Cost ch-5

Chapter Five: Cost Allocation: Joint Products and By Products
Chapter Five
Cost Allocation: Joint Products and 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, natural gas, raw LPG
Chemical Industries:
Crude oil ------------- > Gasoline, kerosene, benzene, naphtha
This chapter 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 4 and 5 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 Mild
Split-off point L. 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.(this special decision will
be discussed in the management accounting course)
Cost and Management Accounting I Page 1

 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.
 Note that the basis of the classification is selling price. Thus the classification of a product as main,
joint, by-product may change over time and may vary from one company to the other.
 In accounting for joint products, the basic question is how much of the production cost incurred before
separation (joint costs) should be allocated to each product.
Reasons for allocating Joint Costs to Individual Products
a) To value inventory (WIP and FDG) and NI determination for financial accounting purposes and
report for income tax authorities.
b) To value inventory and COGS for internal reports (including profitability analysis and
performance evaluation). Such reports are used in division profitability analysis and affect
evaluation of division manager’s performance.
c) For cost reimbursement under contracts were not all the separable products go to a single customer
so that allocation of the joint costs is necessary.
d) For settlement of insurance claims involving separable products at or beyond split-off.
e) For rate regulation when one or more jointly produced products or services are subject to rate
regulation based on cost. Recent gas utility rates and energy price policies are based in part on
joint cost allocations.
f) Litigation in which costs of joint products are key inputs.
 It is obviously impossible to allocate joint costs precisely to each joint product. This is because the
“joint costs”, cannot be allocated using the “cause and effect” logic. So there is no accurate way to
determine the amount of joint cost that is caused by any particular joint product. Even so, the joint cost
allocations need to be performed to accomplish some of the purposes discussed above.
 The production report is prepared for joint processes in the same manner as it was discussed in the
preceding chapters using the same information.
 Physical summary – summarize the physical flow of quantity during the period. But the quantity
of each product manufactured is indicated under transferred out to finished goods/next department.
 Equivalent unit – equivalent units of production for joint products are computed in the same way
as for a single product.

 Equivalent unit cost for each cost category and total cost to account for – are computed as though a
single product were being produced.
 Cost assignment – it is at this point that the basic accounting problem arises. The total cost of all
goods produced is determined using the equivalent unit costs. But how much of total cost of goods
produced applies to each type of joint product? Allocation may be done in several methods as
discussed below.
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 2004 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?
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 $160,000 $240,000 $400,000
(0.60 x $400,000)
Joint production cost per gallon (cream, $160,000/25,000 $6.4/gal $3.2/gal --
gallons) (Liquid skim, $240,000/75,000 gallons)
Product – line Income statement for May 2004:
Particulars Cream L. Skim Total
Revenues (20,000 gal. X $8 gallons) (75,000 gal. x $4/gallons) $160,000 $120,000 $280,000
(a)
Cost of goods sold (joint costs) 160,000 240,000 400,000
Production costs (0.40 x $400,000) (0.60 x $400,000)
Deduct ending inventory (5,000 x $6.40/gl.) (45,000 x$3.20/gl.) 32,000 144,000 176,000
Cost of goods sold (joint costs) ---------------------------------- (b) 128,000 96,000 224,000
Gross margin (a – b) -------------------------------------------------- $32,000 $24,000 $56,000
Gross-margin percentage (Gross margin/Sales) 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 vice 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 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 2004:
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 sales 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 & 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.
Example 2: Assume the same data as in example 1 except 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 $280,000 Butter cream 20,000 gl., sold
12,000 gl. at $25/gl.
1,10,000 gl. $400,000 NRVB
NRVC $520,000 Cond. Milk 50,000 gl., 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. cream 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 45,000 gl) 234,000 729,000 936,000
Gross profit $66,000 $261,000 $327,000
GP percentage 22% 26.36% 25.34%
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 nonexistent 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 % NRV 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
Product line income statement:
Particulars B. cream C. cream Total
Sales (12,000 gl. X $25) (45,000 gl. X $22) $300,000 $990,000 $1,290,000
Cost of sales: ($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 why, 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.
 Unlike the other market-based methods, this method is both a joint-cost method and profit allocation
method. The total difference between the sales value of production of all products and the separable
cost of all products includes both (a) the joint costs and (b) the total gross margin.
 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.
Accounting for By-products
 A by product is a product that, like a joint product, is not individually identifiable until manufacturing
reaches a split-off point but with relatively insignificant sales values in comparison with the other
products emerging at split-off point. By-products can be sold at split-off or processed further.
 Classifying outputs of a joint process as joint products/main products/by-products/scrap is necessary
because joint cost is only assigned to joint products/main product. This is because these products are

