Chapter Four

Cost allocation
 Purpose of Cost Allocation
Costs that are related to a particular cost object
but cannot be traced to it in an economically
feasible way are called manufacturing overhead
cost or indirect cost.
The term cost allocation describes assigning
indirect cost to the chosen cost object.
Cost allocation can also be assigning cost from
one or more service giving departments to
operating departments.
The followings are some of the purposes of cost allocation.
To provide information for economic decision
To measure income and asset for reporting
To provide more complete cost data for making
decisions in operating departments
To help measure profitability in the operating
departments
 To put pressure on the service departments to operate
efficiently
 To develop overhead rates in the operating
departments.
There is no one best way of allocating cost to cost objects.
However, the followings are the Criteria for guiding cost
allocation decisions usually used by cost accountants.
1.Cause and Effect Criteria: Using this criterion, a
manager identifies the variables that cause a resource to
be consumed.

Cost allocation based on cause and effect criteria are

likely to be the most credible to operating personnel .
Benefit Received Criteria: using these criteria managers identifies the
beneficiary of the output of the cost object.
The cost of the cost object is allocated among the beneficiaries in
proportion to the benefit each received.
Consider corporate wide advertising program that promote the general
image of the corporation rather than any individual product.
The cost of this program may be allocated on the basis of individual
revenue; the higher the revenue, the higher the divisions allocated cost of
the advertising program.
The rationale behind this allocation is that division with higher revenue
has apparently benefited from the advertising more than division with
lower revenue and, therefore ought to be allocated more of the
advertising cost.
Fairness or Equity: This criterion is often cited in government
contracts when cost allocations are the basis of establishing a
price satisfactory to the government and its suppliers.
Cost allocation here is viewed as a reasonable or fair means of
establishing a selling price in the mind of the contracting
parties.
Ability to Bear: this criteria advocates allocating costs in
proportion to the cost objects ability to bear cost allocated to
income.
An example is the allocation of corporate executive salaries on
the basis of division operating income.
 The presumption is that the more profitable division have a
greater ability to absorb corporate headquarters cost.
4.2 Allocating Costs of a single Support Department

Companies distinguish operating departments

from support giving departments.
 An operating department, which is also called a
production department in manufacturing
companies, directly adds value to a product or
service.
These are departments which participate in
production of goods and service.
A support giving department, which is also called
a service department, provides services that assist
other internal departments
Managers face two questions when allocating the
costs of a support department to operating divisions:
(1) Should fixed costs of support departments be
allocated to operating divisions?
(2) If fixed costs are allocated, should variable and
fixed cost be allocated in the same way?
Managers use two basic methods to allocate
support – department costs:
The Single – rate cost – allocation method
The Dual – rate cost – allocation method.
Single – Rate

• Allocates costs in each service department to

cost objects using the same rate per unit of a
single allocation base.
• No distinction is made between fixed and
variable costs
Dual – Rate Methods
classifies costs in each service department into two
pools :
 variable – cost pool
 Fixed- cost pool
With each pool using a different cost – allocation
base.
.
A big benefit of the dual – rate method is that it
signals to division managers how variable
costs and fixed costs behave differently
When the dual rate method is used, allocation
bases must be chosen for both the variable
and fixed cost pools.
Using the single – rate method and the dual-rate method,
managers can allocate support – department costs to operating
divisions based on :

(a)budgeted rate and hours budgeted to be used by operating

divisions,
(b) budgeted rate and actual hours used by operating divisions
(c) actual rate and actual hours used by operating divisions.

Here budgeted rate and actual hours used by operating

divisions is used to allocate cost of service departments to
operating departments.
Illustration
Consider ABC Electronics Company that manufactures computers and its accessories. The company has
one central computer department which gives service to other operating departments. This department has only
two users: the Microcomputer Division and the Peripheral Equipment Division. The following data relate to the
2007 budget:
Fixed costs of operating the computer facility in Br.3,000,000
Maximum capacity 18,750 hours
Budgeted long –run usage (quantity) in hours:
Microcomputer Division 8,000 hours
Peripheral Equipment division 4,000 hours
Total 12,000 hours
Budgeted variable cost per hour
in the 6,000 – 18,750 – hour relevant range Br. 200 per hour used

Actual usage in 2007 in hours:

