Many accountants believe that joint costs should be allocated to individual products according to their ability to absorb joint costs. The advantage of this approach is that joint cost allocation will not produce consistently profitable or unprofitable items. The rationale for using ability to bear is the assumption that costs would not be incurred unless the jointly produced products together would yield enough revenue to cover all costs plus a reasonable return. The reverse also would be consistent with this theory; that is, a derived cost that the purchaser of materials and other joint costs is willing to incur for any individual product could be obtained by relating costs to sales values. On the other hand, fluctuations in the market value of any one or more of the end products automatically change the apportionment of the joint costs, though actually it costsno more or no less to produce than before.
The relative market value approach to joint cost allocation is better than the physical units approach if two conditions hold: (1) the physical mix of output can be altered by incurring more (less) total joint costs and (2) this alteration produces more (less) total market value.Several variants of the relative market value method are found in practice.
Sales-Value-at-Split-Off Method
The sales-value-at-split-off method allocates joint cost based on each product’s proportionate share of market or sales value at the split-off point. Under this method, the higher the market value, the greater the share of joint cost charged against the product. As long as the prices at split-off are stable, or the fluctuations in prices of the various products are synchronized (not necessarily in amount, but in the rate of change), their respective allocated costs remain constant. Using the same example of lumber mill costs given in the preceding discussion of the physical units method, the joint cost of $186,000 is distributed to the various grades on the basis of their market value at split-off.
The relative market value approach to joint cost allocation is better than the physical units approach if two conditions hold: (1) the physical mix of output can be altered by incurring more (less) total joint costs and (2) this alteration produces more (less) total market value.Several variants of the relative market value method are found in practice.
Sales-Value-at-Split-Off Method
The sales-value-at-split-off method allocates joint cost based on each product’s proportionate share of market or sales value at the split-off point. Under this method, the higher the market value, the greater the share of joint cost charged against the product. As long as the prices at split-off are stable, or the fluctuations in prices of the various products are synchronized (not necessarily in amount, but in the rate of change), their respective allocated costs remain constant. Using the same example of lumber mill costs given in the preceding discussion of the physical units method, the joint cost of $186,000 is distributed to the various grades on the basis of their market value at split-off.
Note that the joint cost is allocated in proportion to sales value at the split-off point. No. 1 common, for example, is valued at $240,000 at split-off, and that amount is 47.99 percent of the total sales value. Therefore, 47.99 percent of total joint cost is assigned to the No. 1 common grade.
factors based on price. The advantage is that the price-based weights do not change as market prices do. An example of this method is found in the glue industry. Material is put into process in the cooking department. The products resulting from the cooking operations are the several “runs of glue.” The first run is of the highest grade, has the highest market value, and costs the least. Successive runs require higher temperatures, cost more, and produce lower grades of products. Glue factories do not attempt to determine the actual cost of each skimming because the effect would be to show the lowest cost on the first grade of product and the highest cost on the lowest grade. Instead, the cost of all glue produced is determined, and this total cost is spread over the various grades on the basis of their respective tests of purity. The relative degree of purity is an indicator of the quality and, therefore, of the market value of each run or grade produced. Hence, multiplying the yield for each run by its relative purity is equivalent to multiplying it by the market value. The amounts weighted by purity are used to allocate the joint costs to each run. Additional runs would be undertaken, of course, only as long as the incremental revenue of the additional run is equal to or exceeds the incremental costs incurred.
The weighting factor based on market value at split-off is conceptually the same as the weighting factor method under physical units. However, in this case, the weighting factor is based on sales value, while the weighting factor described in the physical units section could be based on various other considerations such as processing difficulty, size, and so on. These other considerations may or may not be related to market value.
Net Realizable Value Method
When market value is used to allocate joint costs, we are talking about market value at the split-off point. However, on occasion, there is no ready market price for the individual products at the split-off point. In this case, the net realizable value method can be used. First, we obtain a hypothetical sales value for each joint product by subtracting all separable (or further) processing costs from the eventual market value. This approximates the sales value at split-off. Then, the net realizable value method can be used to prorate the joint costs based on each product’s share of hypothetical sales value.
