15 - 1 Cost Allocation: Joint Products and By-products ACCT7320 Dr. Bailey.

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Cost Allocation: Joint Products and By-products

ACCT7320

Dr. Bailey

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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 the

beneficiaries 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 proportion

to 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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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

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Joint Products and By-products

Sales Value

High Low

Main or

Joint Products By-products

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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

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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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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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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)

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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.

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The End