Microcomputer Division 9,000 hours
Peripheral Equipment Division 3,000 hours
Total 12,000 hours
• Single – rate Method: ABC Electronics can
allocate central computer department’s cost
based on the budget rate and actual hours
used by the operating divisions.
Budgeted usage 12,000 hours
Budgeted total cost pool: Br. 3,000,000 +
(12,000 hours  Br. 200/hour) Br.5, 400,000
Budgeted total rate per hour: Br. 5,400,000 
12,000 hours Br. 450 per hour used
Note that, the budgeted rate of Br. 450 per hour
differs significantly from the Br. 200 budgeted
variable cost per hour.
That’s because the Br.450 rate includes an allocated
amount of Br. 250 per hour (budgeted fixed costs,
Br. 3,000,000,  budgeted usage, 12,000 hours) for
the fixed costs of operating the facility.
•The central computer department costs are
allocated to the two divisions on the basis of actual
hours used as follows.
Microcomputer Division: 9,000 hours  Br. 450
Br. 4,050,000
Peripheral Equipment Division: 3,000 hours  Br.450
per hour Br. 1,350,000
Dual – rate Method: When the dual – rate
method is used, allocation bases must be
chosen for both the variable and fixed cost pools
of the central computer department.
ABC allocates variable costs to each division
based on budgeted variable cost per hour of Br.
200 for actual hours used by each division. ABC
allocates fixed costs based on budgeted fixed
costs per hour and budgeted number of hours
for each division.
• The Central Computer department budgets
usage of 12,000 hours: 8,000 hours for the
microcomputer Division and 4,000 hours for
the peripheral Equipment Division. The
budgeted fixed – cost rate is Br. 250 per hour
(Br. 3,000,000,  budgeted usage, 12,000
hours).
• The costs allocated to the Microcomputer
Division in 2007 would be:
Fixed costs: Br. 250 per hour  8,000 (budgeted)
hours Br. 2,000,000
Variable costs: Br. 200 per hour  9,000 (actual)
hours 1,800,000
Total costs Br.3,800,000
The costs allocated to the peripheral Equipment
Division in 2007 would be:
Fixed costs: Br. 250 per hour  4,000 (budgeted)
hours Br.1, 000,000
Variable costs: Br.200 per hour  3,000 (actual)
hours 600,000
Total costs
Br.1,600,000
 Allocating Costs of Multiple
Support Departments
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.
There are three ways of allocating cost in this case:
 direct,
 step – down and
 reciprocal methods
 Direct method

 Also called direct cost allocation method

 Allocate cost to operation department only
Advantage:
 easy to use
 no need to predict the usage of support department
service by other department.
Disadvantage: it ignore reciprocal service provided
among support departments by other support
departments.
Illustration: Consider Mesfin engineering, which
operates at maximum capacity to assemble Vehicles
in its factory. Mesfin Engineering has two support
departments and two operating departments in its
manufacturing facility.
 Support Department Operating Department
Plant Maintenance (PM) Machining (M)
Information Systems (IS) Assembly (A)
Support department Operating department
PM IS M A
Budgeted MOH cost
before allocation Br.600,000 Br.116,000 Br.400,000 Br.200,000
Service provide by:
Plant maintenance - 1600hrs 2400hrs 4000hrs
Information system 200hrs - 1600hrs 200hrs
The direct method does not allocate support department
costs to other support departments. The base used to
allocate plant maintenance costs to the operating
departments is the budgeted total maintenance labor – hours
worked in the operating department: 2,400 + 4,000 = 6,400
hours. This amount excludes the 1,600 hours of budgeted
support time provided by plant maintenance to information
systems. Similarly, the base used for allocation of information
systems costs to the operating departments is 1,600 + 200 =
1,800 budgeted hours of computer time, which excludes the
200 hours of budgeted support time provided by information
systems to plant maintenance.
The following diagram shows the relationship between the departments.

PM 2,400 Hrs M
Br. 600,000
4,000 Hrs
1,600 Hrs
IS A
Br 116,000
200 Hrs
The cost in each service departments will be allocated to the
operating departments as follows:
Allocating cost of Plant maintenance to :
Machining = (2400/6400) ×Br. 600,000 = Br. 225,000
Assembly = (4000/6400) ×Br. 600,000 = Br. 375,000
Allocating cost of Information systems to :
Machining = (1600/1800) ×Br. 116,000 = Br. 103,111
Assembly = (200/1800) × Br. 116,000 = Br. 12,889

Cost before Allocation
Cost allocated from PM
Cost allocated from IS
Total cost
Machining Assembly Total
Br.400,000 Br.200,000 Br.600,000
225,000 375,000 600,000
103,111 12,889 116,000
Br 728,111 Br.587,889 Br.1,316,000
 Step – Down Method
 Also called the step down allocation method
 allocates support – department costs to other support
departments and to operating departments in a sequential
manner that partially recognizes the mutual services provided
among all support departments
 It requires the support departments to be ranked (sequenced) in
the order that the step – down allocation is to proceed
 A popular step – down sequence begins with the support
department that renders the highest percentage of its total
services to other support departments
 Under the step – down method, once a support department’s
costs have been allocated, no subsequent support – department
costs are allocated back to it
 2,400 Hrs
PM M
Br. 600,000
4,000 Hrs
1,600 Hrs 1,600 hrs
IS A
Br 116,000
200 Hrs
The cost in each service departments will be allocated to the operating departments as
follows using step down method:
 Allocating cost of Plant maintenance to :
Machining = (2400/8000) ×Br. 600,000 = Br. 180,000
Assembly = (4000/8000) ×Br. 600,000 = Br. 300,000
Information system = (1600/8000) ×Br. 600,000 = Br. 120,000
 Allocating cost of Information systems( 116,000 + 120,000 = Br.236,000) to :
Machining = (1600/1800) ×Br. 236,000 = Br. 209,778
Assembly = (200/1800) × Br. 236,000 = Br. 26,222
The cost summary for step down cost allocation wil be given as follows:
Machining Assembly Total
Cost before Allocation Br.400,000 Br.200,000 Br.600,000
Cost allocated from PM 180,000 300,000 480,000
Cost allocated from IS 209,778 26,222 236,000
Total cost Br. 789,778 Br.526,222 Br.1,316,000
 3. Reciprocal Method

