CHAPTER FOUR: COST ALLOCATION

(Allocation of Support-Department Costs)

Operating (producing) department’s Vs. Service (supporting) departments

Cost allocation is a serious issue in every organization either they are service or
manufacturing organization in order to accumulate product cost properly.

Companies distinguish operating departments (and operating divisions) from support

departments. Most large organizations have both operating departments and service
departments. An operating department, also called a production department, directly adds
value to a product or service. Examples are manufacturing departments where products are
made. Operating dep’ts are directly responsible for manufacturing or creating the product or
services or directly add value to a product or service that is observable by customer.

In contrast, service departments do not directly engaged in operating activity. Instead they
provide essential services (support) or assistance for operating departments (production
dep’ts). A support department, also called a service department, provides the services that
assist other internal departments (operating departments and other support departments) in
the company. Examples of support departments are information systems, production control,
materials management, and plant maintenance.

Purpose of cost allocation

Service department costs are allocated to operating department for a variety of reasons
including:

 Price decision
 To measure the profitability of operating department (product line)
 To predict future production volume
 To motivate managers and employees
 To value inventory for external financial report purposes

Allocating One Support Department Cost Using the Single-Rate and Dual-Rate
Methods
The single rate cost allocation method allocates costs in each cost pool to cost objects using
the same rate per unit of the single allocation base.

Or the single rate cost allocation pools all costs in one cost pool and allocate them to cost
objects using the same per unit of a single allocation basis. No differentiation (distinction) of
costs as variable and fixed costs when rates are calculated.

By contrast, the dual-rate method partitions the cost of each support department into two
pools, a variable cost pool and a fixed-cost pool, and allocates each pool using a different
cost-allocation base.
 Variable costs
 Fixed costs

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And when using dual rate method allocation bases or rate for each different sub costs pool
(variable and fixed) must be chosen.

Example: XY textile factory has two operating departments, the Assembly Department and
the Machining Department, where production occurs and one support departments, Materials
Management, that provide essential services to the operating departments for manufacturing
the specialized machinery. The following data for 2013 is given related to factory.

Budgeted fixed cost ---------------------------------$300,000

Budgeted variable cost per unit ------------------------$200
Available capacity ---------------------------------------1500 hrs

Budgeted usage of service /facilities in central department

Assembly Department ------------------------ 800 hrs

Machining Department ----------------------- 400 hrs
Total --------------------------------- 1200 hrs

Actual usage of division hours during 2013

Assembly Department -----------------------900 hrs

Machining the Department -----------------300 hrs
Total -------------------------------------- 1200 hrs

Actual fixed cost of the materials department is equal to $ 300,000.

Required: allocate the cost of the support department to Assembly Department and
Machining the Department.

Using 1) single rate

2) Dual rate

1. Single rate method

In this method, a combined budgeted rate is used for fixed and variable costs. The rate is
calculated as follows:

Budgeted usage 1,200 hours

Budgeted total cost pool: $300,000 + $200(400 hours +800hours) $540,000
Budgeted total rate per hour: $540,000/ 1,200 hours $450 per hour used
Allocation rate for machining department $450 per hour used
Allocation rate for assembly department $450 per hour used
The support costs allocated to the two departments under this method are as follows:

Assembly Department = $ 450/hrs x 900hrs = $405,000

Machining the Department = $ 450/hrs x300hrs = $135,000
Total ------------------------------------$540,000

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Therefore, the materials department incurs $ 405,000 for Assembly Department and $135,000
for Machining the Department when the department use single rate method.

2. Dual rate method

As in the single-rate method, variable costs are assigned based on the budgeted variable cost
per hour of $200 for actual hours each department uses. However, fixed costs are assigned
based on budgeted fixed costs per hour and the budgeted number of hours for each
department. Given the budgeted usage of 800 hours for the Assembly department and 400
hours for the Machining Department, the budgeted fixed-cost rate is $250 per hour
($300,000/ 1,200 hours), as before.

