Cost Allocation: Joint Products and By-products ACCT7320 Dr. Bailey Tuesday, February 17, 2009

Criteria to Guide Cost-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.

Criteria to Guide Cost-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.

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?

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.

Introduction n This “joint cost” problem arises when companies inescapably produce two or more products simultaneously out of the same process. n How do they allocate costs to jointly-produced products. n How are the resulting allocations useful?

Joint-Cost Basics n Joint costs are the costs of a single production process that yields multiple products simultaneously. n Industries abound in which a single production process simultaneously yields two or more products.

Joint-Cost Basics Tomatoes Tomato juiceTomato sauceTomato paste

Joint-Cost Basics Coal GasBenzolTar

Joint-Cost Basics n 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)

Splitoff Point n The splitoff point is the juncture in the production process where one or more products in a joint-cost setting become separately identifiable. n Separable costs are all costs (manufacturing, marketing, distribution, etc.) incurred beyond the splitoff point that are assignable to one or more individual products.

Joint Products and By-products n Joint products have relatively high sales value at the splitoff point. n Main product is the result of a joint production process that yields only one product with a relatively high sales value. n By-products are incidental products resulting from the processing of another product.

Joint Products and By-products n A by-product has a relatively low sales value compared with the sales value of a joint or main product. »Revenue from byproducts generally reduces the costs of the joint products. We aren’t studying the details. n Some outputs of the joint production process have zero sales value. »No journal entries are made to record the processing of such outputs with zero sales value.

Joint Products and By-products Sales Value High Low Main Products Joint Products By-products

Joint Products and By-products n The classification of products as main, joint, or by-product depends on its sales value. n Products can change from by-products to joint products when their relative sales values increases and changes from joint products to by-products when their relative sales value decreases.

Why Allocate Joint Products? n 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).

Why Allocate Joint Products? 3 Insurance settlements »Require cost allocation when damage claims made by businesses with joint products, main products, or by- products are based on cost information. 4 Rate regulation »The allocation of joint costs is required if one or more of the jointly produced products or services are subject to price regulation.

Why Allocate Joint Products? 5 Litigation »Joint cost allocation is important in litigation involving one or more joint products.

Approaches to Allocating Joint Costs n The two basic approaches to allocating joint costs are: n Approach 1: Use market-based data such as revenues. n Approach 2: Use physical measures such as weight or volume.

Allocating Joint Costs n Approach 1: n The sales value at splitoff method n The estimated net realizable value (NRV) method n The constant gross-margin percentage NRV method

Allocating Joint Costs n Lubbock Company incurred $200,000 of joint costs to produce the following: n Product A: 10,000 units, 20,000 pounds n Product B: 10,500 units, 48,000 pounds n Product C: 11,500 units, 12,000 pounds

Sales Value at Splitoff Method n 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.

Sales Value at Splitoff Method n Assume the following sales values per unit: A: $10.00, B: $30.00, and C: $20.00 n What is the total sales value at splitoff point? n Product A: 10,000 × $10.00 =$100,000 n Product B: 10,500 × $30.00 = 315,000 n Product C: 11,500 × $20.00 = 230,000 n Total$645,000

Sales Value at Splitoff Method n How much joint costs are allocated to each product? n A: $100,000/$645,000 × $200,000 = $ 31,008 n B: $315,000/$645,000 × $200,000 = 97,674 n C: $230,000/$645,000 × $200,000 = 71,318 n Total $200, %

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

Sales Value at Splitoff Method n Assume all of the units produced of B and C were sold (no further processing). n 2,500 units of A (25%) remain in inventory. n What is the gross margin percentage of each product?

Sales Value at Splitoff Method n Product A n Revenues: 7,500 units × $10.00$75,000 n Cost of goods sold: – Joint product costs $31,008 – Less ending inventory 7,752* 23,256 »*$31,008 × 25% n Gross margin$51,744

Sales Value at Splitoff Method n Prod. A: $75,000 – $ 23,256 = $51,744; $51,744 ÷ $75,000 = 69% n Prod. B: ($315,000 – $97,674) ÷ $315,000 = 69% n Prod. C: ($230,000 – $71,318) ÷ $230,000 = 69% The sales value at splitoff method produces an identical gross margin percentage for each product.