 The reciprocal method –also called the

reciprocal allocation method – allocates
support – department costs to operating
departments by fully recognizing the mutual
services provided among all support
departments.
 The reciprocal method fully incorporates
interdepartmental relationships into the
support – department cost allocations.
 2,400 Hrs
PM M
Br. 600,000

4,000 Hrs
200 hrs 1,600 Hrs 1,600 hrs
IS A
Br 116,000
200 Hrs
The reciprocal method requires formulation and
solving of linear equations. This requires three
steps.
•Step 1: Express support – Department costs
and support – Department Reciprocal
relationships in the form of linear equations. Let
PM be the complete reciprocated costs of plant
maintenance and IS be the complete
reciprocated costs of information systems.
We then express the relationship between
support giving departments as:
• PM = Br. 600, 000 + 0.1IS (1)
• IS = Br. 116, 000 + 0.2PM (2)
•The 0.1IS is the percentage of the information
systems services used by plant maintenance.
•The 0.2PM is the percentage of plant
maintenance services used by information
systems.
Step 2: Solve the set of linear equations to
obtain the complete reciprocated costs of each
support department. Substituting equation (2)
in to (1):
PM = Br. 600, 000 + [0.1(Br.116, 000 + 0.2PM]
PM = Br. 600, 000 + Br.11, 600 + 0.02PM
0.98PM = Br. 611, 600
PM = Br. 624, 082
Substituting into equation (2):
IS = Br.116, 600+0.2(Br. 624, 082)
IS = Br.116, 000 + Br.124, 816 = Br. 240, 816
Step 3: Allocate the Complete Reciprocated
costs of each support department to all other
departments (Both support departments and
operating departments) on the basis of the
usage percentages (based on total units of
service provided to all departments).
  Allocating cost of Plant maintenance (Br. 624, 082) to :
Machining = (2400/8000) × Br. 624, 082= Br. 187,225
Assembly = (4000/8000) × Br. 624, 082= Br. 312,041
Information system = (1600/8000) × Br. 624, 082= Br.124,816
 Allocating cost of Information systems( 116,000 + 124,816 = Br. 240,816) to :
Machining = (1600/2000) × Br. 240, 816= Br.192,653
Assembly = (200/2000) × Br. 240, 816= Br. 24,082
Plant Maintenance = 200/2000) × Br. 240, 816 = Br. 24,082
The cost summary for reciprocal cost allocation method will be given as follows
Machining Assembly Total
Cost before Allocation Br.400,000 Br.200,000 Br.600,000
Cost allocated from PM Br. 187,225 Br. 312,041 Br.499,269
Cost allocated from IS Br.192,653 Br. 24,082 Br.216,735
Total cost Br. 779,878 Br.536,123 Br.1,316,000
The reciprocal method is conceptually the most
precise method because it considers the mutual
services provided among all support
departments.
The advantage of the direct and step – down
methods is that they are simple to compute and
understand relative to the reciprocal method.
The direct method is widely used, however, as
computing power to do repeated iterations or
to solve sets of simultaneous equations
increases, more companies find the reciprocal
method easier to implement.
ACCOUNTNG FOR JOINT PRODUCTS AND
BYPRODUCTS
Joint Products
•In some manufacturing processes, multiple products
emerge from the same material and the same
production process. For instance, edible oil and animal
feed emerge from the same material and production
process. Joint products are products that
simultaneously emerge from the same material and
manufacturing process. The cost of the material and
production process is called joint production cost or
simply joint cost. The followings are some examples of
industries that simultaneously yield two or more
products from the same production process.
1. Agriculture and food processing Joint Products

 Cocoa beans Coca butter , cocoa powder, cocoa drink , Tanning cream

 Lamb Lamb Cuts, Hides, Bones, Fat

 Raw milk Cream, Liquid Skim

 Lumber Lumber of different grades and shapes

2. Extractive industry

 Coal Coke, Gas, Bezel, Tar, Ammonia

 Copper ore Copper, Silver, Lead, Zinc

 Petroleum Crude oil, Gas raw LPG (liquefied petroleum gas)