The costs allocated to the Assembly Department in 2013 under the dual-rate method would
be as follows:

Fixed costs: $250 per hour * 800 (budgeted) hours $200,000

Variable costs: $200 per hour * 900 (actual) hours 180,000
Total costs $380,000
The costs allocated to the Machining Department in 2013 would be as follows:

Fixed costs: $250 per hour * 400 (budgeted) hours $100,000

Variable costs: $200 per hour * 300 (actual) hours 60,000
Total costs $160,000

Allocating multiple support (service) department costs to operating departments

In the previous section, we examined general issues that arise when allocating costs from
one support department to operating departments. In this section, we examine the special cost
allocation problems that arise when two or more of the support departments whose costs are
being allocated provide reciprocal support to each other as well as to operating departments.
Cost allocation methods
For allocating service department costs, the process of allocating service cost systematically
follows. The following step all of which affects the success of cost allocation. These steps
are:
1) Identify the costs to be allocated.
2) Choose the appropriate cost allocation base.
3) Select and use a cost allocation method.
4) Determine if the cost allocation achieve the desire result if not change the method.

There are three methods of allocating the cost of service department to producing department.
1. Direct method of allocation
2. Step down method of allocation
3. Reciprocal method of allocation
1. Direct method of allocation
The direct method is the simple of the three cost allocation methods. It allocates each
support-department’s costs to operating departments only. It ignores the service provided by
a service department to other service departments and allocates all of its costs directly to

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operating departments. Even if service departments provide service to another service
department, no allocations are made to service departments. Rather, all costs are allocated
directly to the operating departments.

It assumes that service departments provide service only to producing departments. All
service department costs allocated directly to production costs.

Example
Cost data for castle forced engineering for 2016 is as follows, it has two operating
departments which are machining and assembly. And two service departments which are
plant maintenance and information systems.

Support departments operating departments Total

Plant information machining assembly

maintenance system

Budgeted OH departmental $ 600,000 $116,000 $400,000 $200,000 $1,316,000

cost before allocation

Support work furnished:

By plant maintenance 1600 2400 4000 8000

budgeted labor hour % 20% 30% 50% 100%

By information system 200 1600 200 2000

Budgeted computer time% 10% 80% 10% 100%

Required: allocate service depts. cost using

1) Direct method
2) Step down method
3) Reciprocal method
Allocation base for maintenance dep’t is labour hour and for information system is computer
time used.
Work supported by Plant maintenance
To machine dep’ts. 600,000 x 2400/6400 = 225,000
To assembly dep’ts. 600,000 x 4000/6400 = 375,000

Work supported by information system

To machine depts. 116,000 x1600/1800 =103,111
To assembly depts. 116,000 x 200/1800 = 12,889

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 Direct Method of Allocating Support-Department Costs
Support departments operating departments Total

Plant information machinin Assembly

maintenance system g

Budgeted OH departmental $ 600,000 $116,000 $400,000 $200,000 $1,316,000

cost before allocation

Allocation of plant ($ 600,000) ----- $225,000 $375,000 ($ 600,000)

maintenance(3/8, 5/8)
Allocation of information ---- ($116,000) 103,111 12,889 ($116,000)
system (8/9, 1/9)

total budgeted manufacturing $ 0 $ 0 $ 728,111 $ 587,889 $1,316,000

OH of operating department
N.B 2400/6400= 3/8 1600/1800 =8/9
200/1800 = 1/9 4000/6400= 5/8
2. Step down allocation method
Some organization use step down allocation method, also called the sequential
allocation method. This allows for partial recognition of the services provided by support
dep’ts to other dep’ts.

Step down allocation method provides for allocation of a service department costs to other
service department as well as to operating departments. The step method is sequential.
Typically begins with the departments that provide the greatest amount of service to other
service dep’ts after it cost have been allocated , the process continues , step by step , ending
with the department that provides the least amount of services to other departments.