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

Estimated Net Realizable Value (NRV) Method n The estimated NRV method allocates joint costs to joint products on the basis of the relative estimated NRV. n NRV = (expected final sales value in the ordinary course of business) – (expected separable costs of the total production of these products)

Estimated Net Realizable Value (NRV) Method n Assume that Lubbock Company can process products A, B, and C further into A1, B1, and C1. n The new sales value after further processing are: n A1: 10,000 × $12.00 = $120,000 B1: 10,500 × $33.00 = $346,500 C1: 11,500 × $21.00 = $241,500

Estimated Net Realizable Value (NRV) Method n Additional processing (separable) costs are as follows: n A1: $35,000; B1: $46,500; and C1: $51,500 n What is the estimated net realizable value of each product at the splitoff point?

Estimated Net Realizable Value (NRV) Method n Product A1: $120,000 – $35,000 = $85,000 estimated net realizable value n Product B1: $346,500 – $46,500 = $300,000 estimated net realizable value n Product C1: $241,500 – $51,500 = $190,000 estimated net realizable value n How much of the joint cost is allocated to each product?

Estimated Net Realizable Value (NRV) Method Estimated NRV Proportion Estimated NRV Proportion Product A1$ 85,000 85/575 Product B1 300,000300/575 Product C1 190,000190/575 Total$575,000

Estimated Net Realizable Value (NRV) Method n Product A1: 85/575 × $200,000 =$ 29,565 n Product B1: 300/575 × $200,000 = 104,348 n Product C1: 190/575 × $200,000 = 66,087 n Total$200,000

Estimated Net Realizable Value (NRV) Method Allocated Separable Inventory joint costs costs costs Allocated Separable Inventory joint costs costs costs A1$ 29,565 $ 35,000 $ 64,565 B1 104,348 46, ,848 C1 66,087 51, ,587 Total$200,000 $133,000 $333,000

Estimated Net Realizable Value (NRV) Method n What is the production cost per unit? n Product A1: $64,565 ÷ 10,000 = $6.46 n Product B1: $150,848 ÷ 10,500 = $14.37 n Product C1: $117,587 ÷ 11,500 = $10.22

Physical Measure Method n Allocates joint costs to joint products on the basis of the relative weight, volume, or other physical measure at the splitoff point.

Physical Measure Method n Recall that Lubbock Company incurred $200,00 of joint costs to produce A, B, and C products. n Product A: 10,000 units, 20,000 pounds n Product B: 10,500 units, 48,000 pounds n Product C: 11,500 units, 12,000 pounds

Physical Measure Method n Allocation using the number of pounds produced as the physical measure: n Product A: 20,000/80,000 × $200,000 = $50,000 n Product B: 48,000/80,000 × $200,000 = $120,000 n Product C: 12,000/80,000 × $200,000 = $30,000

Physical Measure Method n What is the cost per pound for each product? n Product A: $50,000 ÷ 20,000 = $2.50 Product B: $120,000 ÷ 48,000 = $2.50 Product C: $30,000 ÷ 12,000 = $2.50 n It is possible to obtain the cost per pound ($200,000 ÷ 80,000 = $2.50) and use this amount to distribute the joint costs.

Physical Measure Method n Under the benefits-received criterion, the physical measure method is less preferred than the sales value at splitoff method. n Why? n Because it has no relationship to the revenue- producing power of the individual products.

Comparison of Methods n Which method of allocating joint costs should be chosen? n The sales value at splitoff method is widely used where market prices exist at splitoff.

Comparison of Methods n Sales value at splitoff method: – Objective – Does not anticipate subsequent management decisions on further processing. – Uses a meaningful common denominator. – Simple – Not available if not all products salable at splitoff

Comparison of Methods n The purpose of the joint-cost allocation is important in choosing the allocation method. n The physical measure method is a more appropriate method to use in rate regulation.

Absolute Irrelevance of Joint Costs for Decision Making n 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.

Irrelevance of Joint Costs for Decision Making n 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. n Units price1 price2 Add’l costs 10,000 A: $10A1: $12$35,000 10,000 A: $10A1: $12$35,000 10,500 B: $30B1: $33$46,500 10,500 B: $30B1: $33$46,500 11,500 C: $20C1: $21$51,500 11,500 C: $20C1: $21$51,500

Irrelevance of Joint Costs for Decision Making n Should A, B, or C be sold at the splitoff point or processed further? n Product A: Incremental revenue $20,000 – Incremental cost $35,000 = ($15,000) n Product B: Incremental revenue $31,500 – Incremental cost $46,500 = ($15,000) n Product C: Incremental revenue $11,500 – Incremental cost $51,500 = ($40,000)

Irrelevance of Joint Costs for Decision Making n Products A, B, and C should be sold at the splitoff point. n 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.

The End