 Salt Hydrogen, Chlorine, Caustic soda

3. Chemical industries

 Raw LPG Butane, Ethane, Propane

• The point where the products emerge as separate
and distinct goods is called the split off point.
Additional costs may be incurred to process the
intermediate products further in order to secure a
higher sales value. The additional cost incurred
beyond the split off point is called separable cost.
Separable cost includes all manufacturing, marketing
and distribution costs incurred in an effort to process
intermediate products further at or beyond the split
off point. Decisions to sale or process further are
considered independently.
• A joint production process at times produces two
types of products; some with positive sales value and
some with zero sale value. An item is considered as a
product only if it has a positive sales value. Thus,
items with zero sales value are not considered as a
product. Consequently, no journal entry is required
in the accounting records to recognize the processing
of outputs with zero sales value. For example, the
joint production of gold and silver also produces dirt
that would be recycled back into the ground.
• Output of a joint production process with a positive
sales value can also exhibit wide differences in terms
of sales value. Those outputs that have a higher sales
value are called joint products. When only one
output has a relatively high sales value as compared
to the others, the output with higher sales value is
called the main product. Outputs with a lower sales
value as compared to the joint or main product are
called byproducts. The distinction between a joint or
main product and by product is a matter of degree
and it changes as the value of the output changes.
The classification of goods as byproduct or main joint
product changes overtime.
• A lower sales value today does not imply a
lower sales value forever. The sales value of
an item changes through time. Thus, as the
sales value increase an item is considered as a
byproduct no more remains as a byproduct. It
becomes a joint product. Also an item with a
higher sales value may show consistent
decrease in price which in turn means that it
will become a byproduct.
 Approaches to Joint Cost Allocation

• As mentioned earlier, a joint production process

results in multiple products. Normally, the different
outputs produced are not sold uniformly altogether
and may not have the same sales value. Thus, it is
essential to allocate the join cost among the
products. Here, one thing you need to be sure is that
it is impossible to know the cost of each output, as
the products themselves are not even separate till
the split off point. The following are some of the
reasons for the allocation of joint costs:
 Without joint cost allocation, it is impossible to prepare external
purpose financial reports. What is the value of units in the ending
inventory?
 Without cost, it is impossible to price units. Further, management
information for internal reporting purposes is impossible.
 Sometimes, an organization may enter into a contract that works on
the basis of commission and cost reimbursement. When such is the
case, to determine the amount of reimbursement, cost information on
the units is essential.
 In the event of possible loss of a main or joint
product, insurance claims would be raised
based on cost information.
 When rate regulation exists, it is important to
determine the cost of the product that is under
the price regulation.
• Cost allocation is the process of apportioning costs
among cost objects. Allocation is made in areas
where cost tracing is impossible. Nonetheless, the
allocation process should not be arbitrary. It should
follow some reason. There are common ways of
allocating cost to cost objects. The most common of
which are allocating costs to cost objects through
cause and effect consideration, and allocating costs
based on benefits received criteria. Costs also be
allocated based on some form of physical measure.
• . Joint cost allocation could not follow the cause and effect consideration.
Joint costs are allocated based on benefits received criteria and through
physical measures. The following are the most common method of
allocating joint cost to the products;

1. Allocating costs using physical measure methods

2. Allocating costs using revenue method

A. Sales value at split off point method

B. Estimated net realizable value method

C. Constant gross profit NRV method

• The physical measure method uses physical measures like
weight and volume as a base to allocate joint costs. Sometimes
the metric of the joint products may not be identical. When
such happens, a common measurement would be used to
allocate the joint cost.
• In the second method, revenue data are used as a means to
allocate joint costs. The sales value at split off point method
uses the revenue of the joint products at the split off point to
allocate the joint cost.
• The items that generate the highest revenue would
take the highest cost and the item with the lowest
revenue would share a proportionately lower cost.
The other two methods work when the products at
the split off point are further processed and sold at a
higher sales value. The estimated net realizable value
method deducts the separable costs from the value
of the final product to arrive at the product at the
split off point. The net value will then be used to
allocate the joint cost to the joint products.
• The constant gross profit margin keeps the
gross margin percentage of all the products
constant. And the joint cost is allocated in
such a way that the gross margin percentage
of all products becomes equal.
• In the simplest joint production process, the
joint products are sold at split off point
without further processing. The above joint
cost allocation methods will be clear when we
see their applications using illustrative
examples. To illustrate the four joint cost
allocation approaches, we use the case of
Sheno Lega farmer’s cooperative.
• Illustration 1: Sheno Lega Farmer’s cooperative
purchase raw milk from individual farmers and
process it until the split of point, where two
products – cream and liquid skim emerges.
These two products are sold to an independent
company, which markets and distributes them
to super-markets and other retail outlets in
Addis Ababa. In the year 2008, 110,000 gallon
of raw milk was purchased and processed.
• Of this, 10,000 gallon was 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.
Cost of purchasing 110,000 gallon of raw milk
and processing it until the split of point to
yield cream and liquid skim is Br.400, 000. The
following table shows production and sales
data for the year ended December 31, 2008
 Products Production Sales

