AE4 Strategic Cost Management

Module 12

Joint cost

 is the result of producing two or more different products from a single cost
factor. It may be defined as the cost incurred to produce two or more different
products by processing one or more raw materials through a common
production process or a series of production processes.

 The joint cost is incurred up to the split-off point (the point at which various
products are separated). Any cost incurred on a particular product after the split-
off point is not included in joint cost but is regarded as further processing cost of
that individual product.
Examples of joint products and joint costs

Some examples of joint products and joint cost are given below:

1. The coal is the basic raw material for the production of coke. In addition to coke,
the production process also produces four other products – light oil, sulfate of
ammonia, gas and crude tar. The most quantity of the gas produced during the
process is not sold but is used to fire the coke ovens and the boilers of the
power plant. For assigning cost to all the products, the coke ovens act as split-off
point. The total cost of each product consists of a share of joint cost plus any
subsequent cost incurred to put the product in marketable condition.
2. Meat packing industry is also a classical example where joint products are found.
In meat packing industry, the original carcass with a joint cost is processed to
obtain various cuts of meats. The process also results in the production of some
by-products.

By-products

 Along with main products, some manufacturing processes produce one or more
products having a relatively small value or no value at all. These products are
usually termed as by products or secondary products. The main products are
produced in larger quantities whereas by-products are produced in relatively
small quantities.

 Normally, the by-products are not considered as finished goods because their
production is not intended in the first place. They come into existence because
their production cannot be avoided because of the nature of production process
or the raw materials being used in the production process. The introduction of
advanced production and engineering processes, however, has made it possible
to control the production of such secondary products to some extent. An example
of such processes can be found in petroleum industry.
Examples of by-products

1. The white sugar is obtained by refining the sugarcane juice. The process
includes the extraction of by-products like molasses, gum, wax, bagasse etc. At
first the sugar cane juice is boiled and mixed with carbon dioxide so that sugar
could be separated from gum and wax. This wax and gum is used to make
erasers and bubble gums respectively. At this stage the sugar is normally dark in
color and known as “brown sugar”. In the next step sugar is refined to produce
‘white sugar’. This is the step in which by-products like molasses (mixture of
water and sugar) and bagasse materialize. Molasses is used for cooking and
baking purposes while bagasse can be used as bio fuel.

Joint cost

 If a company incurs costs prior to a split-off point, it must allocate them to

products, under the dictates of both generally accepted accounting principles and
international financial reporting standards.

 If you were not to allocate these costs to products, then you would have to treat
them as period costs, and so would charge them to expense in the current
period.

 This may be an incorrect statement of the cost if the associated products are not
sold until sometime in the future, since you would be charging a portion of the
product cost to expense before realizing the offsetting sale transaction.
Allocating Joint Costs
- does not help management, since the resulting information is based on
essentially arbitrary allocations. *
How to allocate Joint Cost?
1. Allocate based on sales value. *

- Add up all production costs through split off point, then determine the sales
value of all joint products as of the same split-off point, and then assign the
costs based on the sales values. If there are any by-products, do not allocate
any cost to them; instead charge the proceeds for their sale against the cost
of goods sold.

2. Allocate based on gross margin. *

- Add up the cost of all processing costs that each joint product incurs after the
split-off point, and subtract this amount from the total revenue that each
product will eventually earn.

Sales Value at Split-off Method

- allocate the costs between or among the products.
Joint Cost Allocated to Products = Sales Product x Joint Cost
Total Sales Value of all Joint Products

Net Realizable Value Method

- more suitable because it takes into account, additional cost need to further
process and sell the joint products.
Net Realizable Value = Final Selling Price – Additional Processing Costs – Selling Costs

Cost Allocated to a Joint Product = NRV of the Product x Total Joint Cost
NRV of total production

Constant Gross Margin Percentage

- based on allocating joint costs so that the gross margin percentage is the same
for every product.
Total Gross Margin of all Products = Final Selling Price – Total Joint Cost – Total Separable Costs
 Gross Margin Percentage = Total Gross Margin for all Products
Final Selling Price

APPROACH 2: ALLOCATE JOINT COST USING PHYSICAL MEASURE, SUCH AS

THE WEIGHT QUANTITY (PHYSICAL UNITS), OR VOLUME OF THE JOINT
PRODUCTS.

- This value method is suitable where physical quantity of joint-products closely

reflects their cost. All joint products musts be measurable by some basic units
of measurement.

Advantages and Disadvantages of the Allocating Methods

Approach 1: Sales Value Method

Advantage Disadvantage

 It considers market value of  Uses selling price at the time of splitoff

products as basis of even if the product is not sold by the firm
allocating joint cost. in that form.

Approach 1: Net Realizable Value Method

Advantage Disadvantage

 Allocates joint costs using ultimate net value of each  High information
product. needs.

Approach 1: Constant Gross-Margin Percentage Method

Advantage Disadvantage
  They are deemed equally profitable.  May lead to negative cost allocations.

Approach 2: Physical Measure

Advantage Disadvantage

 Low information  Allocation is unrelated to the revenue-generating

needs. ability of products.