the reason that management undertook the production process. However, before allocation, joint cost
may be reduced by the value of the by-products and scrap less their separable costs.
 Therefore, the presence of by-products in a joint production process can affect the allocation of joint
costs.
 Two accounting methods for by-products: the production method and the sales method
The Production Method
 This method recognizes by-products at the time their production is completed.
 Steps:
1. Calculate the NRV of the by-product (i.e. final sales value – separable costs, or sometimes if
specified, final sales value – separable costs – normal GP)
2. Subtract this NRV of the by-product from the total joint cost and set the amount up as by-product
inventory
By-product inventory --------------- xx
WIP (joint costs) --------------------- xx
3. Allocate the revised joint cost in the usual way to the joint products using one of the four methods
4. Record any sales of the by-product as follows:
Cash (A/R) -------------------------- xx
By-product inventory ----------- xx
Note: Because the NRV of the by-product is treated as a reduction in the total joint cost allocation and
because the by-product is given no status as a separate product, there is no sales account and no COGS
account for the by-product itself-only balance sheet accounts.
Sales Method
1. The sales method delays recognition of by-products until the time of their sale. Only a memo entry
is required to record the physical account of by-products manufactured. No inventory value is
assigned to by-products when they are produced. Instead, any amount that can be attributable to by-
products remains with the main products.
2. When by-products are sold the revenues are reported as revenue item in the income statement
grouped with other sales, included as other income, or deducted from costs of goods sold not from
joint cost of joint products.
Cash A/R ------------------------------ xx
Other Income/COGS ----------------xx
3. Therefore, no part of the joint production costs is attributable to by-products.
Example: 3 The meat works group processes meat from slaughterhouses. One of its departments cuts
lamb shoulders and generates two products;
 Shoulder meat (the main product) – sold for $60 per pack
 Hock meat (the by-product) – sold for $4 per pack (net of any selling costs)
Data under each column indicate the number of packs for this department in July 2004 are:
Production Sales Beg. Inv. Ending Inv.
Shoulder meat 5,000 4,000 0 1.000
Hock meat 1,000 300 0 700
The joint manufacturing costs of these products in July 2004 were $250,000, comprising $150,000 for direct
materials and $100,000 for conversion costs. Both products are sold at the split-off point without further
processing. Therefore, we have no separable costs in this example.
Required: Under each method:

