Equivalent units are notional complete units that represent incomplete units (work in progress inventory). For e.g., If 10 units are in the process of production and 40% of their total production costs have been incurred, equivalent units of these 10 incomplete units would be 4 units (10 x 40%).
In process costing, the business knows the cost incurred during an accounting period. However, it cannot be exactly traced to the units produced. If there are some incomplete units (work in progress) at the end of an accounting period, the accountants calculate equivalent units for the purpose of working out the following two things:
- Cost of output (completed units)
- Cost of work in progress (incomplete units)
The concept of equivalent units often confuses students, so let’s look at it with the help of a simple example.
A company is manufacturing 5 units of a product. Total cost (material, labour and production overheads) of making one unit is $1,000.
At the end of an accounting period, these 5 units are still in the production process. Total cost of $2,000 has been incurred during the period. In other words, these 5 units are 40% complete as work on these products is done simultaneously.
The concept of equivalent assumes that the production is not done simultaneously. Instead, it is assumed that all costs are incurred firstly on one unit, then on the second unit and so on. Using this assumption, two units of the product would have been completed by incurring $2,000 of cost.
So, in this example, we can say that 5 units of the product which are 40% complete are equivalent to 2 complete units.
Following example will show you how equivalent units are used to calculate the cost of output and cost of closing work in progress inventory.
Example – Use of equivalent units in process costing
1,000 units were input into a particular process. 800 fully complete units were produced, and 200 units were in work-in-progress. The WIP progress units are 100% complete concerning material cost. The following information is available: