in the variousproduction segments of continuous processes in the manufacture of homogeneousproducts. The study is strictly exploratory and, as such, there is no suggestion that theresults can be generalized to other enterprises. The database of Fipecafi – the BrazilianInstitute for Accounting, Actuarial and Financial Research Foundation – was used inselecting the companies. The companies targeted in our sample were those notedin Melhores e Maiores, a ranking of the best and biggest Brazilian companies. A total of175 questionnaires were sent to pre-selected enterprises, each with revenues of morethan US$100 million per year, and the 50 returned questionnaires are analyzed asfollows.

FindingsQuestion 1. Does any segment of the manufacturing plant work as a continuous process– i.e. by continuous manufacturing of an homogeneous product?From the total of 50 returned questionnaires, 43 enterprises worked on a continuousprocess and seven on a production order system. The reflections that follow are madeon the basis of the information given by the 43 enterprises that worked on a continuousmanufacturing process.

Question 2. What is the main activity of this segment?Most firms were involved in food processing or chemical and petrochemicalenterprises. The sectoral distribution of firms is as follows: paper and cellulose,

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14 per cent; sugar and alcohol, 5 per cent; heavy industries, 19 per cent; metals mining,12 per cent; food production, 27 per cent; and petrochemical and chemical, 23 per cent.

Question 3. In the segment of the manufacturing plant operating by a continuousprocess system, does the enterprise use the completion rate and equivalent units ofproduction concepts to assess the costing of goods-in-process?A sum of 11 enterprises stated that they used the concepts of completion rate andequivalent units of production. Twenty-three enterprises replied that they did not usethese concepts, even though they were well known. Nine enterprises replied that theseconcepts were not known internally. Of the 43 enterprises analyzed, 74 per cent did notcalculate the completion rate and equivalent units of production. These results are verysignificant in the context of establishing the validity of the fundamental hypothesis ofthis paper.

Question 4. Which department of the enterprise computes the completion rate?This question was answered only by the 11 enterprises that stated that they used theconcepts of completion rate and equivalent units of production. The accountingdepartment was most likely to be responsible for the calculation of completion rate(46 per cent), followed by production/manufacturing (27 per cent), production planning& control/process control (18 per cent) and others (9 per cent).

Question 5. How does the enterprise calculate the completion rate? (Give us a broadoutline.)Some explanations given by the enterprises with respect to the calculation of thecompletion rate are reproduced below.

(1) It is globally defined that every good-in-process has 80 per cent completionlevel.

(2) The cost is computed per product in each process phase. There is a cost matrixthat details the specific consumption of each product cost component for eachprocess phase. The matrix considers the process benefits and the productivityin each phase or equipment. Every cost computation is made phase by phase foreach produced ton. The equivalent unit of production is the ton of each product,or for each product code that is specified by type of steel (chemical composition,profile, finishing level, quality level and special flows).

(3) Legal quality standards required by the market and measured by laboratoriesinstalled inside the manufacturing plants.

(4) Research was undertaken by the production department in order to identify thevolume of existing equivalent units of production in process. This volumeresults from calculations that were based on the residues, pastes and unfinishedcellulose present along the lines, from the entry of wood until the packaging.Consequently, from knowledge of the wood’s average efficiency, the entrancecubic volume and finished production of the period were verified. The differencebetween the cellulose production that the wood will generate and what waseffectively produced represents the unfinished volume, on which the completionpercentages of equivalent production units were applied.

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(5) We use production order control on which technical specifications and theoperations for the production appear. Through the daily appointment of themanufacturing sectors (lithography, printing and assembly), we register in eachproduction order the operations and the finished production, generating at theend of each accounting period a report which contains the situation andthe completion rate of the goods-in-process.

(6) It is based on the production standard routines, applied to the specificproduction phase in which the parts are weighted by the real consumption andthe really spent production hours. This constitutes the basis for the inventoryevaluation.

(7) It is calculated for each type of product made by the enterprise. For instance,crystal sugar, refined sugar, liquid sugar, hydrated alcohol, etc.