Example: allocate the above example by using step down allocation method
Support departments operating departments Total

Plant information machining assembly

maintenance system

Budgeted OH departmental $ 600,000 $116,000 $400,000 $200,000 $1,316,000

cost before allocation

Support work furnished:

By plant maintenance 1600 2400 4000 8000

budgeted labor hour % 20% 30% 50% 100%

By information system 200 1600 200 2000

Budgeted computer time% 10% 80% 10% 100%

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 Plant maintenance 1600 x 100% =20% it will be first allocate
8,000

Information system 200 X 100% = 10% it will be 2nd

2000
Solution

Time labor hour = 8,000 (1600+ 2400+ 4000)

Information system 1600/8000 =1/5 x$ 600,000 = $120,000
Machine 24000/8000 = 3/10 x $ 600,000 = $ 180,000
Assembly 4000/8000 =1/2 x $ 600,000 = $ 300,000
Rate of information system
Machine dep’ts 1600/1800 = 8/9 x 236,000 = 209,778
Assembly dep’ts 200/1800 = 1/9 x 236,000 = 26,222
Step down allocation method
Support departments operating departments Total
Plant information machinin assembly
maintenance system g
Budgeted OH departmental $ 600,000 $116,000 $400,000 $200,000 $1,316,000
cost before allocation
Allocation of plant ($ 600,000) $120,000 $180,000 $300,0000
maintenance(1/5, 3/10, 1/2)
$236,000
Allocation of information 0 ($236,000) $209,778 22,622
system (8/9, 1/9)
total budgeted manufacturing 0 0 $ 789,778 $ 526,222 $1,316,000
OH of operating department

3. Reciprocal method of cost allocation

The reciprocal method allocates service department costs in both directions. Or it allocate
costs by explicitly including the mutual service provide among all support dep’ts. For
example, plant maintenance department maintains all the computer equipment in the
information system. Similarly, information system provides database support for plant
maintenance and machine dep’ts. The reciprocal method fully incorporates interdepartmental
relationship into support dep’ts cost allocation.

Therefore, the direct and step down methods are less accurate when support department
provide service to another reciprocally.

Reciprocal allocation requires the use of simultaneous linear equations. Example: allocate the
above example by using reciprocal method allocation.

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 Support departments operating departments Total

Plant information machining assembly

maintenance system

Budgeted OH departmental $ 600,000 $116,000 $400,000 $200,000 $1,316,000

cost before allocation

Support work furnished:

By plant maintenance 1600 2400 4000 8000

budgeted labor hour % 20% 30% 50% 100%

By information system 200 1600 200 2000

Budgeted computer time% 10% 80% 10% 100%

Total cost for plant maintenance = 600,000 + 10% information system

Total cost for information system = 116, 000 + 20% plant maintenance

Total cost for P.M (plant maintenance)

P.M = 600,000 + 10 %( 116,000 + 20% P.M)
P.M = 600,000 + 116,000 + 0.02 P.M
1PM – 0.02P.M = 611,600
0.98P.M = 611,000
Total cost for P.M = 611,600/0.98P.M = 624,081
Total cost of information system(I.S)
I.S = 116,000 + 20% P.M
I.S = 116,000 + 20% X 624,081
I.S = 116,000 + 124,816
I.M = 240,816
Support departments operating departments Total
Plant information machining assembly
maintenance system
Budgeted OH departmental cost $ 600,000 $116,000 $400,000 $200,000 $1,316,000
before allocation
1ST Allocation of Plant ($ 600,000) $120,000 $180,000 $300,000
maintenance (2/10, 3/10, 5/10)
$236,000
1st allocation of information 23,600 ($236,000) 188,800 23,600
system (1/10, 8/10, 1/10)
2ND
Allocation of P.M (2/10, (23,600) 4,720 7,080 11,800
3/10, 5/10)
2ND Allocation of I. S (1/10, 472 4,720 3,776 472
8/10, 1/10)
3RD Allocation of P.M (2/10, (472 94 142 236
3/10, 5/10)
3RD Allocation of I. S (1/10, 9 (94) 75 10
8/10, 1/10)
4Th Allocation of P.M (2/10, (9) 2 2 5

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3/10, 5/10)
4TH Allocation of I. S 0 (2) 2 0