Cream 25,000 gallons 20,000 gallons at Br.8 per gallon

Liquid skim 75,000 gallons 30,000 gallons at Br.4 per gallon

The following diagram depicts the basic relationship in this

example
 Cream
25,000 gallon
Raw milk

Liquid skim

75,000 gallon

Split off point

• Required: Allocate the joint cost using

1.Physical measure method

2.Sales value at split off method

 1. Physical-measure method
• The physical- measure method allocates joint
costs to products on the basis of the relative
weight, volume, or other physical measures at
the split off point of the total production of
these products during the accounting period.
In the illustration above, the Br.400, 000 joint
costs produces 25,000 gallons of cream and
75,000 gallons of liquid skim. Using the
number of gallons produced as the physical
measure, joint costs are allocated as follows.
 Cream Liquid Total
Skim
Physical measure of total production(gallons) 25,000 75,000 100,000
weighting (cream: 25,000/100,000, liquid skim: 0.25 0.75
75,000/100,000)
Joint costs allocated (cream: 0.25xBr. 400,000,
liquid skim 0.75xBr. 400,000) Br100,0 Br300,000 Br.400,0
00 00
Joint production cost per gallon (cream: Br. Br4/gal Br4/gal
100,000/25,000 gal, liquid skim, Br. 300,000/75,
000 gal)
• The table below presents the product-line income
statement using the physical –measure method:
Cream Liquid Total
skim
Revenues (Cream, 20,000 gal x Br. 8/gal, Liquid skim, Br. Br. 120,000 Br.280,00
30,000 gal x Br. 4/gal ) 160,000 0

Costs of goods sold ( 20,000 gal x Br 4; 30,000 gal x 80,000 120,000 200,000
Br. 4)
Gross margin percentage Br. 80,000 0 Br. 80,000
Gross margin percentage 50% 0% 28.8%
• Under the benefits- received criterion, the physical –measure method is
less preferred than the sales value at split off method. Why? Because, it has
no relationship to the revenue producing power of the individual products.
Consider a gold mine that extracts ore containing gold, silver and lead. Use
of a common physical measure (tons) would result in almost all costs being
allocated to the products that weighs the most but has the lowest revenue-
producing power. In this case, the method of cost allocation is inconsistent
with the reason for the mine owner incurring mining costs- to find gold
and silver, not lead.
• In order to use physical measure method for joint cost allocation, the joint products
should be expressed in the same measuring unit. Determining which products of a
joint process to include in a physical measure computation can greatly affect the
allocations between or among those products. Outputs with no sales value (such as
dirt in gold mining) are always excluded. Although many more tons of dirt than
gold is produced costs are not incurred to produce outputs that have zero sales
vales. Byproducts with low sales values relative to the joint products or the main
product also are often excluded from the denominator used in the physical measure
method. The general guideline for the physical measure method is to include only
the joint product outputs in the weighting computations.
 Sales Value at Split off Point
Method
• The sales value at split of point method
allocates joint costs to joint products on the
bases of the relative sales value at the split off
point of the total production of these
products during the accounting period. For
Sheno Lega farmer’s cooperative, the joint
cost will be allocated using sales value at the
split off point method as follows:
 Liquid
Cream skim Total
Sales value of total production at split off point (in Br.)
(Cream;25,000 gal x 8/gal; Liquid skim; 75,000 gal x
4/gal) 200,000 300,000 500,000
Weighting(200,000/500,000; 300,000/500,000) 0.40 0.60
Joint cost allocated (In Br.) (Cream,0.4 x Br. 400,000;
Liquidskim,0.60 x Br. 400,000) 160,000 240,000 400,000
Joint cost per gallon(Cream,160,000/25,000 gal; liquid Br. Br.
skim,240,000/75,000 gal) 6.4/gal 3.2/gal
• This method uses sales value of the entire
production of the accounting period. The
reason is that, the joint costs were incurred on
all units produced not just the portion sold
during the current period. The table below
presents the product-line income statement
using the sales value at split off point method.
Both cream and liquid skims have gross-
margin percentages of 20%.
 Cream Liquid Total
skim
Revenues (Cream, 20,000 gal x Br. 8/gal; Br. Br. Br.
Liquid skim, 30,000 gal x Br. 4/gal ) 160,000 120,000 280,000

