Allocation for costs of Joint Products, Byproducts, Scrap, Rework, and Spoilage

Cost Allocation for

Joint Products, Byproducts, Scrap, Rework, and Spoilage
The need to measure more accurately how different products and services use resources, has led
companies to refine their costing systems. As a result, successful companies pay more attention to avoid
over or under costing. Companies do more efforts to avoid product-cost cross- subsidization which might
lead to either loosing market share or incurring actual loss.

Joint products are produced as a direct result of the strategic planning process of the company.
These products are considered to be of major importance to the company and, therefore, represent a
significant focus for management, accounting, and financial reporting. The accounting allocation methods
are discussed later in this paper.

Byproducts emerge from a common process along with primary products but are not considered to
be important or valuable enough to be a major focus of management. Two methods for accounting for
byproducts can be followed, byproducts recognized at time production is completed in the financial
statements as (NRV) or revenues are not recognized until sale of the byproduct occurs.

Scrap on the other part is the waste or the residual pieces / parts of the material used in the
production process. It is the material left over when making a product and has low sales value compared
with the sales value of the product. Examples are short lengths from woodworking operations, edges from
plastic modeling operations, and frayed cloth and end cuts from suit-making operations. Scrap has no cost
and hence it can be considered as revenue that should reduce the cost of either a specific job or the
manufacturing overhead in common when sold.

Rework is units of production that do not meet the standards required by customers for finished units
that are subsequently repaired and sold as acceptable finished units. It is units of production that are
inspected, determined to be unacceptable, repaired, and sold as acceptable finished goods. It can be
distinguished as normal rework attributable to a specific job, normal rework common to all jobs, and
abnormal rework.

Normal rework cost attributable to a specific job are charged to that job, when normal rework is
common to all jobs, the costs are charged to manufacturing overhead and spread, through overhead
allocation, over all jobs. As for abnormal rework the costs are charged to a loss account. The
abovementioned classification is vital for rationalizing the decision-making process.

Spoilage is units of production- whether fully or partially completed- that do not meet the standards
required by customers for good units that are discarded or sold for reduced prices. Spoilage may be normal
spoilage or abnormal spoilage, normal spoilage is inherent in a particular production process that arises even
under efficient operating conditions. Costs of normal spoilage are typically included as a component of the
costs of good units manufactured and the logic for this treatment is that good units can not be made without
also making some units that are spoiled. Normal spoilage rates are computed by dividing units of normal
spoilage by total good units completed, not total actual units started in production because normal spoilage
is the spoilage related to the good units produced.

Abnormal spoilage, on the other hand is spoilage that would not arise under efficient operating
conditions. It is not inherent in a particular production process. Abnormal spoilage is usually regarded as
avoidable and controllable. Line operators and other plant personnel can generally decrease or eliminate

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abnormal spoilage by identifying reasons for machine breakdowns, accidents, and the like, and taking steps
to prevent their recurrence.

To highlight the effect of abnormal spoilage costs, companies calculate the units of abnormal
spoilage and the cost of abnormal spoilage in a loss from abnormal spoilage account, which appears as a
separate line item in the income statement.

Why joint costs should be allocated to individual products?

There are some reasons that require joint costs to be allocated to individual products:

(1) To reimburse cost incurred under contracts for companies that have few of their services or
products reimbursed under cost-plus contracts with government agency for example.
(2) To compute and calculate inventorial costs and cost of goods sold for internal reporting purposes.
These reports affect evaluation of division managers’ performance and thus are used in division
profitability analysis.
(3) Also inventorial costs and cost of goods sold are used for financial accounting purposes and
reporting purposes for income tax authorities.
(4) To regulate rates for one or more of the jointly produced products or services that is subject to
price regulation.
(5) As a basis for settlement insurance claims such as damage claims made on the basis of cost
information by businesses having joint products, main products, or byproducts.

Methods used to allocate joint costs

The following problem involves the case of a manufacturer of soy- bean oil principally. Assume that
the relationship between the market value of oil and meal remains fairly constant-ranging, say, between
ratios of 80-20 and 50-50, over a period of several years, for each 60 pounds of raw material placed in the
productive process. Management has instituted the policy of treating these two commodities as joint
products and of allocating the joint costs between oil and meal, for the purpose of calculating the amount of
profit (or loss) on each of these two items. The problem then becomes one of accounting for the distribution
of joint costs.