total budgeted manufacturing $0 $0 $ 779,877 $ 536,123 $ 1,316,000

OH operating dep’ts. cost

Allocation of Joint- Costs to Main Products & By-products

 Preceding chapters have emphasized costing for companies that produce only a single product or
companies that produce several products in separate processes. We now consider the relatively
more-complex case in which companies produce two or more products simultaneously in the
same (common) process(es).A single process in which one product cannot be manufactured
without producing other is known as a joint process. Producing more of one product in the group
means producing more of all products in the group. Some common examples are:
Agriculture and Food Processing Industries
Cocoa beans ----------> Cocoa butter, Cocoa powder, Cocoa drink mix, tanning cream
Lambs -----------------> Bacon, ham, spare ribs, pork roast
Lumber --------------- > Lumber of varying grades and shapes
Raw milk ------------- > Cream, liquid skim
Extractive Industries
Copper ore ----------- > Copper, silver, lead, and Zinc
Petroleum ----------- > Crude oil and natural gas
Chemical Industries
Crude oil ------------- > Gasoline, kerosene, benzene, naphtha
This section discusses joint processes, their related product outputs, and the accounting treatment of
joint cost.
The Joint Process & its Outputs
 Joint products are typically produced in companies using mass production processes and, thus, a
process costing accounting method. For simplicity, chapter 3 on process costing included
examples of only single-product processes.
 Joint costs – are the costs of a production process up to the point of separation that yields
multiple products simultaneously. These costs include DMs, DL, and FOH and disposal of
waste. These are costs not specifically identifiable with any of the products being simultaneously
produced.
 The split-off point – is the juncture (point) in a joint production process at which two or more
products become separately identifiable. A joint process may have one or more split-off point,
depending on the number and types of output produced.
 Separable cost – are all costs – manufacturing, marketing, distribution, and so on incurred
beyond the split-off point that are identifiable with individual products.
Joint costs
Joint process Cream Further processing Butter cream
Raw Milk
Split-off point Liquid Skim Further Processing Condensed milk

Separable costs
 At or beyond the split-off point, decisions relating to sale or further processing of each
identifiable product can be made independently of decisions about the other products.

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  The outputs of a joint production process can be classified into two general categories:
outputs with a positive sales value and outputs with a zero sales value.
 Product – describes any output that has a positive sales value (or an output that enables an
organization to avoid incurring costs). The sales value can be high or low.
 Main products – the product with the highest sales value relative to other products beyond split-
off point.
 Joint products - two or more products with a relative high sales value that are not identifiable as
individual products until the split-off point. These products are also called primary products,
main products, or co-products. Main product /Joint products are the primary reason management
undertakes the production process yielding them.
 By-product and Scrap - both are incidental outputs of a joint process identified at split-off point.
Both are saleable, but have low sales value that would not be sufficient for management to justify
undertaking the joint process. By-products are viewed as having a higher sales value than scrap.
 Waste – refers to outputs of the joint production process with zero sales value. Any cost of
disposing waste materials (e.g. cost of handling non-saleable toxic substances) should be added to
the joint production costs that are allocated to joint products or main products.
Methods of Joint Cost Allocation
Joint costs can be accounted for in a variety of ways. Two approaches for allocating joint costs
include allocating the costs on the basis of 1) market-based data and, 2) physical-measures.
a) Methods where a measure is available at the split-off point for each separable product.
1) Sales Value at Split-off:
 This method allocates joint costs to the separable products based on the relative sales value of
each product at the split-off point. This method is used whether or not one or more of the joint
products are actually processed further, as long as a market price (sales value) exists for all the
products at split-off.
 This approach follows the “ability to bear” the cost logic. Although it may not seem “fair and
equitable” to the products involved, this method is expedient since a “cause and effect” or
“benefits received” determination is not feasible.
Example 1:Farmer’ dairy purchases raw milk from individual farms and process it until the split-
off point, when two products, cream and liquid skim, emerge. These two products are sold to an
independent company, which markets and distributes them to supermarket and other retail outlets.
Summary data for May 2016 are
 Raw milk processed, 110,000 gallons; 10,000 gallons are lost in the production process
due to evaporation, spoilage, and the like, yielding 25,000 gallons of cream and 75,000
gallons of liquid skim.
Production Sales
 Cream 25,000 gallons 20,000 gallons at $8 per gallon
 Liquid skim 75,000 gallons 30,000 gallons at $4 per gallon

Begin. Inventory End. Inventory

Raw milk 0 gallons 0 gallons
Cream 0 gallons 5,000 gallons
Liquid skim 0 gallons 45,000 gallons
 Cost of purchasing 110,000 gallons of raw milk and processing it until the split –off point
to yield cream and liquid skim, $400,000.
 Required: How much of the $400,000 joint costs should be allocated to the cost of goods
sold and ending inventory of each product?

