Chapter 11: Allocation of Joint Costs and Accounting for By-Product/Scrap

1. Chapter 11:Allocation of Joint Costs and Accounting for By-Product/Scrap © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. Learning Objectives • How are the outputs of a joint process classified? • What management decisions must be made before beginning a joint process? • How is the joint cost of production allocated to joint products? • How are by-product and scrap accounted for? • How should not-for-profit organizations account for the cost of a joint activity? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3. Joint Process • Joint process—single process in which one product cannot be manufactured without producing others • Extractive industries • Agriculture industries • Food industries • Chemical industries • Industries that produce both first-quality and factory seconds merchandise in a single operation • When the process is unstable and is unable to maintain output at a uniform quality level or • The output quality varies © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4. © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5. Joint Costs • Joint costs—material, labor, and overhead incurred during a joint process • Allocate to primary products of a joint process using • Physical measures • Monetary measures • Interpret costs allocated to joint products carefully • Product profitability is determined largely by the allocation method © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6. Joint Process Products • A joint process produces • Joint products—primary outputs of a joint process; substantial revenue-generating ability • By-products—incidental output of a joint process with a higher sales value than scrap but less than joint products • Scrap—incidental output of a joint process with a low sales value • Waste—residual output with no sales value © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7. Cost at Various Stages of Production • Separate cost—incurred in later states of production; assignable to specific primary products • Split-off point—when joint products are first identifiable as individual products • At split-off, joint costs are allocated to joint products • Joint costs are sunk costs once the split-off point is reached • Joint costs may be reduced by the sales value of by-products and/or scrap © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8. Illustration of a Joint Process • D’s Chicken Soup Company • Chicken Noodle • Chicken & Dumplings • Chicken Rice • Chicken, water, spices and vegetables are joint inputs Cook vegetables and chicken in water Chicken Water Spices Prepare vegetables, discard waste © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9. Illustration of a Joint Process Cooked, canned, and into FG inventory split off point add Chicken Noodle Noodles Basic chicken soup Rice Chicken Rice Dumplings Chicken & Dumplings © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10. To Process or Not to Process? Decide before the joint-process is started • Will revenues exceed total costs? • Revenue from sale of joint process outputs • Costs • Joint costs • Processing costs after split-off • Selling costs • What is the opportunity cost? • Is income from the joint process greater than income from other uses? • Is the joint production process the best use of capacity? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

11. To Process or Not to Process? Decide at the split-off point • How to classify outputs • Primary • By-product • Scrap • Waste • Joint costs, reduced by the value of by-products and scrap, are assigned to primary products only • Sell at split-off or process further? • If primary products are marketable at split-off, process further only if value added to the product (incremental revenue) exceeds incremental cost © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

12. Allocating Joint Costs • Each method may allocate a different cost to joint products • Physical measure • Common physical characteristic • Monetary measure © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

13. Physical Measures Treats each unit as equally desirable Assigns same cost to each unit Provides an unchanging yardstick of output over time Use for products with unstable selling prices Use in rate-regulated industries Ignores revenue-generating ability of joint product Examples of Physical Measures Tons of meat, bone, and hide in meat packing and chicken processing Tons of ore in mining Linear board feet in lumber milling Barrels of oil in petroleum refining Number of computer chips in semiconductors Joint Cost Pounds $150 300 lbs = $0.50 per lb = Physical Measures © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

14. Monetary Measures • Monetary Measure • Recognizes the revenue—generating ability of joint products • The base is not constant— unchanging • Choices • Sales value at split-off • Net realizable value (NRV) at split-off • Approximated NRV at split-off © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

15. Monetary Measure Allocation Steps • Choose a monetary allocation base • List values that comprise the base for each joint product • Sum the values • Divide each individual value by the total value; this is the numerical proportion for each value • Multiply joint costs by each proportion; this is the amount to allocate to each product • Divide allocated joint cost for each product by the number of equivalent units to obtain a cost per equivalent unit © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

16. Monetary Measure Allocation Example (slide 1 of 3) • Choose a monetary allocation base • Sales value at split-off • List values that comprise the base for each joint product Product Revenue (at split-off) A $ 1,000 B $ 4,000 C $ 5,000 • Sum the values • $1,000 + $4,000 + $5,000 = $10,000 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