1. What is the value of ending inventory of joint (main) products, by-products and COGS?
2. Prepare the income statement and show balance sheet presentation of inventory.
3. Pass the necessary journal entries.
Solution
Shoulder meat 5,000 packs --- > sold 4,000 at $60/pack
Lamb shoulder $250,000
Hock meat 1,000 packs, --- > sold 300 at $4/pack
The Production Method:
1. By-product inventory produced at NRV = 1,000 packs x $4 = $4,000
By-product ending inventory = 700 packs x $4 = $2,800
Total cost of main (joint) product inventory is as follows:
$250,000 total production cost - $4,000 NRV of the by-product = $246,000
Cost per unit for the main product (shoulder meat) = $246,000/5,000 packs = $49.20
Cost of main product ending inventory = &49.20 x 1,000 packs = $49,200
Cost of goods sold for main product is computed as follows:
Main product beg. Inventory --------------------------------- $0
Joint production costs ----------------------------------------- 250,000
Less: By-product revenue ------------------------------------------- 4,000
Less: Main product ending inventory ---------------------------- 49,200
Cost of goods sold ---------------------------------------------$196,800
2. Income Statement
Revenue (4,000 packs x $60) ----------------------------------- $240,000
COGS ----------------------------------------------------------------- 196,800
Gross Margin ------------------------------------------------------- 43,200
Gross margin % ($43,200/$240,000) 18%
Balance Sheet
Inventories:
Main product: Shoulder meat -------------------------- $49,200
By-product: Hock meat (700 packs x $4/pack) ----- 2,800
3. Journal Entries:
i) WIP -------------------------------------------- 150,000
Accounts Payable ---------------------------------- 150,000
(To record direct materials purchased & used in production during July)
ii) WIP -------------------------------------------- 100,000
Various accounts --------------------------------- 100,000
(To record conversion costs in the production process during July)
iii) By-product Inventory – Hock Meat( (1,000 packs x 4) ------- 4,000
Finished goods – shoulder meat ($250,000 - $4,000) ------- 246,000
Work in process ($150,000 + $100,000) ------------------------------ 250,000
(To record cost of goods completed during July)
iv) a. COGS (4,000 packs / 5,000 packs) x $246,000 ------------ 196,800
Finished goods – shoulder meat ------------------------------------ 196.800
(To record the cost of the main product sold during July)
b. Cash or A/R (4,000 packs x $60/pack ----------------------- 240,000

Revenues – shoulder meat ------------------------------------------- 240,000

(To record the sales of the main products during July)
v) Cash or A/R (300 packs x $60/pack) -------------------------- 1,200
By-product inventory – hock meat ---------------------------- 1,200
(To record the sales of the by-product during July)
One variation of this method would be to report by-product inventory at its NRV reduced by a normal profit
margin. When the by-product inventory is sold in a subsequent period, the income statement would match
the selling price with the “net” selling price reported for the by-product inventory.
The Sales Method
1. By-product inventory value is zero. No value is assigned to the 1,000 packs of by-products at the
time of production. But the $1,200 (300 packs x $4) resulting from the sale of by-products is
reported as revenues.
Total cost of main (joint) product inventory is unaffected = $250,000
Cost per unit for the main product (shoulder meat) = $250,000/5,000 packs = $50
Cost of main product ending inventory = $50 x 1,000 packs = $50,000
Cost of goods sold for the main products is computed as follows:
Main product beg. Inventory ----------------------------------- $0
Joint production costs -------------------------------------------- 250,000
Less: main product ending inventory ------------------------------- 50,000
Cost of goods sold ------------------------------------------------$200,000
2. Income Statement
Revenues:
Main product sold (4,000 packs x $60) -------------------------------- $240,000
By-product sold (300 packs x $4) --------------------------------------- 1,200
Total revenues ------------------------------------------- $241,200
Less: COGS ------------------------------------------------------------------------ 200,000
Gross margin --------------------------------------------------------------- $41,200
Gross margin percentage (41,200/241,200) ----------------------- 18%
Balance Sheet
Inventories:
Main product: shoulder meat -----------------------------------$50,000
By-product hock meat -------------------------------------------- 0
3. Journal Entries:
This method makes no journal entries until sale of the by-product occurs. Revenues of the by-
product are reported as revenue item in the income statement at the time of sale. These revenues are
grouped with other sales, included as other income, or deducted from costs of goods sold.
i. Same as for production method
ii. Same as for production method
iii. No entry is made to record by-product inventory
Finished goods: shoulder meat --------------250,000
WIP ----------------------------------------------------- 250,000
iv. a. COGS (4,000 packs/5,000 packs) x $250,000 ---------200,000
Finished goods – shoulder meat ------------------------------ 200,000