Costs of goods sold ( 20,000 gal x Br. 6.4; 128,000 96,0000 224,000
30,000 gal x Br. 3.2)
Gross margin percentage Br. Br. 24,000 Br. 56,000
Gross margin percentage 32,000 20% 20%
20%
• You can now see why the sales values at split off
method follow the benefits-received criterion of cost
allocation. Costs are allocated to products in
proportion to their expected revenues. This method
is both straightforward and intuitive. The cost
allocation base is total sales value at split off point
that is systematically recorded in the accounting
system. To use this method, a company needs the
market selling price for all products at the split off
point.
 .3. Net Realizable Value (NRV)
Method
• In many cases, products are processed
beyond the split off point to bring them to a
marketable form or to increase their value
above their selling price at the split off point.
To illustrate the cost allocation in this case,
let’s extend the case of Sheno Lega farmers
cooperative.
•
• Illustration 2: Assume the same data as in illustration 1, except that, here
both cream and liquid skim can be processed further. 25,000 gallons of
cream are further processed to yield 20,000 gallons of butter ream at
additional processing costs of Br. 280, 000. Butter cream, which sells for
Br. 25 per gallon, is used in the manufacture of butter-based products.
75, 000 gallons of liquid skim are further processed to yield 50,000 gallons
of condensed milk at additional processing costs of Br. 520, 000.
Condensed milk sells for Br. 22 per gallon. The following diagram depicts
how raw milk is converted into cream and liquid skim in a joint production
process and how the cream is separately processed into butter cream and
liquid skim is separately processed into condensed milk.
•
 Br.280, 000
Cream B. Cream
25,000 20,000gal
gallon
Raw milk Processing
Br.400, 000
110,000 gallon
Liquid skim
75,000 gal Br.520, 000 C. Milk
50,000gal

Split off point

• Sales during the accounting period were
12,000 gallons of butter cream and 45,000
gallons of condensed milk leaving 8,000
gallons of better cream and 5,000 gallons of
condensed milk as end inventory. There is no
other beginning or end inventory than these
two.
• The net realizable value (NRV) method allocates joint
cost to joint products on the basis of the relative
NRV. NRV is final sales value minus the separable
costs of the total production of the joint products
during the accounting period. The NRV method is
typically used in preference to the sales value at split
off method only when we don’t know the market
selling prices for one or more products at split off
point. Joint costs in this example are allocated as
follows:
 Butter Condensed Total
Cream Milk
Final sales value (Butter cream: 20,000 gal x Br. Br. 500,000 Br. 1,100,000 Br1,600,000
25/gal, condensed milk 50,000 gal xBr.22/gal)

Deduct: Separable costs to complete and sell 280,000 520,000 800,000

Net realizable value at split off point Br. 220,000 Br. 580,000 Br. 800,000
Weighting (220,000/800,000;580,000/800,00) 0.275 0,725
Joint costs allocated (Butter cream 0.275x Br.110,000 Br.290,000 Br.400,000
400,000; condensed milk 0.725 x 400,000)
Production cost per gallon(Butter cream: Br.19.50/gal Br.16.20/gal.
{Br.110,000+Br.280,000}/20,000gal;condens
ed milk {Br.290,000+Br.520,000}/50,000
gal)
• The product line Income statement using the
estimated NRV method can be prepared as follows

Condensed
Butter Cream Milk

Revenues (Butter cream, 12,000gal x Br.25/gal;