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Solution
Cream 25,000 gl., sold 20,000 gl. at $8 each
110,000 gallons $400,000

Loss (shortage) 10,000 gallons Liquid skim 75,000 gl., sold 30,000 gl. at $4
each
Sales value at Split-off Method
Particulars Cream L. Skim Total
Sales value of total production at split-off point $200,000 $300,000 $500,000
(Cream, 25,000 gl. x $8/gl.); (L. skim 75,000 gl. X $4/gl.)
Weighting ($200,000/$500,000) ($300,000/$500,000) 0.40 0,60 --
Joint costs allocated (cream, 0.40 x $400,000) Liquid skim (0.60 x $160,000 $240,000 $400,000
$400,000)
Joint production cost per gallon (cream, $160,000/25,000 gallons) $6.4/gal $3.2/gal --
(Liquid skim, $240,000/75,000 gallons)

Product – line Income statement for May 2016:

Particulars Cream L. Skim Total
Revenues (20,000 gal. X $8 gallons) (75,000 gal. x $4/gallons) (a) $160,000 $120,000 $280,000
Production costs (0.40 x $400,000) (0.60 x $400,000) 160,000 240,000 400,000
Deduct ending inventory (5,000 x $6.40/gl.) (45,000 x $3.20/gl.)
Cost of goods sold (joint costs) ----------------------------------------- (b) 32,000 144,000 176,000
128,000 96,000 224,000
Gross margin (a – b) ----------------------------------------------------------©
Gross-margin percentage (Gross margin/Sales)(c/a) $32,000 $24,000 $56,000
20% 20% 20%

 If the shortage of 10,000 gallon was abnormal then we would allocated total joint cost amount
to cream, liquid skim and abnormal goods.
 The allocations based on sales value at the split-off point are more acceptable from both
financial reporting (inventory values for both products are below their market values) and
decision perspectives (because the products appear equally profitable at the point of
separation this will not at least support incorrect decision with regard to product liquid skim).
2. Physical Measures Method:
 This method uses some measure of weight of volume common to all separable products at the
split-off point such as the number of pounds, gallons, litres, or board feet associated with each
point product at the split-off point. This requires that we have the same physical measurements
for all products, whether that is tons, gallon, or pounds. E.g. litres are not equal to Barrels and
we should bring barrels into litres or versa.
 The problem with this method is that cost is considered to be a function of quantity or some
physical measures. As a result, for example, an ounce of gold, which is much more valuable, and
an ounce of lead would get the same cost allocation. This affects the profit contribution of each
product.
 As a result some products (e.g. Lead) may receive joint cost that exceeds their market value.
This creates a problem for both accounting (LCM requirement) and product managers (confusion

10
 concerning whether to process the products beyond the split-off point and how to price the
products).
 This method is arbitrary and indefensible from both the “cause and effect”. And “benefits
received” logic. Thus, the most appealing characteristic of this method is its simplicity, not its
accuracy.
 The joint cost allocation under this method is as follow:
Solution: UC = TC/TQ = $400,000/100,000 gl. = $ 4 per gallon
Joint cost allocated to:
Cream = 25,000 gl. X $4 = $100,000
Liquid skim = 75,000 gl. X $4 = $300,000
$400,000
So cost of goods sold is:
Cream = 20,000 gl. X $ 4 = $80,000
Liquid skim = 30,000 gl. X $4 = 120,000
$200,000
Cost of ending inventory is:
Cream = 5,000 gl. X $ 4 = $20,000
Liquid skim = 45,000 gl. X $4 = 180,000
$200,000

Product-line income statement for May 2016:

Particulars Cream L. skim Total
Revenues (20,000 gl. X $8/gl.) (30,000 gl. X $4/gl.) $160,000 $120,000 $280,000
Cost of goods sold 80,000 120,000 200,000
Gross margin 80,000 0 80,000