Suppose that a company manufactures two products, Alpha and Beta, from a joint process. One production run costs $5,750 and results in 1,000 gallons of Alpha and 3,000 gallons of Beta. Neither product is salable at split-off, but must be further processed such that the separable cost for Alpha is $1 per gallon and for Beta is $2 per gallon. The eventual market price for Alpha is $5 and for Beta, $4. Joint cost allocation using the net realizable value method is as follows:
factors based on price. The advantage is that the price-based weights do not change as market prices do. An example of this method is found in the glue industry. Material is put into process in the cooking department. The products resulting from the cooking operations are the several “runs of glue.” The first run is of the highest grade, has the highest market value, and costs the least. Successive runs require higher temperatures, cost more, and produce lower grades of products. Glue factories do not attempt to determine the actual cost of each skimming because the effect would be to show the lowest cost on the first grade of product and the highest cost on the lowest grade. Instead, the cost of all glue produced is determined, and this total cost is spread over the various grades on the basis of their respective tests of purity. The relative degree of purity is an indicator of the quality and, therefore, of the market value of each run or grade produced. Hence, multiplying the yield for each run by its relative purity is equivalent to multiplying it by the market value. The amounts weighted by purity are used to allocate the joint costs to each run. Additional runs would be undertaken, of course, only as long as the incremental revenue of the additional run is equal to or exceeds the incremental costs incurred.
The weighting factor based on market value at split-off is conceptually the same as the weighting factor method under physical units. However, in this case, the weighting factor is based on sales value, while the weighting factor described in the physical units section could be based on various other considerations such as processing difficulty, size, and so on. These other considerations may or may not be related to market value.
Net Realizable Value Method
When market value is used to allocate joint costs, we are talking about market value at the split-off point. However, on occasion, there is no ready market price for the individual products at the split-off point. In this case, the net realizable value method can be used. First, we obtain a hypothetical sales value for each joint product by subtracting all separable (or further) processing costs from the eventual market value. This approximates the sales value at split-off. Then, the net realizable value method can be used to prorate the joint costs based on each product’s share of hypothetical sales value.
Suppose that a company manufactures two products, Alpha and Beta, from a joint process. One production run costs $5,750 and results in 1,000 gallons of Alpha and 3,000 gallons of Beta. Neither product is salable at split-off, but must be further processed such that the separable cost for Alpha is $1 per gallon and for Beta is $2 per gallon. The eventual market price for Alpha is $5 and for Beta, $4. Joint cost allocation using the net realizable value method is as follows:
Note that joint cost is allocated on the basis of each product’s share of hypothetical market value. Thus, Alpha receives 40 percent of the joint cost ($2,300) because it accounts for 40 percent of the hypothetical market value. The net realizable value method is particularly useful when one or more products cannot be sold at the split-off point but must be processed further.
Constant Gross Margin Percentage Method
The net realizable value method is easy to apply. However, it assigns all profit to the hypothetical market value. In other words, the further processing costs are assumed to have no profit value even though they are critical to selling the products. The constant gross margin percentage method corrects for this by recognizing that costs incurred after the split-off point are part of the cost total on which profit is expected to be earned, and it allocates joint cost such that the gross margin percentage is the same for each product. Using the data for Alpha and Beta, we can allocate the $5,750 joint cost using the constant gross margin percentage method. First, total revenues and costs are calculated to determine overall gross margin and the gross margin percentage. Then, revenues for the individual products are adjusted for gross margin, separable costs are deducted, and the resulting figure is the allocated joint cost.
Constant Gross Margin Percentage Method
The net realizable value method is easy to apply. However, it assigns all profit to the hypothetical market value. In other words, the further processing costs are assumed to have no profit value even though they are critical to selling the products. The constant gross margin percentage method corrects for this by recognizing that costs incurred after the split-off point are part of the cost total on which profit is expected to be earned, and it allocates joint cost such that the gross margin percentage is the same for each product. Using the data for Alpha and Beta, we can allocate the $5,750 joint cost using the constant gross margin percentage method. First, total revenues and costs are calculated to determine overall gross margin and the gross margin percentage. Then, revenues for the individual products are adjusted for gross margin, separable costs are deducted, and the resulting figure is the allocated joint cost.
The constant gross margin percentage method allocates more joint cost to Alpha than did the net realizable value method. This is due to the assumption of a relationship between cost and the cost-created value. That is, the net realizable value assumed no gross margin attributable to further processing costs, while the constant gross margin percentage method assumed not only that further processing yields profit but also that it yields an identical profit percentage across products. Which assumption is correct? There are two important questions: first, whether there is a “direct relationship” between cost and value and, second, whether the relationship is necessarily the same for all products jointly produced before and after the split-off point. The practice of product-line pricing to meet competition tends to make such assumptions invalid. Although exceptions exist, many companies do not try to maintain more-or-less equal margins between prices and full costs on their various products.
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