Condensed milk 45,000 gal x Br.22/gal) Br. 300,000 Br. 990,000

x Br.19.50/gal;
Cost of goods sold :(Butter cream ,12,000gal
Condensed Milk, 45,000 gal x Br.16.20/gal) 234,000 729,000
Gross Margin Br. 66,000 Br. 261,000
Gross Margin percentage 22% 26.4%
• Because the sales value at split off method does not
require knowledge of the processing steps beyond
the split off point, it is less complex than the NRV
method. However using the sales value at split off
method is not always feasible. That is because; there
may not be market prices for at least one of the
products at the split off point. Market prices may
only be available after processing occurs beyond the
split off point. In this case, we have to use NRV
method.
 4. Constant Gross Margin
Percentage NRV Method
• The constant gross margin percentage NRV method allocates
joint cost to joint products in such a way that the overall gross
margin percentage is identical for the individual products.
This method entails three steps:
• Step 1: Compute the overall gross margin percentage for all
joint products together.
• Step 2: Multiply the overall gross margin percentage and the
final sales values of each product to calculate the gross
margin for each product. Subtract the gross margin for each
product from the final sales value of each product to obtain
the costs that each product will bear.
• Step 3: Deduct the separable costs from the total
costs that each product will bear to obtain the joint
cost allocated.
•
• The joint costs allocated to a product can be negative
under this method. Some products may receive
negative allocation of joint costs to bring gross margin
percentages up to the overall average. The following
table presents the overall income statement for the
constant gross margin percentage NRV method.
Step 1 Total
Final sales value of total production
( 20,000 gal x Br. 25/gal + 50,000 gal x
Br. 22/gal Br. 1,600,000
Less; Total cost (Br. 400,000 + Br. 800,000) 1,200,000
Gross Margin Br. 400,000
Gross Margin percentage(Br. 400,000/Br.1,600,000) 25%
 Butter Condensed
Step 2 & 3 Cream Milk
Final sales value of total production
(Butter cream, 20,000 x Br.25/gal; con.
Milk , 50,000 gal x Br.22/gal) Br. 500,000 Br.1,100,000
Less : Gross margin (25% x Br.500,000, 25% x
Br.1,100,000) 125,000 275,000
Cost of Goods available for sale Br. 375,000 Br. 825,000
Less: Separable cost to complete and sell 280,000 520,000
Joint costs Allocated Br.95,000 Br.305,000
Total cost per gallon ( Br. 375,000/20,000gal, Br.
825,000/50,000 gal Br.18.75/gal Br.16.5/gal
• The constant gross margin percentage NRV method is
different in one fundamental way from the two other market
based joint cost allocation methods described earlier. The
sales value at split off method and the NRV method allocate
only the joint costs to the joint products. Neither method
takes account of profits earned either before or after the split
off point when allocating the joint cost. In contrast, the
constant gross margin percentage NRV method is both a joint
cost method and a 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. Gross margin is allocated to
the joint products under the constant gross margin
method to determine the joint cost allocation so that
each product has the same gross margin percentage.
The following table presents the product line income
statement under constant gross margin NRV
method.
 Butter Condensed
Cream Milk
Revenues (butter cream, 12,000 gal x
Br.25/gal; condensed milk 45,000 gal x Br. Br.
22/gal) 300,000 Br. 990,000
Cost of goods sold:(Butter cream ,12,000gal x Br.
18.75/gal; Condensed Milk, 45,000 gal x
Br. 16.50/gal) 225,000 742,500

Gross Margin Br. 75,000 Br. 247,500

Gross Margin percentage 25% 25%

Which method of allocating joint costs should be used? Use the sales value at split off
method when selling price data are available (even if further processing is done).
Reasons for using the sales value at split off method include:

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 all the other method of allocating joint costs.
• The sales value at split off method does not require
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.
• The sales value at Split off method and the other market-
based methods have a meaningful basis to allocate joint costs
to products. In contrast the physical measure method may
lack a meaningful basis that can be used to allocate joint costs
to individual products.
• The sales value at split off method is simple. In
contrast, the NRV and constant gross margin
percentage NRV method 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 products are sold.
 Further Processing Decision
• Many manufacturing companies constantly face the
decision of whether to further process a joint
product. For example, Sheno Lega can sell the joint
products: cream and liquid skim at the split off point
or further process them into butter cream and
condensed milk. In the petroleum refining industry,
the refiner must decide whether to see raw liquefied
petroleum gas as a product or process it further into
butane, ethane and propane.
• Should the joint costs allocated to the joint
products be used in making pricing decisions
for each joint product? No. why not? Because
all joint cost allocations to products are
somewhat arbitrary. There is no cause and
effect relationship that identifies the
resources demanded by each joint product
that can be used as a basis for pricing.
• Relevant revenues are expected future revenues that differ among
alternative courses of action. These concepts have important implications
for decisions on whether a joint product should be sold at the split off
point or processed further. Joint costs incurred up to the split off point are
irrelevant because these costs will be incurred whether the product is sold
at the split off point or processed further. Therefore, the decision whether
to process further should not be influenced by the total amount of the
joint costs. The decision to incur additional costs for further processing
should be based on the incremental operating income attainable beyond
the split off point. The incremental analysis for these decisions to process
further is given below
 Butter Condensed
Cream Milk
Incremental revenue (Butter cream, 20,000gal x
Br. 25/gal- 25,000 gal x Br. 8/gal ; Condensed
milk 50,000 gal x Br. 22/gal – 75,000 gal x Br.
4/gal) Br. 300,000 Br.800,000
Less: Incremental cost 280,000 520,000
Incremental income from further processing Br.20,000 Br.280,000
• In this example, operating income increases for
both products so the manager should process
cream into butter cream and liquid skim in to
condensed milk. The Br. 400,000 joint costs
incurred up to split off and how they are
allocated are irrelevant in deciding whether to
process further. Why irrelevant? Because the
joint costs of Br. 400, 000 are the same
whether or not further processing occurs.
• Incremental costs are the additional costs incurred for an
activity such as process further. Do not assume all separable
costs in joint cost allocation are always incremental costs.
Some separable costs may be fixed costs such as lease costs
on building where the further processing is done: some costs
may be sunk costs such as depreciation on the equipment
that converts cream into butter cream. Some separable costs
may be allocated costs such as corporate costs allocated to
the condensed milk operations. None of these costs will differ
between the automotives of selling products at the split off
point or processing further.
 6.4 Accounting for Byproducts