Gross margin percentage 50% 0% 28.6%

 Note that the inventory level difference between the physical-measure method and the sales
value at split of method of $24,000 ($80,000 - $56,000) explain the difference in total gross
profit between the two methods which is also $24,000.
b) Methods where there isn’t market for all of the separable products at split-off
If market value for one or more products is not determinable at split-off point some other method has
to be used that approximates the situation at the split-off point. (The allocation must relate to the
situation at split-off because joint costs cease to have meaning beyond the split off point). There are
two methods that can approximate the situation at split-off:
i) Estimated Net Realizable Value Method (NRV)
 In many case, products are processed beyond the split-off point to bring them to a marketable
form or to increase their selling price at the split-off point.
 The NRV method allocates joint costs to joint products in proportion to their net realizable value.
 NRV refers to a product’s estimated sales value at the split-off point. Accountants presume the
first sales point after split-off gives the best approximation of sales value at split-off even though
several possible points re available.
NRV = Final Sale Value of Total Production – Separable Costs
(To get an estimated NRV for all products combined that is approximately equal to joint
costs, you would also need to deduct selling the administrative expenses and gross profit. This is
not usually done in practice just to keep things simple)
 If the joint product is sold at split-off without further processing, the NRV is simply the sales
value at split-off.

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 Example 2: Assume the same data as in example 1 except the here both cream and liquid skim
can be processed further:
 Cream ---> Butter cream: 25,000 gallons of cream are further processed to yield 20,000
gallons of butter cream at additional processing costs of $280,000. Butter cream sells for
$25 per gallon.
 Liquid skim ---> condensed milk: 75,000 gallons of liquid skim are further processed to
yield 50,000 gallons of condensed milk at additional processing cost of $520,000.
Condensed milk sell for $22 per gallon.
Sales during the accounting period were 12,000 gallons of butter cream and 45,000 gallons of
condensed milk. Inventory information follows:
Beg. Inventory End inventory
Raw milk 0 gallons 0 gallons
Cream 0 gallons 0 gallons
Liquid skim 0 gallons 0 gallons
Butter cream 0 gallons 8,000 gallons
Condensed milk 0 gallons 5,000 gallons
Required: Compute the joint cost allocated to the products and prepare product line income
statement.
25,000 gl. Cream $280,000Butter cream 20,000 gl., sold 12,000 gl. at
$25/gl.
110,000 gl. $400,000 NRVB
NRVC $520,000 Cond. Milk 50,000gl. sold
45,000 gl. at $22/gl.
10,000 gl. Normal shrinkage 75,000 gl. Liq.sk.25,000 gl.normal shrinkage

Solution: NRV Method

NRV = Final Sales Value – Separable Costs
NRVB = (20,000 x $25) - $280,000 = $220,000
NRVC = (50,000 x $22) - $520,000 = 580,000
Total $800,000
Compute relative percentage
Butter cream Condensed milk
NRV $220,000/$800,000 = 27.5% $580,000/$800,000 = 72.5%
Joint cost allocated:
0.275 x $400,000 $110,000
0.725 x $400,000 $290,000
Add: Separable costs 280,000 520,000
Total costs $390,000 $810,000
Divided by: Total unites /20,000 /50,000
Unit cost $19.50 $16.20

Joint cost per unit is: $110,000/20,000gl. = $5.50/gl. For butter cream
$290,000/50,000gl. = $5.8/gl. For condensed milk
 If we had marketing costs as separable costs we would not add it to the joint costs to get the
inventoriable unit costs. Only manufacturing costs are inventoriable.
Product line income statement:
Particulars B. cream C. milk Total
Sales (12,000 gl. X $25) (45,000 gl. X $22) $300,000 $990,000 $1,290,000
Cost of sales: ($19.5 x 12,000 gl.) ($16.2 x 234,000 729,000 936,000
45,000 gl) $66,000 $261,000 $327,000

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 Gross profit 22% 26.36% 25.34%
GP percentage

