Cost Allocation: Joint Products and By-products

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Cost Allocation: Joint Products and By-products

ACCT7320Dr. Bailey

Tuesday, September 29, 2009

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Nature of Cost Allocations

Pervasive in accounting–Across time (depreciation)–Between departments (e.g., service depts)–To products, customers, branch offices, etc.

Often arbitrary–May mislead in decision making

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Criteria to GuideCost-Allocation Decisions

Cause-and-effect:Using this criterion, managers identify thevariable or variables that cause resources

to be consumed.Benefits-received:

Using this criterion, managers identify thebeneficiaries of the outputs of the cost object.

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Criteria to GuideCost-Allocation Decisions

Fairness or equity:This criterion is often cited on government

contracts when cost allocations are the basisfor establishing a price satisfactory to the

government and its suppliers.Ability to bear:

This criterion advocates allocating costs in proportionto the cost object’s ability to bear them.

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Role of Dominant Criteria

The cause-and-effectand the benefits-received criteria

guide mostdecisions related

to cost allocations.

Fairness and abilityto bear are lessfrequently used.

Why?

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Role of Dominant Criteria

Fairness is an especially difficult criterionto obtain agreement on.

The ability to bear criterion raises issuesrelated to cross-subsidization across users

of resources in an organization.

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Joint Costs

This “joint cost” problem arises when companies inescapably produce two or more products simultaneously out of the same process.

How do they allocate costs to jointly-produced products.

How are the resulting allocations useful?

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Joint-Cost Basics

Joint costs are the costs of a single production process that yields multiple products simultaneously.

Industries abound in which a single production process simultaneously yields two or more products.

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Joint-Cost Basics

Tomatoes

Tomato juice Tomato sauce Tomato paste

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Joint-Cost Basics

Coal

Gas Benzol Tar

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Joint-Cost Basics

The outputs of a joint production process fall into two general categories:

1 Joint products—those that the company is in business to produce (higher total value)

2 By-products—those that also emerge (lesser value)

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Splitoff Point

The splitoff point is the juncture in the production process where one or more products in a joint-cost setting become separately identifiable.

Separable costs are all costs (manufacturing, marketing, distribution, etc.) incurred beyond the splitoff point that are assignable to one or more individual products.

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Joint Products and By-products

Joint products have relatively high sales value at the splitoff point.–Main product is the result of a joint

production process that yields only one product with a relatively high sales value.

By-products are incidental products resulting from the processing of another product.

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A by-product has a relatively low sales value compared with a joint or main product.–Revenue from byproducts generally reduces

the costs of the joint products. We aren’t studying the details.

Some outputs of the joint production process have zero sales value.– “Waste” can be ignored in accounting

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Sales Value

High Low

Main orJoint Products By-products

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To reiterate: sales value determines the classification

Products can change from by-products to joint products when their relative sales values increases, and vive-versa–Kerosene once main product of petroleum

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Why Allocate Joint Product Costs?

The purposes for allocating joint costs to products include:

1 Inventory costing – Important for financial accounting purposes, reports to income tax

authorities, and internal reporting purposes.2 Cost reimbursement contracts

– Cost allocation is required for cost reimbursement purposes under contracts when only a portion of a business’ products or services is sold or delivered to a single customer (government agency).

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Why Allocate Joint Product Costs?

3 Insurance settlements» Require cost allocation when damage/loss claims made

by manufacturer: What was the “cost”?4 Rate regulation

» If one or more of the jointly produced products or services are subject to price regulation (nat. gas).

5. Litigation» Joint cost allocation is important in litigation

involving one or more joint products.

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How to Allocate Joint Costs?

The two basic approaches to allocating joint costs are:–Use market-based data such as relative

product revenues.» “Sales value at splitoff”» “Estimated net realizable value”

–Use physical measures such as weight or volume.

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Allocating Joint Costs

Lubbock Company incurred $200,000 of joint costs to produce the following:

Product A: 10,000 units, 20,000 pounds Product B: 10,500 units, 48,000 pounds Product C: 11,500 units, 12,000 pounds

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Sales Value at Splitoff Method

Allocates joint costs to joint products on the basis of the relative total sales value at the splitoff point.–All outputs must have sales values at this

point to use the method.

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Assume the following sales values per unit: A: $10.00, B: $30.00, and C: $20.00

What is the total sales value at splitoff point? Product A: 10,000 × $10.00 =$100,000 15.5% Product B: 10,500 × $30.00 = 315,000 48.8% Product C: 11,500 × $20.00 = 230,000 35.7% Total $645,000 100%

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How much joint costs are allocated to each product?

A: 15.5%× $200,000 = $ 31,008 B: 48.8% × $200,000 = 97,674 C: 35.7% × $200,000 = 71,318 Total $200,000

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What are the joint production costs per unit? Product A: $31,008 ÷ 10,000 = $3.10 Product B: $97,674 ÷ 10,500 = $9.30 Product C: $71,318 ÷ 11,500 = $6.20

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Assume all of the units produced of B and C were sold (no further processing).

2,500 units of A (25%) remain in inventory. What is the gross margin percentage of each

product?

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Product A Revenues: 7,500 units × $10.00 $75,000 Cost of goods sold:

– Joint product costs $31,008– Less ending inventory 7,752*

23,256» *$31,008 × 25%

Gross margin $51,744

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Prod. A: $75,000 – $ 23,256 = $51,744; $51,744 ÷ $75,000 = 69%

Prod. B: ($315,000 – $97,674) ÷ $315,000 = 69% Prod. C: ($230,000 – $71,318) ÷ $230,000 = 69%

The sales value at splitoff method produces an identical gross margin percentage for each product.

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Estimated Net Realizable Value (NRV) Method

Often products are processed further beyond the splitoff point to make them marketable or increase their value.

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Estimated Net Realizable Value (NRV) Method

The estimated NRV method allocates joint costs to joint products on the basis of the relative estimated NRV.

NRV = (expected final sales value in the ordinary course of business) – (expected separable costs of the total production of these products)

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Absolute Irrelevance of Joint Costs for Decision Making

Joint costs incurred up to the splitoff point are past (sunk) costs irrelevant to the decision to sell a joint (or main) product at the splitoff point or to process it further.

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Irrelevance of Joint Costs for Decision Making

Assume that products A, B, and C can be sold at the splitoff point (at price1) or processed further into A1, B1, and C1 and sold at price2.

Units price1 price2 Add’l costs 10,000 A: $10 A1: $12 $35,000 10,500 B: $30 B1: $33 $46,500 11,500 C: $20 C1: $21 $51,500

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Should A, B, or C be sold at the splitoff point or processed further?

Product A: Incremental revenue $20,000 – Incremental cost $35,000 = ($15,000)

Product B: Incremental revenue $31,500 – Incremental cost $46,500 = ($15,000)

Product C: Incremental revenue $11,500 – Incremental cost $51,500 = ($40,000)

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Products A, B, and C should be sold at the splitoff point.

No techniques for allocating joint-product costs can guide decisions about whether a product should be sold at the splitoff point or processed beyond splitoff.

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The End

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Cost Allocation: Joint Products and By-products