b. same as for production method
v. Cash or A/R ---------------------------------1,200
Revenues-shoulder meat ------------------1,200
(To record the sales of the by-Product during July)
SERVICE DEPARTMENT COSTS ALLOCATION
 The first step in cost allocation is to determine just what the cost objects are. A department is one
common cost object. There are two categories of departments: Producing (operating) departments and
support (service) departments.
 Producing departments are directly responsible for creating the products or services sold to customers.
In a large public accounting firm, examples of producing departments are Auditing, Tax, and
Management Advisory Services (Computer System Services).
 In a manufacturing setting, producing departments are those that work directly on the products being
manufactured such as Assembly & Finishing.
 Support departments provide essential services for producing departments. These departments are
indirectly connected with an organization’s services or products. Examples of support departments
included purchasing, personnel, maintenance and cafeteria.
 Once the producing and support departments have been identified, the overhead costs incurred by each
department can be determined.
 Note that this involves tracing costs to the departments, not allocating costs, because the costs are
directly associated directly with the individual department.
 A factory cafeteria, for example, would have food costs, wages of cooks and servers, depreciation on
dishwashers and stoves, and supplies (e.g. napkins and plastic forks).
 Overhead directly associated with a producing department such as assembly in a furniture-making plant
would include utilities (if measured in that department), supervisory salaries, and depreciation on
equipment used in that department.
 Overhead that cannot be easily assigned to a producing or support department is assigned to a catchall
department such as General Factory. General Factory might include depreciation on the factory
building, the plant manger’s salary, telephone service costs and the costs of restriping the parking lot.
 Once the company has been departmentalized and all overhead costs have been traced to the individual
departments, support departments costs are assigned to producing departments, and overhead rates are
developed to cost products. Although support departments do not work directly on the products and
services that are sold, the costs of providing these support services are part of the total product cost and
must be assigned to the products. This assignment of costs consists of a two-stage allocation:
1. Allocation of support department costs to producing departments and
2. Assignment of these allocated costs to individual products.
 The second-stage allocation achieved through the use of departmental overhead rates is necessary
because there are multiple products being worked on in each producing department.
 If there were only one product with in a producing department, all the support costs allocated to that
department would belong to that product.
 A predetermined overhead rate is computed by taking total estimated overhead for a department and
dividing it by an estimate of an appropriate base.

 Now we see that a producing department’s overhead consists of two parts: overhead directly associated
with a producing department and overhead allocated to the producing department from the support
departments.
 A support department cannot have an overhead rate that assigns overhead costs to units produced,
because it doesn’t make a saleable product. That is, products do not pass through support departments.
 The nature of support departments is to service producing departments, not the products that pass
through support departments.
 For example, maintenance personnel repair and maintain the equipment in the assembly department, not
the furniture that is assembled in that department.
Allocation Bases
 Producing departments cause support activities; therefore, the costs of support departments are also
caused by the activities of the producing departments.
 Causal factors are variables or activities within the producing departments that provoke the incurrence
of support costs.
 In choosing a basis for allocating support department costs, effort should be made to identify appropriate
causal factors (activity drivers). Using causal factors results in product costs being more accurate.
 Furthermore, if the causal factors are known, managers are more able to control the consumption of
service.
Below is a list of possible allocation bases for support departments.
Accounting Number of transactions
Cafeteria Number of employees
Data processing Number of lines entered, Number of house of
services
Engineering Number of change orders, Number of machine
hours
Maintenance Machine hours, maintenance hours
Materials store room number of material moves, Pounds of material
moved,
Number of different parts
Payroll Number of employees
Personnel Number of employees, Number fog firings or
layoffs,
Number of new hires, Direct labor cost
Purchasing Number of orders
Shipping Number of orders
Cost allocation for a single support department
 Frequently the costs of a support department are allocated to another department through the use of a
charging rate. In this case, we focus on the allocation of one department’s costs to other
departments. For example a company’s data processing department may serve various other
departments.
 The costs of operating the data processing department are then allocated to the user departments.
While this seems simple and straightforward, a number of considerations go into determining an
appropriate charging rate. The two major factors are:
1. The choice of a single or dual charging rate ad