• Joint production processes may yield not only join products

and main products but byproducts as well. Although
byproducts have much lower sales values than the sales values
of joint or main products, the presence of byproducts in a joint
production process can affect the allocation of joint costs.
Let’s consider a two product example consisting of a main
product and a byproduct.
•
• Illustration 3: Kierra meat processing company
processes meat from slaughterhouses. One of
its departments cuts lamb shoulders and
generates two products: Shoulder meat (the
main product) sold for Br. 60 per pack. Hock
meat (the byproduct)-sold for Br.4 per pack
(net of any selling costs). The data below
indicates the number of packs produced and
packed in this department in July 2009:
 Production Sales Ending inventory
Shoulder meat 5,000 4,000 1,000
Hock meat 1,000 300 700

The joint manufacturing costs of these products in July 2009 were Br.
250,000 comprising Br. 150, 000 for direct materials and Br.100, 000 for
conversion costs. Both products are sold at the split off point without
further processing. There are two byproduct accounting methods:
 . Method A: Byproducts Recognized at Time
Production is Completed

• The production method - recognizes byproducts in the

financial statements at the time production is completed. This
method recognizes the byproduct in the financial statements
- the 1,000 packs of hock meat - in the month it is produced,
July 2009. The NRV form the byproduct produced is offset
against the costs of the main product
• 1. Work in process--------------------150,000
• Accounts payable------------------------- 150,000
• (To record direct materials of Br 150,000 used in production
during July)
2. Work in process-------------------100,000
Various accounts -------------------100,000
(To record the consumption of conversion costs of Br. 100,000 in July)
3. Byproduct inventory—hock meat (1,000 packs x Br. 4/pack) -- 4,000
Finished goods—shoulder meat (Br.250, 000-Br.4, 000) ------- 246,000
Work in process (Br.150, 000+Br.100, 000) ---------- --------250,000
(To record cost of goods completed during July)
4a) Cost of goods sold [(4,000 packs /5,000 packs) x Br. 246, 000--196,800
Finished goods –shoulder meat----------------------------------196,800
(To record the cost of the main product sold during July)
4b) Cash or Accounts receivable (4,000 packs x Br.60/pack) ---240,000
Revenues----shoulder meat----------------------------240,000
(To record the sales of the main product during July)
5) Cash or Accounts receivable (300 packs x Br. 4/pack) -----1,200
Byproducts inventory---hock meant------ ------1,200
(To record the sales of the byproduct during July)
This method reports the byproduct inventory of hock meat in the balance sheet
prepared on July 31,2009 at its Br. 4 per pack selling price [(1,000 packs-300 packs) x
Br. 4/pack = Br. 2, 800]
Method B: Byproducts Recognized at
Time of Sale
• The sales method delays recognition of byproducts until
the time of sale. Recognition of byproducts at the time
of production is conceptually correct recognition than at
the time of sales. However, sales method is often used
in practice when the birr amounts of the byproduct are
immaterial. This method makes no journal entries until
sales of the byproduct occur. Revenues of the byproduct
are reported as a revenue item in the income statement
at the time of sales. These revenues are grouped with
other sales, included as other income or deducted from
cost of goods sold.
• In the above example, byproduct revenues in
July 2004 are Br. 1, 200 (300 packs x Br.
4/pack) because only 300 packs of the hock
meat are sold in July (of the 1,000 packs
produced). The journal entices are presented
below:
Journal entries 1 and 2 are the same as for method A.
3. Finished goods---- shoulder meat 250,000
Work in process 250,000
(To record cost of goods completed during July)
4a) Cost of goods sold [(4,000 packs/ 5, 000packs) x Br.250, 000] 200,000
Finished goods-------------- ------------------------------200, 000
4b) The same as for method A.
5. Cash or account receivable------------ 1,200
Revenues----shoulder meat ----------- 1,200
(To record the sales of the byproduct during July)
• Method B is used in practice primarily on the ground
that the birr amounts of byproducts are immaterial.
However, this method permits managers to report
earnings by timing when they sell byproducts.
Managers may store byproducts for several periods
and give revenues and income a “small boost” by
selling byproducts accumulated over several periods
when revenues and profits from the main product or
joint products are low. The following table presents
the income statement and balance sheet under both
methods:
 Production Sales method
Income statement method
Revenue:
Main product 4,000 pack x Br. Br. 240,000 Br. 240,000
60/pack
By product 300 packs x Br 4/pack - 1,200
Total Revenue Br. 240,000 Br. 241,200
Cost of goods sold 196,800 200,000
Gross Margin Br. 43,200 Br. 41,200
Gross Margin Percentage 18% 17%
Balance sheet
End of period Inventory:
 Main product Br. 49,200 Br. 50,000
 Byproduct 2,800 0
Total Inventory Br. 52,000 Br. 50,000