Chapter 6 - Cost allocation: joint-cost situations Flashcards
6.1 What is a joint cost?
Joint costs are the costs of a production process that yields multiple products simultaneously
6.2 Define separable costs
separable costs are costs incurred beyond the split-off point that are assignable to one or more individual products. At or beyond the split-off point, decisions relating to sale or further processing of individual products can be made independently of decisions about other products.
- Identify the split-off point(s) in a joint-cost situation
The juncture in the process when one or more products in a joint-cost setting become separately identifiable is called the split-off point
- Distinguish between joint products and by-products
Joint products all have relatively high sales value but are not separately identifiable as individual products until the split-off point
A by-product has a low sales value compared with the sales value of the main or joint product(s)
Individual products can change from being a by-product or a joint product when their market prices move sizably in one direction
Scrap has minimal sales value
- Provide six reasons for allocating joint costs to individual products
- Stock costing and COGS computations for external financial statements and reports for income tax authorities
- Stock costing and COGS computations for internal financial reporting. Such reports are used in division profitability analysis when determining compensation for division managers
- Cost reimbursement under contracts when only a portion of a business’s products or services is sold or delivered to a single customer
- Customer profitability analysis where individual customers purchase varying combinations of joint products or by-products as well as other products of the company
- Insurance settlement computations when damage claims made by businesses with joint products, main products or by-products are based on cost information
- Rate regulation when one or more of the jointly produced products or services are subject to price regulation
- Explain two alternative methods of allocating joint costs
There are two main approaches:
- Allocate costs using market-based data (e.g. revenues). Three methods in this approach: the sales value at split-off method, the estimated net realisable value (NRV) method, the constant gross-margin percentage NRV method
- Allocate costs using physical measure-based data such as weight or volume
No-allocation is also an option
- Identify the criterion used to support market-based joint-cost allocation methods
In joint-cost settings, it is not feasible to use the cause-and-effect criterion to guide individual product-cost allocations. Joint costs, by definition, cannot be the subject of cause-and-effect analysis at the individual product level. The cause-and-effect relationship exists only at the joint process level
The benefits-received criterion leads to a preference for methods under approach 1. Revenue in general, are a better indicator of benefits received than are physical measures such as weight or volume
Describe the sales value at split-off method
Allocates costs on the basis of the relative sales value at the split-off point of the total production in the accounting period of each product
We assign a weighting to each product, which is a percentage of total sales value
Using this weighting, we allocate joint costs to the individual products
This method uses the sales value of the entire production of the accounting period
The joint costs were incurred on all units produced and not just those sold
Exemplifies the benefits-received criterion of cost allocation - costs are allocated to products in proportion to their ability to contribute revenue
Cost allocation base - sales value at split-off
Describe the physical measure method
Allocates joint costs on the basis of their relative proportions at the split-off point, using a common physical measure such as weight or volume of the total production of each product
Using the benefits-received method, the physical measure is less preferred than the sales value at split-off method as the physical weights may have no relationship to the revenue-producing power of the individual products
Describe the estimated NRV method
Allocates joint costs on the basis of the relative estimated net realisable value (expected final sales value in the ordinary course of business minus the expected separable costs of production and marketing of the total production of the period)
Estimating the net realisable value of each product at the split-off point requires information about the subsequent processing steps to be taken (and their expected separable costs)
Weighting based on NRV at split-off point is assigned to each product and costs are allocated on the basis hereof
Describe the constant gross margin percentage NRV method
Allocates joint costs in such a way that the overall gross-margin percentage is identical for all the individual products
Three steps:
1. Calculate the overall gross-margin percentage
2. Use the overall gross-margin percentage and deduct the gross margin from the final sales values to obtain the total costs that each product should bear
3. Deduct the expected separable costs from the total costs to obtain the joint-cost allocation
Uses the expected final sales value of the total production of the period and not the actual sales of the period
The tenuous assumption underlying the constant gross-margin percentage NRV method is that all products have the same ratio of cost to sales value
A constant ratio of cost to sales value across products is rarely seen in companies that produce multiple products but have no joint costs
The main advantage of this method is that it is easy to implement
- Describe the irrelevance of joint costs in deciding to sell or further process
The decision to incur additional costs beyond split-off should be based on the incremental operating profit attainable beyond the split-off point
The joint costs are irrelevant as they are the same whether or not further processing is done
The only relevant items are incremental revenue and incremental costs
Joint costs incurred up to the split-off point are past (sunk) costs
Sunk costs mean that these costs were incurred anyways and therefore are irrelevant to the decision to sell a joint (or main) product at the split-off point or to process it further.
Decision making is forward-looking and we must therefore focus on the future-oriented alternatives.
- Distinguish alternative methods of accounting for by-products
Two major questions when accounting for by-products:
1) When are by-products first recognised in the general ledger? The two basic choices are (a) at the time of production, or (b) at the time of sale
2) Where do by-product revenues appear in the income statement? The two basic choices are (a) as a cost reduction of the main or joint product(s), or (b) as a separate item of revenue or other income
Combining these two question give four possible ways of accounting for by-products
Describe the additional benefits of the sales value at split-off method
No anticipation of subsequent management decisions - does not presuppose an exact number of subsequent steps undertaken for further processing
Availability of meaningful common denominator to calculate the weighing factors (common denominator - euros). The physical measure method may lack a meaningful common denominator
Simplicity. In contrast, NRV method can be very complex in operations with multiple product and multiple split-off points. The total sales value at split-off point is unaffected by any change in the production process after the split-off point
6.4 Why might the number of products in a joint-cost setting differ from the number of outputs? Give an example.
In some joint-cost settings, the number of outputs produced exceeds the number of products. This situation can occur where an output, produced as an inherent part of the joint production process, is recycled without any value being added by its production. For example, the offshore processing of hydrocarbons to yield oil and gas also yields water as an output, which is recycled back into the sea.