2. The use of budgeted versus actual support department costs.

A Single charging rate
Some companies prefer to use a single charging rate. That is both variable and fixed costs of the supporting
department are allocated using a single rate.
Example
Hana and Associates, a large public accounting firm, develops an in-house photocopying department to
serve its three producing departments (Audit, Tax, and Management Advisory Systems, or MAS). The
budgeted costs of Photocopying department include fixed costs of Br. 26,190 per year (salaries and machine
rental) and variable costs of Br. 0.023 per page copied (paper and toner). Estimated and actual pages are
given below.
Estimated usage Actual usage
Audit department 94,500 92,000
Tax department 67,500 65,000
MAS department 108,000 115,000
Total Br.270,000 Br. 272,000
Variable costs (o.023 x 270,000) Br. 6,210
Fixed costs 26,190
Total cost estimated for the photocopying department Br. 32,400
Budgeted cost per page = 32,400/270,00 = Br. 0.12
Photocopying department costs allocated
Audit department 0.12 x 92,000 = 11,040
Tax department 0.12 x 65,000 = 7,800
MAS department 0.12 x 15,000 = 13,800
272,000 Br.32,640
Note that the use of a single rate treats the fixed costs as if it were variable. The photocopying department
didn’t actually need Br. 32,640 to copy 272,000 pages. It needed only Br. 32,446 (Br. 26,190 + 272,000 x
0.023). The extra amount charged is due to the treatment of a fixed cost in a variable manner.
Dual charging rates
 While the use of single rate is simple, it ignores the differential impact of changes in usage on costs.
The variable costs of a support department increase as the level of service increases.
 For example, the costs of paper and toner for the photocopying department increase as the number o
pages copied increases. Fixed costs, on the other hand, do not vary with the level of service.
 For example, the rental payment for photocopying machines doesn’t change as the number of pages
increases or decreases. We can avoid the treatment of fixed costs as variable by developing two rtes:
one for fixed costs and one for variable costs.
Variable rate
 The variable rate depends on the costs that change as the activity driver changes. In photocopying
department, for example, the activity driver is the number of pages copied.
 As the number of pages increases; more paper and toner are required. Since these materials average
Br. 0.023 per page, the variable rate is br. 0.023.
Fixed costs allocation ratio
 Fixed service costs can be considered capacity costs; they are incurred to provide the capacity
necessary to deliver the service units required by the producing departments.
 When the support department was established, its delivery capability was designed to serve the long
term needs of the producing departments.
 Since the original support needs caused the creation of the support service capacity, it seems
reasonable to allocate fixed costs based on those needs.
 Either the normal or peak activity of the producing departments provides a reasonable measure of
original support needs. Normal capacity is the average capacity achieved over more than one fiscal
period.
 If service is required uniformly over the time period, normal capacity is a good measure of the activity.
Peak capacity. Peak capacity allows for variation in the need for the support department, and the size
of the department is structured to allow for maximum need.
 The choice of normal or peak capacity in allocating budgeted fixed service costs depends on the needs
of the needs of the individual firm.
The allocation of the costs photocopying department in Hana and Associates using dual rates follows.
Variable rate = Br. 0.023 per page
Assume the photocopying departments fixed costs are allocated using normal photocopying needs of
producing departments and the budgeted usage given represents normal support needs.
Original support needs
Audit department 94,500 (35%)
Tax department 67,500 (25%)
MAS department 108,000 (40%)
Total 270,000
Variable costs (A) fixed costs (B) Total costs (C= A+B)
Audit 0.023 x 92,000 = 2,116 0.35 x 26,190 = 9,167 11,283
Tax 0.023 x 65,000 = 1,495 0.25 x 26,190 = 6,548 8,043
MAS 0.023 x 115,000 =2,645 0.40 x 26,190 = 10,476 13,121
26,191 32,447
Budgeted versus Actual Costs
 Managers of both producing and support departments are held accountable for the costs of their
departments. The costs of support departments allocated to other departments must be budged rather
than actual costs.
 Otherwise the efficiencies or inefficiencies of the support departments will be transferred to other
departments. And we shouldn’t use in the performance evaluation of a manager costs over which he or
she has no control.
 The level of usage used in allocating service department costs may be actual or budgeted depending on
the purpose of the allocation. For product cost determination a budgeted overhead rate must be known
for each producing department at the beginning of every year,
 Computing the overhead rate requires the total overhead costs of the producing departments. A
producing department’s overhead consists of two parts: overhead directly associated with a producing
department and overhead allocated to the producing department from the support departments.
 Therefore support department costs should first be allocated at the beginning of the year on the basis of
the budgeted usage.
 During the year each department would also be responsible for support department costs allocated to it.
This is done using costs allocated using actual usage.