(8) Considering the product or its final feature.

(9) We define specific codes that indicate that a given product is in process and,therefore, we can attribute the raw material costs, variable expenses, fixedexpenses, depreciation and, in some cases, the packing material.

(10) All production is controlled by lots, entries of goods-in-process and thecorresponding finished output.

(11) Using the physical-chemical quantification and the final use of the product bythe client.

Explanation (1) shows that only one enterprise used an explicit percentage(of 80 per cent), but it did not specify how this percentage was obtained.Explanations (2) and (6) indicate that the companies adopt concepts related to thedetermination of the completion level rate, meanwhile they did not specify clearly thecalculations. Explanations (3), (4), (7), (8) and (11) are too generic, approaching aspectsnot directly related with the computation of completion level percentage. Explanations(5), (9) and (10) mention the use of product code and order control, concepts that areusually applied in the order costing system. Generally the answers demonstrated that,in many companies, there existed misunderstandings about the concepts of completionrate and equivalent units of production.

Question 6. What procedure does the enterprise use to evaluate the work-in-processinventory on a monthly basis?This question was analyzed for the group of 32 companies that did not adopt theconcepts of completion level and equivalent units of production. Two of them repliedthat they were using the standard cost. Seven enterprises considered the closinginventory of work-in-process to have a “zero” value because of the characteristics of theproduction process. Nine enterprises replied that they used the standard cost,calculated cost variations, and proportionally distributed the variations to productionand to the work-in-process inventory. The other 14 enterprises did not specifyexplicitly which procedures they used. The following expressions appeared incertain replies:

. actual monthly average cost;

. we use the average cost to evaluate the inventory;

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. production orders are opened;

. the costing is the actual monthly cost;

. joint costs theory and full costing;

. the goods-in-process inventory is very small but we are using the average cost;

. average unit cost computation;

. monthly average cost;

. actual cost per production phase; and

. use of one costing for each production phase with real appointments of quantitiesproduced in each one of these phases.

In these selected quotations from the responses received, it can be observed thatemphasis was given to the calculation of the cost per unit. It must be noted, however,that cost accounting does not use the concepts of completion level and equivalent unitsof production for the calculation of the unit cost. It can be inferred that, in practice, thecompanies simplified in order to obtain the unit cost, considering units in process asbeing equal to transferred or finished goods in cost terms. Nine companies revealed theuse of the scientifically valid procedure, using the standard costing method includingthe distribution of the cost variations to production and to the ending inventory, asdemonstrated in item 6.

Proposed method for calculating the completion levelIn the light of the above discussion, the present study proposes a method to calculatethe completion level. The proposed method rests on the concept of standard cost.

Given that: ga, completion rate; ep, each production stage of the product; cp,standard unit cost accumulated until the specific stage; cf, finished product unit cost;and q, quantity of goods-in-process at a given specific stage.

The fundamental premise is that the completion rate must reflect the finishing levelin cost terms. That is, if it is established that a product is a per cent completed, thismeans that the product has received a per cent of all costs that will be required fromstart to finish. At the level of each specific production stage, the ga equals cp/cf. If costaccounting were performed at each specific stage (i.e. a calculation of the realizedmanufacturing costs of the period, a calculation of unit costs, an evaluation of theinitial inventories, a calculation of production costs transferred to the next stage, anevaluation of ending inventories, and so on), the completion level problem would besolved.

Keeping in mind that a company’s cost accounting is not, with rare exceptions,analyzed stage-by-stage, because it requires information and analytical controls thatare not always available, the completion level should be calculated at the level of themanufacturing plant.

Returning to the fundamental assumption that the completion level is given in costterms, it can be observed that goods-in-process (allowing for different quantities atdifferent stages of the manufacturing process) will be a per cent completed when theyreceive a per cent of all costs required to start and finish them. This requires aconsideration of the sum of the cp/cf ratios weighted by the respective quantities (qp)that exist in the different stages.