There are mainly two approaches to allocate joint costs

(1) Market Based Methods.

 Sales value at split-off point.

The sales value at split-off point method allocates joint costs to joint products on the basis of
the relative total sales value at the split-off point of the total production of these products during the
accounting period. It is clear that this method follows the benefits-received criterion of cost
allocation (costs are allocated to products in proportion to their expected revenues).

As such this method is simple, straightforward, and intuitive. To apply this method, a
company needs the market selling prices for all products at the split-off point. This method considers
market factors by recognizing that joint or primary products produced from a joint or common
process have different values. Market factors affect both the selling price of soy-beans and the
decision to purchase and crush soy-beans into meal and oil.

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 Consequently, joint products with higher sales value are allocated relatively more joint cost
than joint products with lower sales values. The value at split-off point method takes into
consideration market factors when valuing the various joint or primary products produced from a
common or joint process. In some cases, one or more of the joint (primary) products produced may
not be salable at the split-off point but must be processed further before a sales value is available.
Using the value at split-off point method, we can substitute the estimated sales value for the
actual sales value at split-off point. The estimated sales value at split-off point is found by computing
the total sales value of a joint (primary) product at the point closest to the split-off point and then
subtracting the appropriate further processing cost from this total. This modified approach
accommodates situations where sales values are not available at the split-off point. However it does
not properly recognize the value added by the further processing cost.

As a general rule, adding cost to a product also adds value, in turn increasing its selling price.
The greater the further processing cost is for a joint (primary) product, the more the final selling
price is a result of that further processing cost. The result is that the estimated value at the split-off
point, for those products that have significant further processing costs, is overstated by the gross
profit associated with the further process cost. This weakness can be overcome by using the net
estimated total sales value at the split-off point. This is computed by subtracting both the further cost
and the gross profit associated with the further processing cost from the sales value closest to the
split-off point.

 Net realizable value (NRV) method.

Products may be processed beyond the split-off point in many cases to bring these products to
a marketable form or to increase their value above their selling price at the split-off point. The net
realizable value (NRV) method allocates joint costs to joint production on the basis of the relative
NRV (The final sales value minus the separable costs) of the total production of the joint products
during the accounting period.

This method is typically used in preference to sales value at split-off method only when we
do not know the market selling prices for one or more products at split-off.

The NRV method is often implemented using simplifying assumptions. Thus if the selling
prices of joint products vary frequently, a given set of selling prices may be consistently used
throughout the accounting period. Since the sales value at split-off point method does not require
knowledge of the processing steps beyond the split-off point, it is less complex than the NRV
method simply because market prices may only be available after processing occurs beyond the split-
off point.

 Constant gross-margin percentage NRV method.

This method allocates joint costs to joint products in such a way that the overall gross-margin
percentage is identical for the individual products. The constant gross-margin percentage NRV
method takes account of profits earned either before or after the split-off point when allocating the
joint costs unlike the sale value at split-off method and the NRV methods.

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 (2) Physical Measures such as the weight, length, or volume.

The physical-measure method allocates joint costs to joint products on the basis of the
relative weight, volume, or other physical measure at the split-off point of the total production of
these products during the accounting period.

Under the benefits received criterion, the physical-measure method is less preferred
than the sales value at split-off method because it has no relationship to the revenue producing power
of the individual products.

Which method is preferred? Why?

The sales value at split-off point method is the most reliable method if it is available for some
reasons:

(1) It has a meaningful basis for joint cost allocation which is revenues.
(2) The sales value at split-off method is straight forward and simple to apply.
(3) It measures the value of the joint product immediately at the end of the joint process.
(4) This method does not require information on the processing steps after split-off point, if there is
further processing.

The NRV method assumes that all markup or profit margin is attributable to the joint process not to
the separable costs. NRV can be used when selling prices at split-off are not available. Thus this method
tries to approximate the sales value at split-off point by subtracting separable costs incurred after the
split-off point on each product from selling prices.

The constant gross-margin percentage method is easy to implement. This method avoids the
complexities in NRV method since it assumes that all products have the same ratio of cost to sales value.

The physical measures method can be used in rate regulation. However there are difficulties in using
this method for other decisions.