Support Department cost allocation methods

 In the preceding discussions allocation of a single service department was illustrated. In many cases,
however, multiple service departments exist.
 Under such circumstances allocation of support department costs are made using one of three methods:
direct method, sequential (step) method or reciprocal method.
 Usually service departments provide service not only to producing departments but also to other rupport
departments.
 For instance maintenance department (support department) provides maintenance service to producing
and support departments such as purchasing.
 All the three methods allocate service department costs to producing departments but they differ on
whether they recognize the service one support department gets from other support departments and
whether the method recognizes the interaction between the departments fully or partially.
 The three methods are described as follows.
1. Direct method
 The direct method allocates service department costs only to producing departments. It is the
simplest and most straightforward way to allocate support department costs.
 However no support department cost is allocated to other support departments. That is it
doesn’t recognize the interaction among support departments.
2. Sequential (step) method
 This method recognizes partially the services one support departments provides to another. First
the support departments are ranked according to the amount of service they provide from the
highest to the least. The amount of service is usually measured by the direct costs of the support
departments.
 The costs of the support department rendering the greatest support service are allocated first.
They are distributed to all support departments below it in the sequence and to all producing
departments.
 Then, the costs of the support department next in sequence are similarly allocated, and so on. In
the sequential method, once a support department’s costs are allocated, it never receives s
subsequent allocation from another support department above it in the sequence.
 Also note that the costs allocated from a support department are its direct costs plus any costs it
receives in allocations from other support departments.
3. Reciprocal method
 The reciprocal method recognizes all interactions of support departments. Under the reciprocal
method, the usage of one support department by another is used to determine the total cost of
each support department, where the total cost reflects interactions among the support
departments.
 Thus, the new total of support department costs is allocated to the producing departments. This
method fully accounts for support department interaction.
Example: Malor Company has two support departments, Power and Maintenance, and two producing
departments, Grinding and Assembly. The allocation bases of Power department costs and Maintenance
department costs are number of employees and maintenance hours respectively. The budgeted direct costs
and budgeted activity levels are given below. For producing departments, direct costs refer only to
overhead costs that are directly traceable to the department. For simplicity a single charging rate is used.
Support d departments Producing departments
Particulars Power Maintenance Grinding Assembly

Direct costs Br. 250,000 Br. 160,000 Br. 100,000 Br. 60,000
Activity levels –
Kilowatt-hours - 200,000 600,000 200,000
Maintenance hours 1,000 - 4,500 4,5000
Direct Method
Support departments Producing departments
Power department cost allocation in
Kilowatt-hours basis
(600,000/800,000) (200,000/800,000)
Weights: (0.75 : 0.25) (250,000) 187,500 62,500
Power department costs allocated
Maintenance department cost allocation in
maintenance hours basis
(4,500/9,000)*2 Weights: (0.5:0.5) (160,000) 80,000 80,000
Maintenance department cost allocated 0 0 267,500 202,500
Even if power department and maintenance department provide service to producing departments and to
each other as well, their costs are allocated only to the producing departments (Grinding & assembly).
Sequential method
(200,000/1,000,000)(600,000/1,000,000)
(200,000/1,000,000)
Weights: (0.2: 0.6 : 0.2) (250,000) 50,000 150,000 50,000
(4,500/9,000)(4,500/9,000) Wei(0.5:0.5)
Maintenance department cost allocated (210,000) 105,000 105,000
Total costs 0 0 355,000 215,000
The fact that power department serves all the other three departments is recognized by the sequential
method because power department costs are allocated to all of the three departments. Nevertheless power
department doesn’t share maintenance department costs, i.e. this method failed to account for the service
power department gets from maintenance department. Hence the interaction between power and
maintenance departments is recognized partially.
Reciprocal Method
Let P be the total costs of power department (the costs incurred in power department plus cost of
maintenance department allocated to power department) and Let M be the total costs of maintenance