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So, to realize the required weighting:

ga ¼

Pðqp · cpÞ

Pðqp · cfÞ

Keeping in mind that cf is always the same for all units:

ga ¼

Pðqp · cpÞ

PðqpÞ · cf

To illustrate the proposed model, a numerical example of calculating the completionrate is presented below. Consider the continuous manufacturing process of a uniqueproduct involving five stages. At the end of a given period, a physical inventory ofthe quantity of goods-in-process (qp) is made at various specific stages (ep)(Table I).

The standard unit cost of the product is presented below, as accumulated at eachspecific stage (cp) (Table II):

Applying the proposed formula:

ga ¼

Pðqp · cpÞ

ðP

qpÞ · cf

requires a calculation ofP

ðqp · cpÞ and ðP

qpÞ · cfThese calculations are performed as follows.P

ðqp · cpÞ value is calculated and the results are shown in Table III. The amount of$1,045,000 represents the cost of all units in process, considering the stage that theyhave reached.

ThusP

ðqp · cpÞ ¼ $1; 045; 000

ep qp (u)

1 5002 1,0003 1,9004 1,4005 200Table I.

ep cp ($)

1 502 1203 2004 3005 500Table II.

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ðP

qpÞ · cf represents how much the total cost would be if all the units in process werefinished: ð

PqpÞ ¼ 5; 000u; cf ¼ $500; ð

PqpÞ · cf ¼ 5; 000u £ $500 ¼ $2; 500; 000;

Thus ðP

qpÞ · cf ¼ $2; 500; 000The calculation of ga can now be performed using the proposed formula:

ga ¼

Pðqp · cpÞ

ðP

qpÞ · cf

The completion level, in cost terms, of the units in process at the end of the period thusbecomes:

ga ¼

Pðqp · cpÞ

ðP

qpÞ · cf

Therefore:

ga ¼$1; 045; 000

$2; 500; 000¼ 4:18

Thus ga ¼ 41.8 per cent.

Comparison of the proposed model and the best practice used by somecompaniesAn example of process costing using the completion level and equivalent units ofproduction calculated in accordance with the proposed theoretical solution is presentedbelow. The results are compared with the standard costing method, including thedistribution of the cost variations to production and to the ending inventory – thisbeing considered the best practice used by the companies.

The following data are given: ct, $9,000,000; qf, 15,000u; qp, 5,000u; and ga,41.8 per cent.

Applying conventional cost accounting procedures using the completion rate forproduction costing leads to the following:

(1) Calculation of the equivalent units of production:

qe ¼ 5,000u · 0.418

qe ¼ 2,090u.

(2) Calculation of the production unit cost of the period:

cp ¼ $9,000,000/(15,000 þ 2,090)u

cp ¼ $526,624/u.

ep qp (u) cp ($) qp· cp ($)

1 500 50 25,0002 1,000 120 120,0003 1,900 200 380,0004 1,400 300 420,0005 200 500 100,000P

(qp · cp) 1,045,000 Table III.

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(3) Calculation of the total cost of the units completed and transferred out:

15,000u £ $526,624 ¼ $7,899,360.

(4) Calculation of the total cost of the ending work-in-process inventory:

5,000u £ 0.418 £ $526,624 ¼ $1,100,640.

Without using the completion rate, and assuming that the company uses standardcosting with the same data as above, leads to the following:

(1) Calculation of the standard cost of the production transferred to the productinventory:

15,000u £ $500 ¼ $7,500,000

(2) Calculation of the standard cost of the final goods-in-process inventory(Table IV).

These procedures yield the standard cost of the finished production and the standardcost of the work-in-process inventory.

For legal and financial objectives, it is necessary to determine the correspondingeffective costs. The most appropriate practical alternative, as observed in someresponses in the exploratory study, uses the standard values as a basis, determinesthe total cost variation (difference between standard cost and actual cost), and adds tothe standard cost of the finished production and the standard cost of thegoods-in-process inventory a specific part of the total cost variation (in proportion tothe standard values), thus obtaining the accounting values. The analytical proceduresinvolve:

(1) Determination of the cost variation:

standard cost of the production processed: $8,545,000 ¼ $1,045,000 þ$7,500,000

actual cost debited to production: $9,000,000

cost variation: $455,000(D).

