Efficient Cost Allocation Methods for Joint Products and Byproducts

1. CHAPTER 16 Cost Allocation: Joint Products and Byproducts

2. Chapter 16 learning objectives • Identify the split-off point in a joint-cost situation and distinguish joint products from byproducts • Explain why joint costs are allocated to individual products • Allocate joint costs using four methods • Identify situations where the sales value at splitoff method is preferred when allocating joint costs

3. Chapter 16 learning objectives, concluded • Explain why joint costs are irrelevant in a sell-or-process further decision • Account for byproducts using two methods

4. Joint Cost Terminology • Joint costs—the costs of a production process that yields multiple products simultaneously. • Splitoff point—the juncture in a joint production process where two or more products become separately identifiable. • Separable costs—all costs incurred beyond the splitoff point that are assignable to each of the specific products identified at the splitoff point.

5. Joint Cost Terminology, cont’d • Categories of joint process outputs: • Outputs with a positive sales value • Outputs with a zero sales value. • Product—any output with a positive sales value, or an output that enables a firm to avoid incurring costs: • Sales value can be high or low.

6. Joint Cost Terminology, concluded • Main product—output of a joint production process that yields one product with a high sales value compared to the sales values of the other outputs. • Joint products—outputs of a joint production process that yields two or more products with a high sales value compared to the sales values of any other outputs. • Byproducts—outputs of a joint production process that have low sales values compared to the sales values of the other outputs.

7. Examples of Joint Cost Situations

8. Allocating Joint Costs Before a manager is able to allocate joint costs, he or she must first look at the context for doing so. Joint costs must be allocated to individual products or services for several purposes, including: • Computation of inventoriable costs and cost of goods sold for financial accounting and tax reporting. • Reimbursing companies that have some products reimbursed under cost-plus contracts. • Regulating the rates or prices of one or more of the jointly produced products. • Litigation or insurance settlement situations

9. Two approaches to allocating Joint costs • Market-based—allocate using market-derived data (dollars): • Sales value at splitoff • Net realizable value (NRV) • Constant gross-margin percentage NRV. • Physical measures—allocate using tangible attributes of the products, such as pounds, gallons, barrels, and so on.

10. Joint Cost Illustration Overview

11. Joint Cost example Data

12. Sales Value at Splitoff Method • The sales value at splitoff method allocates joint costs to joint products produced during the accounting period on the basis of the relative total sales value at the splitoff point. • This method uses the sales value of the entire production of the accounting period, not just the quantity sold. • The sales value at splitoff method follows the benefits-received criterion of cost allocation.

13. Sales Value at Splitoff example

14. Physical-Measure Method • The physical-measure method allocates joint costs to joint products produced during the accounting period on the basis of a comparable physical measure, such as the relative weight, quantity or volume at the splitoff point.

15. Physical Measures example

16. Net Realizable Value Method • Allocates joint costs to joint products produced during the accounting period on the basis of relative NRV. • NRV = Final Sales Value – Separable Costs. • In many cases, products are processed beyond the splitoff point to bring them to a marketable form or to increase their value above their selling price at the splitoff point.

17. Net Realizable Value Method Overview

18. Net Realizable Value Method example

19. Net Realizable Value Method example, concluded

20. Constant Gross Margin NRV Method • The constant gross-margin percentage NRV method allocates joint costs to joint products produced during the accounting period in such a way that each individual product achieves an identical gross-margin percentage. The method works backward in that the overall gross margin is computed first. • Joint costs are calculated as a residual amount by subtracting the separable costs and gross margin from the final sales value.

21. Constant gross-margin percentage nrv method: 3 steps • The constant gross-margin percentage NRV method can be broken down into 3 steps: • Compute the overall gross margin percentage • Compute the total production costs for each product • Compute the allocated joint costs.

22. Constant Gross Margin NRV Illustrated

23. Choosing an allocation Method • If selling price at splitoff is available, the sales value at splitoff method is preferred even if further processing is done. Reasons include: • Best measure of benefits received • Independent of further processing decisions • Common allocation basis (revenue) • Simplicity • If selling prices are not available, the NRV method is the best alternative • Despite this, some firms choose not to allocate joint costs at all.

24. Sell-or-Process Further Decisions • In chapter 11, we introduced the concepts of relevant revenues, which are expected future revenues that differ among alternative courses of action, and • Relevant costs, which are expected future costs that differ among alternative courses of action. • These concepts can be applied to decisions on whether a joint product or main product should be sold at the splitoff point or processed further.

25. Sell-or-Process Further Decisions, concluded • In sell-or-process further decisions, joint costs are irrelevant. Joint products have been produced, and a prospective decision must be made: to sell immediately or process further and sell later. • Joint costs are sunk costs. • Don’t assume all separable costs in joint-cost allocations are always incremental costs. • Some separable costs may be fixed costs. • Separable costs need to be evaluated for relevance individually.

26. Other issues to consider: • The potential conflict between cost concepts used for decision making and cost concepts used for evaluating the performance of managers often arises when sell-or-process further decisions are being made. • Firms should be wary of using the full cost of a joint product as the basis for making pricing decisions (potential lack of cause-and-effect relationship)

27. Accounting for Byproducts • Two methods for accounting for byproducts • Production method—recognizes byproduct inventory as it is created, and sales and costs at the time of sale. • Sales method—recognizes no byproduct inventory, and recognizes only sales at the time of sales: byproduct costs are not tracked separately.

28. Byproducts Illustration Overview

29. Comparative Income Statements for Accounting for Byproducts

30. Selecting the method to account for byproducts • The production method is consistent with the matching principle and is the preferred method. • The production method recognizes the byproduct inventory in the accounting period in which it is produced and simultaneously reduces the cost of manufacturing the main or joint products, thereby better matching the revenues and expenses from selling the main product. • Sales method is simpler but allows a firm to “manage” reported earnings by timing the sale of byproducts.

31. Terms to learn