department (the costs incurred in maintenance department plus cost of power department allocated to
maintenance department).
Support departments Producing dep’ts
Particulars Power Maintenance Grinding Assembly Total
Kilowatt-hours - 200,000 600,000 200,000 1,000,000
Weights 0.2 0.6 0.2 1
Maintenance hours 1,000 - 4,500 4,500 10.000
Weights 0.1 0.45 0.45 1
P = 250,000 + 0.1M
M = 160,000 + 0.2P
M = 160,000 + 0.2(250,000 + 0.1M)
M = 160,000 + 50,000 + 0.02M)
M = 214,286
P = 250,000 + 0.1(214,286) = 271,429
(200,000/1,000,000)(600,000/1,000,000)
(200,000/1,000,000)
Weights: (0.2: 0.6 : 0.2) (271,429) 54,286 162,857 54,286
(1,000/10,000)(4,500/10,000)(4,500/10,000)
Weights: (0.1: 0.45:0.45)
Maintenance department cost allocated 21,429 (214,286) 96,429 96,429
Total costs 0 0 359,286 210,714
 The reciprocal method fully recognizes the services support departments provide to each other. But
as the number of support departments increases the computations will become more complex.
 It is important to keep a cost-benefit perspective in choosing an allocation method. We must weigh
the advantages of better allocation against the increased cost using a more theoretically preferred
method.
 For example the reciprocal method may be superior to the other methods. But the increased cost
resulting from using it may outweigh the additional benefit it produces.
Departmental Overhead rates and Product Costing
 When the costs of goods and services produced in producing departments are determined, direct
costs are traced to the products and overhead costs are allocated using overhead rtes.
 A single overhead rate may be used for all the producing departments or separate rates may be
developed for each of them.
 The overhead rate is computed by adding the allocated service cots to the overhead costs that are
directly traceable to the producing department and dividing this total by the overhead allocation base
selected for the department.

Example
Assume that Malor Company uses the sequential method of service department costs allocation. Therefore
total budgeted overhead costs of Grinding and Assembly departments are Br. 355,000 and Br 215,000
respectively. The allocation bases and expected levels of the allocation bases are given below.
Grinding department Assembly department
Overhead allocation bases machine hours direct labor hours
Budgeted machine hours 71,000 --
Budgeted direct labor hours -- 107,500
Data pertaining to one unit of a product follow.
Direct materials costs Br.7 Br.8
Direct labor costs 2 4
Machine hours 2 -
Direct labor hours - 1
Compute the unit cost.
Overhead rate = Br. 355,000 Br. 215,000
71,000 M/H 107,500 DLH
Br.5 per MH Br. 2 per DLH
Direct material costs (7 + 8) 15
Direct labor cost (2 + 4) 6
Overhead costs
Grinding ( 2 machine hour x Br. 5) 10
Assembly (1 direct labor hour x Br. 2) 2 12
Unit cost 33

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Chapter Five: Cost Allocation: Joint Products and By Products

Cost and Management Accounting I Page 1

Cost and Management Accounting I Page 2

(Cream, 25,000 gl. x $8/gl.); (L. skim 75,000 gl. X $4/gl.)

Cost and Management Accounting I Page 4

Cream = 20,000 gl. X $ 4 = $80,000

Cream 0 gallons 0 gallons

Cost and Management Accounting I Page 6

Cost and Management Accounting I Page 7

Cost and Management Accounting I Page 8

Cost and Management Accounting I Page 9

Cost and Management Accounting I Page 10

Revenues – shoulder meat ------------------------------------------- 240,000

Cost and Management Accounting I Page 11

Cost and Management Accounting I Page 12

Cost and Management Accounting I Page 13

2. The use of budgeted versus actual support department costs.

Cost and Management Accounting I Page 15

Support Department cost allocation methods

Particulars Power Maintenance Grinding Assembly

Cost and Management Accounting I Page 17

Cost and Management Accounting I Page 18

Cost and Management Accounting I Page 19

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