(2) Determination of the accounting value of the finished production:

$7,500,000 þ [($7,500,000/$8,545,000) £ $455,000] ¼ $7,899,360.

(3) Determination of the accounting value of the final goods-in-process inventory:

$1,045,000 þ [($1,045,000/$8,545,000) £ $455,000] ¼ $1,100,640.

Production stages Processing quantities (u) Unit standard cost ($) Total standard cost ($)

1 500 50 25,0002 1,000 120 120,0003 1,900 200 380,0004 1,400 300 420,0005 200 500 100,000Total 5,000 1,045,000Table IV.

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An analysis of the numbers presented leads to the conclusion that the accountingvalues of the finished production and the goods-in-process inventory, as determined bymeans of the two methodologies, are identical. This means that, in practice, thecompanies that determine the financial accounting values using the standard cost andadding an allowance for variation (in proportion to the standard values), unknowinglyobtain the same result as would be obtained by the finishing level and equivalentproduction units, as in the model proposed.

ConclusionsA literature review of the theoretical procedures used for continuous process costingrevealed no indication of an objective method for determining the completion level ofthe units in process and for calculating the equivalent units of production. Theempirical research in the present study confirmed that, in practice, companies do notadopt the general procedures proposed by the theory responding to the first researchquestion of this study.

The field of cost accounting contains an attractive idea in the form of the completionrate concept but, until now, the accounting literature has not provided any objectivemethod of calculation. The solution developed in this work for determining thecompletion rate solves the problem, and by virtue of its simplicity, makes it possible touse the process-costing method established in cost accounting theory, thus respondingto the second research question of this study.

On the other hand, it has also been demonstrated that one of the procedures used bycompanies employing a continuous process system is perfectly valid. This procedureinvolves the use of the standard cost and a determination of the accounting value of thefinished products and the goods-in-process inventory, incorporating (in proportion tothe standard values) the cost variations determined. This approach has been shown tobe an adequate alternative in the absence of an objective conceptual approach, in thatits results are identical to the results obtained with the method proposed for calculatingthe completion rate.

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Further reading

Alnestig, P. and Segerstedt, A. (1996), “Product costing in ten Swedish manufacturingcompanies”, International Journal of Production Economics, Vol. 46/47, pp. 441-57.

Ask, U. and Ax, C. (1992), “Trends in the development of product costing practices andtechniques – a survey of Swedish manufacturing industry”, paper presented at the15th Annual Congress of the European Accounting Association, Madrid.

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Benke, R.L. Jr (1995), “Why are students underprepared for product costing?”, ManagementAccounting, Vol. 76 No. 10.

Bjornenak, T. (1997), “Conventional wisdom and costing practices”, Management AccountingResearch, Vol. 8, pp. 367-82.

Bjornenak, T. and Olson, O. (1999), “Unbundling management accounting innovations”,Management Accounting Research, Vol. 10, pp. 325-38.

Brigth, J., Davies, R.E., Downes, C.A. and Sweeting, R.C. (1992), “The deployment of costingtechniques and practices: a UK study”, Management Accounting, Vol. 3, pp. 201-12.

Burns, J. (2000), “The dynamics of accounting change: inter-play between new practices, routines,institutions, power and politics”, Accounting, Auditing & Accountability Journal, Vol. 13No. 5, pp. 566-96.

Burns, J. and Scapens, R.W. (2000), “Conceptualizing management accounting change: aninstitutional framework”, Management Accounting Research, Vol. 11, pp. 3-25.

Burns, J. and Vaivio, J. (2001), “Management accounting change”, Management AccountingResearch, Vol. 12, pp. 389-402.

Cohen, J.R. and Paquette, L. (1991), “Management accounting practices: perceptions ofcontrollers”, Journal of Cost Management for the Manufacturing Industry, pp. 73-83.

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Corresponding authorReinaldo Guerreiro can be contacted at: reiguerr@usp.br

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