 Sales Value at Split off method

The sales-value-at-split-off method allocates joint cost based on each product’s
proportionate share of market or sales value at the split-off point. In this method, the
higher the market value, the greater the joint cost assigned to the product.
Joint Product Costs

Raw Milk Cost: 400,000

Joint costs
Separation Process Cost: 200,000
Split off point

Whole Milk Cream Joint products

Sales Value Sales Value

240,000 360,000

Relative Sales Value:

Sales Value of Whole milk + Sales value of Cream = Total sales value of the product
240,000 + 360,000 = 600,000
240,000 / 600,000 = 40%
360,000 / 600,000 = 60%

 Net Realizable Value Method

Net realizable value (NRV) is the value of an asset that can be realized upon the sale of
the asset, less a reasonable estimate of the costs associated with the eventual sale or
disposal of the asset. NRV is a common method used to evaluate an asset's value for
inventory accounting. NRV is a valuation method used in both Generally Accepted
Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS)/
  Constant Gross Margin NRV Method
The constant gross margin percentage method allocates joint costs such that the
gross margin percentage is the same for each product. This method assumes that the
further processing yields an identical profit percentage across all products.
A B C Total
Sales
Revenue 1,000,000 2,000,000 700,000 3,700,000
Cost of
goods
sold:
Joint cost 1,250,000
Separable
Cost 750,000 750,000 210,000 1,710,000

2,960,000
Gross 740,000
Margin

Gross margin percentage : Gross margin/Sales Revenue

=740,000/3,700,000
= 0.2 or 20%

A B C Total

Ultimate 1,000,000 2,000,000 700,000 3,700,000

sales value
Less 20% 200,000 400,000 140,000 740,000
gross
margin
Total cost 800,000 1,600,000 560,000 2,960,000

Separable 750,000 750,000 210,000 1,710,000

cost
Joint cost 50,000 850,000 350,000 1,250,000
allocation

 Quantitative or Physical Units Method

Under quantitative unit method (also known as physical unit method), the joint cost is
allocated among joint products on the basis of measurement units like tons, gallons,
pounds or feet etc.
For example, while manufacturing coke, the joint products like coke, benzol, coal tar,
gas and sulfate of ammonia are measured in different units and the yield of recovered
units of these products is measured on the basis of product quantity extracted per ton of
coal used

*Distribution of waste to recovered products:

(Yield in pounds of recovered products per ton of pound × Waste)/Total weight in
pounds excluding the weight of waste
Coke: (1,320 × 100)/(2,000 – 100) = 69.474 lbs
Coal tar: (120 × 100)/(2,000 – 100) = 6.316 lbs
Benzol: (21.9 × 100)/(2,000 – 100) = 1.153 lbs
Sulfate of ammonia: (26 × 100)/(2,000 – 100) = 1.368 lbs
Gas: (412.1 × 100)/(2,000 – 100) = 21.689 lbs

**Materials cost of each product per ton of coal:

(Revised weight of recovered products × Joint cost)/Total weight after distributing the
weight of waste
Coke: (1,389.474 × 20)/2,000 = $13.895
Coal tar: (126.316 × 20)/2,000 = $1.265
Benzol: (23.053 × 20)/2,000 = $0.230
Sulfate of ammonia: (27.368 × 20)/2,000 = $0.275
Gas: (433.789 × 20)/2,000 = $4.335
Price Formulation for Joint Products and By-Products
 The costs allocated to joint products and by-products should have no bearing on the
pricing of these products, since the costs have no relationship to the value of the
items sold.

 Prior to the split-off point, all costs incurred are sunk costs, and as such have no
bearing on any future decisions – such as the price of a product.

* Split off point - is the point at which joint production stops and processing for separate
products begins; thus, their costs can be identified individually after the split-off point.
* Sunk costs - refers to money that has already been spent and which cannot be
recovered.
The situation is quite different for any costs incurred from the split-off point onward.
Since these costs can be attributed to specific products, you should never set a product
price to be at or below the total costs incurred after the split-off point. Otherwise, the
company will lose money on every product sold.

If the floor for a product’s price is only the total costs incurred after the split-off point, this
brings up the odd scenario of potentially charging prices that are lower than the total
cost incurred (including the costs incurred before the split-off point). Clearly, charging
such low prices is not a viable alternative over the long term, since a company will
continually operate at a loss. This brings up two pricing alternatives:
Short-term pricing. Over the short term, it may be necessary to allow extremely low
product pricing, even near the total of costs incurred after the split-off point, if market
prices do not allow pricing to be increased to a long-term sustainable level.

Short Term Pricing Strategy examples:

 Destroyer Pricing - Setting a very low price to destroy the competition. Product
probably being sold at a loss; however once competition is destroyed the price
will return to market price.
Promotional Pricing - Used to boost sales and create interest in a product by
lowering the price.
If a company is unable to set individual product prices sufficiently high to more than
offset its production costs, and customers are unwilling to accept higher prices, then it
should cancel production – irrespective of how costs are allocated to various joint
products and by-products.