Equivalent units of production is a rather arbitrary tool – unless you’re in process costing or run a large manufacturing business in which case it’s completely relevant and you should keep reading. Cost accounting (the umbrella accounting concept above process costing) is essentially organizing and recording costs associated with a business. This includes overhead expenses, cost of goods and services, fixed asset depreciation, loss return on investments and so on to make sure your ledger doesn’t end up in the red.
An expense to keep a close eye on in any profitable venture is the cost of goods and services. This is to say the amount of money that is spent in order to produce the good or service being sold. It’s sometimes referred to as COGS for short. In an Introduction to Financial Accounting you can learn more about COGS and accounting in general.
What are equivalent units of production?
The long and short of it is, the equivalent units of production is an indicator of how much work was done by a manufacturer who has partially completed products in process at the end of a designated period. Maybe that wasn’t so “short”, but it’s a weird and semi-complex term to understand. Basically, all of the work-in-process inventory at the end of a period is expressed as fully-completed units which gives us the equivalent units of production. If you’re a new business, it might be beneficial to take the course Business Accounting for Start-ups to familiarize yourself with these terms and concepts.
For example, you work as a welder for a sign company. At the end of a quarter the sign company has 1,000 fully completed units and 300 partially completed units. The 300 partially completed units were, as estimated by the company, 50% completed. It seems silly to count the 300 partially completed signs as full units when calculating the company’s departmental output. Instead, these 300 partially done units are turned into an equation that equals the equivalent number of completed units of production. So this sign company would say it has completed 1,150 equivalent units of production. Confusing? It’s okay. Here’s the formula.
# of partially completed units x % of completion = equivalent units of production
In the sign shop’s case it would look like=
300 (partially completed) x .50 (50% completed) = 150 equivalent units of production
Then you would add the equivalent units of production to the completed units for a total unit count for the quarter.
150 (equivalent unit of production) + 1000 (completed) = 1,150 total units completed
Now, what does this have to do with accounting? This number is used to calculate the amount of money spent on making the fully completed and partially completed goods – which is part of COGS. So let’s say the cost accountant sees that the sign shop spent $25,000 on overhead, labor and materials for the quarter to produce the 1,150 signs. The accountant would divide the total overhead costs by the amount of units produced to get the direct production cost per equivalent unit. Tackle accounting head-on like a CFA in this Level 1 Accounting course. The formula for the direct production cost for this scenario is:
$25,000 / 1,150 = $21.74 direct production costs per equivalent unit
Because only some of the units are completed, we have to assign a certain amount of the budget to complete them and a certain amount to the already completed ones (to make sure it’s accounted for).
This means that $21,740 ($21.74 x 1,000) of the total overhead budget is applied and to the completed units and $3,260 ($21.74 x 150) will be assigned to the partially completed units.
Really, if you aren’t in process costing and you’re not running a manufacturing business, this concept is irrelevant. However, if you are then you should know that it’s likely the equivalent units of production will fall under one of two inventory management principles: first in first out (FIFO) or weighted-average. You can add the weighted average cost to the very beginning of the inventory and then add new purchases to the direct materials, or you add the cost of the oldest inventory in stock using FIFO (read more about FIFO in this article).
It depends on which method of inventory accounting your company uses. FIFO is typically more accurate, but it’s more complex than the weighted average. Make sure you try to maintain universal inventory accounting methods across the company or the books can get messed up really easy and really quick. Check out the course Your Business by the Numbers to get a detailed look at accounting methods.