Equivalent units of production are used to account for products still in manufacturing at the end of a reporting period. Failing to include these in a report would result in disparities because of the expended materials and labor involved. Treating them as finished units ready for sale also wouldn’t be accurate, because they aren’t complete. Thus, companies consider the number of units currently being made and the percentage of completeness to convert them into a number of hypothetical equivalent units of production.
Essentially, for accounting purposes, two half-complete units would be considered a single finished unit. This allows for easier reporting on documentation associated with production costs and allocation of funds. These products cannot be considered raw materials anymore, moving them to a different accounting category, but they are also not finished, and can’t be considered part of that inventory without adjustment. The base formula for finding equivalent units of production involves multiplying the number of partially completed units in inventory by the percentage of completion.
If a widget manufacturer has 100 products still in the manufacturing phase at the end of an accounting period and they’re 60% complete, it would add 60 equivalent units of production to the reporting totals. This requires knowing how much materials and labor go into the production of a single unit so the company can convert accurately. Accountants create a benchmark standard that can be used to be as accurate as possible.
Estimating equivalent units of production can be challenging. Accountants consider the amount of materials that go into production, and can look at how many raw materials have been delivered. They can also use formulas to find the number of labor hours required to finish products. Using this information, they can see how much labor has gone into making products thus far and arrive at a percentage estimate. This simplifies the manufacturing process and is not necessarily ideal, but will provide a reasonable estimate for the purpose of generating financial documentation.
When accounting for costs associated with production, firms determine how much money to allocate to departments over the coming period. They also use this information to monitor efficiency and overall expenses associated with making new products. If a department is not operating effectively, it may be necessary to consider reorganization or a new approach to cut down on waste. This could include shutting down manufacturing entirely if there is no feasible way to meet a productivity goal.