 The NRV method is used only when it is impossible to use the sales value at split-off
method.
 The NRV method is less defensible because it assumes that the entire mark-up or profit
margin is attributable to the joint process and none of the mark-up is attributable to the
separable costs. But much of the profit may be created by activities performed after split-off
point.
 Although the NRV method is acceptable from the financial reporting perspective, it confuses
the issue of whether to sell the products at the split-off point or process them further. If all
the value is created by the joint processing activities, there would be no reason to further
process the joint products. Remember this confusion was non-existent it sales value at split-
off point method.
 The NRV method is often implemented using simplifying assumptions. For example,
companies that frequently change the number of processing steps beyond the split-off point
often assume a specific set of such steps. Also, if the selling prices of joint products vary
frequently, a given set of selling prices may be consistently used throughout the accounting
periods.
ii) Constant Gross Profit % Method
 This method works backward. It assumes every separable product earns the same GP% (this may
not be very realistic).
 It starts with the final sales value of production and subtracts the Gross Profit (which is equal to
sales x constant GP %), and then subtracts the Separable costs. The result is an approximation of
the Joint Costs for each separable product at split-off.
 Refer to the example 2 and give the answer using constant gross profit % NRV method.
Solution: This method entails three steps:
Step 1: Compute the overall GP% for all joint products together
Total sales value of total production (not actual sales):
(20,000 gl. X $25/gl.) + (50,000 gl. X $22/gl) $1,600,000
Total cost ($400,000 + $280,000 + $520,000) 1,200,000
Total gross profit $400,000
Gross profit % = $400,000/1,600,000 = 25%
Step 2: Compute total cost of each product
B. Cream C. Milk
Total sales value $500,000 $1,100,000
Less: Gross Profit (25% of sales value) 125,000 275,000
Total cost $375,000 $825,000
Step 3: Determine joint cost allocation
Total costs $375,000 $825,000
Less: Separable costs 280,000 520,000
Joint cost allocated $95,000 $305,000

NB. Unit cost = $375,000 $825,000

20,000. $50,000
$18.75 $16.5

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 Product line income statement:
Particulars B. cream C. m Total
Sales (12,000 gl. X $25) (45,000 gl. X $22) $300,000 $990,000 $1,290,000
CGS: ($18.75 x 12,000 gl.) ($16.5 x 45,000 gl.) 225,000 724,500 967,500
Gross profit $75,000 $724,500 $322,500

GP percentage 25% 25% 25%

Note:
 Under this method, the GP% for each product is the same regardless of its separable costs.
This method, in effect, subsidizes products with relatively high separable costs by assigning
fewer joint costs to them. This is a way, in our example, butter cream has 25% gross margin
under this method but has a 22% gross margin percentage under the NRV method. Under this
method some products that are less profitable may end up with a negative allocation of joint
costs in an attempt to bring their GP% up to the overall average. And an amount that
exceeds the total joint costs may be allocated to the more profitable products.
 Advocates of this method argue that any attempt to determine gross profit% for individual
joint products is useless for management decision purposes because the production or
discontinuance of individual joint products are not alternatives. The average or overall profit
margin is the relevant measurement for the decision to produce or discontinue the joint
process. However, critics of this method argue that since all joint products are not equally
profitable, the joint cost allocation method should not imply that they are.
 Note that joint costs do not have a cause and effect relationship with individual products; that
is because the production process simultaneously yields multiple products. Using the
benefits received criterion leads to a preference to market value based methods (sales value at
split-off point, NRV, and constant GP% method). Revenues are, in general, a better
indicator of benefits received than physical measures. Mining companies, for example,
receive more benefits from 1 ton of gold than they do from 10 tons of coal.
Choosing a method
Which method of allocating joint costs should be used? The sales value at split-off method is widely
used (even if further processing is done) for the following reasons:
1. It measures the value of the joint product immediately at the end of the joint process.
The sales value at split-off is the best measure of the benefits received as a result of joint
processing relative to the other methods of allocating joint costs.
2. No anticipation of subsequent management decisions. The sales value at split-off method
does not required information on the processing steps after split-off, if there is further
processing. In contrast, the NRV method and constant gross-margin percentage. NRV
method require information on (a) the specific sequence of further processing decisions (b)
the separable costs of further processing, and (c) the point at which individual products are
sold.
3. Availability of a meaningful basis to allocate joint costs to products. The sales value at
split-off method and the other market-based methods have a meaningful basis to allocate joint
costs to products, which are revenues. In contrast, the physical-measure method may lack a
meaningful basis that can be used to allocate joint costs to individual products.
4. Simplicity. The sales value at split-off method is simple. In contrast, the NRV and constant
gross-margin percentage NRV methods can be complex for processing operations having
multiple products and multiple split-off points. This complexity is increased when
management makes frequent changes in the specific sequence of post-split-off processing
decisions or in the point at which individual product are sold.

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