Cost Allocation: Joint Products and By-products

1. Cost Allocation: Joint Products and By-products ACCT7320 Dr. Bailey Tuesday, September 29, 2009

2. 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

3. Criteria to GuideCost-Allocation Decisions Cause-and-effect: Using this criterion, managers identify the variable or variables that cause resources to be consumed. Benefits-received: Using this criterion, managers identify the beneficiaries of the outputs of the cost object.

4. Criteria to GuideCost-Allocation Decisions Fairness or equity: This criterion is often cited on government contracts when cost allocations are the basis for establishing a price satisfactory to the government and its suppliers. Ability to bear: This criterion advocates allocating costs in proportion to the cost object’s ability to bear them.

5. Role of Dominant Criteria The cause-and-effect and the benefits- received criteria guide most decisions related to cost allocations. Fairness and ability to bear are less frequently used. Why?

6. Role of Dominant Criteria Fairness is an especially difficult criterion to obtain agreement on. The ability to bear criterion raises issues related to cross-subsidization across users of resources in an organization.

7. 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?

8. 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.

9. Joint-Cost Basics Tomatoes Tomato juice Tomato sauce Tomato paste

10. Joint-Cost Basics Coal Gas Benzol Tar

11. Joint-Cost Basics • The outputs of a joint production process fall into two general categories: • Joint products—those that the company is in business to produce (higher total value) • By-products—those that also emerge (lesser value)

12. 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.

13. 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.

14. Joint Products and By-products • 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

15. Joint Products and By-products Main or Joint Products By-products High Low Sales Value

16. Joint Products and By-products • 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

17. Why Allocate Joint Product Costs? • The purposes for allocating joint costs to products include: • Inventory costing • Important for financial accounting purposes, reports to income tax authorities, and internal reporting purposes. • 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).

18. Why Allocate Joint Product Costs? • Insurance settlements • Require cost allocation when damage/loss claims made by manufacturer: What was the “cost”? • Rate regulation • If one or more of the jointly produced products or services are subject to price regulation (nat. gas). • Litigation • Joint cost allocation is important in litigation involving one or more joint products.

19. 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.

20. 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

21. 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.

22. Sales Value at Splitoff Method • 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 = 230,00035.7% • Total $645,000 100%

23. Sales Value at Splitoff Method • 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

24. Sales Value at Splitoff Method • 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

25. Sales Value at Splitoff Method • 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?

26. Sales Value at Splitoff Method • 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

27. Sales Value at Splitoff Method • 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 methodproduces an identical gross margin percentage for each product.

28. Estimated Net Realizable Value (NRV) Method • Often products are processed further beyond the splitoff point to make them marketable or increase their value.

29. 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)

30. 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.

31. 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. • Unitsprice1price2Add’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

32. Irrelevance of Joint Costs for Decision Making • 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)

33. Irrelevance of Joint Costs for Decision Making • 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.

34. The End