17. Monetary Measure Allocation Example (slide 2 of 3) • Divide each individual value by the total value; this is the numerical proportion for each value Product Revenue A $ 1,000 1,000/10,000 = 10% B $ 4,000 4,000/10,000 = 40% C $ 5,000 5,000/10,000 = 50% $10,000 100% • Multiply joint costs ($3,000) by each proportion; this is the amount to allocate to each product Joint Cost Product Joint Costs Proportion Per Product A $3,000 * 10% $ 300 B $3,000 * 40% $1,200 C $3,000 * 50% $1,500 $3,000 • $3,000 of joint costs are allocated to Products A, B and C © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

18. Monetary Measure Allocation Example (slide 2 of 3) • Divide allocated joint cost for each product by the number of equivalent units to obtain a cost per EUP Joint Cost Equivalent Cost Product Per Product Units Per EU A $ 300 / 100 $3.00 B $1,200 / 600 $2.00 C $1,500 / 300 $5.00 $3,000 © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

19. Monetary Measure: Sales Value at Split-Off • Sales value at split-off • Uses relative sales value at split-off point • All joint products must be marketable at split-off • Uses a weighting technique based on both • Quantity produced • Selling price of production © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

20. Monetary Measure: NRV at Split-Off Sales revenue at split-off less product disposal costs equals NRV • NRV at split-off • Assigns joint costs based on the proportional NRVs of the joint products at the split-off point • All joint products must be marketable at split-off • Approximated NRV at split-off • Some or all joint products are not marketable at split-off • Uses simulated NRV at split-off in place of actual NRV at split-off • Incremental separate cost equals all processing and disposal costs incurred between split-of point and point of sale • Assumes that incremental revenue from further processing is equal to or greater than the incremental costs of further processing and selling Final sales price less incremental separate costs equals simulated NRV at split-off © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

21. Choosing Monetary Measures • Which monetary measure method to use? • Sales value at split-off • NRV at split-off • Approximated NRV at split-off • Superior method of measuring benefits • Matches costs of joint processing with its benefits • Provides expected contribution of each product line to the coverage of joint costs • More complex due to required estimates © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

22. Accounting for By-Products and Scrap (slide 1 of 3) • By-products, scrap, and waste may provide substantial revenue • Companies are devoting time, attention, and creativity to developing innovative revenue sources from by-products, scrap, and waste • Sales value of by-products/scrap is recorded using • NRV Method or • Realized Value Method • Choose method based on • Magnitude of NRV • Need for additional processing after split-off Decide before joint costs are allocated to the joint products © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

23. Accounting for By-Products and Scrap (slide 2 of 3) • Selling Price • Less Process, Storage, Disposal Costs equals NRV of By-Product/Scrap • NRV • Use this method when NRV is significant • Scrap or by-product recorded at NRV • NRV reduces joint cost of main products • Any loss is added to cost of the main products • Indirect method • NRV reduces cost of goods sold for joint products • Conservative; joint cost is reduced when the product/scrap is sold • Direct method • NRV reduces work in process for joint products • Joint cost is reduced when by-product/scrap is produced © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

24. Accounting for By-Products and Scrap (slide 3 of 3) • NRV is the traditional method, not necessarily best method • By-products have either no assignable costs or costs equal to their net sales value • Difficult for management to • Monitor production and further processing of by-products • Make effective decisions for by-products © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

25. Firstoption Proceeds recorded as Other Revenue Costs of additional processing or disposal added to costs of primary products Provides little information to management as it does not match revenues and expenses Second option Proceeds less related costs shown as Other Income Matches revenues and related expenses for storage, further processing, transportation, and disposal costs Highlights the revenue enhancement provided by managing the costs and revenues related to by-products/scrap Allows for better control and improved performance By-Products & Scrap: Realized Value (slide 1 of 2) By-product/scrap value is recognized when items sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

26. By-Products & Scrap: Realized Value (slide 2 of 2) • Other clerically efficient options • Proceeds added to gross margin • Proceeds reduce cost of goods manufactured • Proceeds reduce cost of goods sold © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

27. If most jobs create by-products or scrap Proceeds reduce the manufacturing overhead account The journal entry using the realized value approach is: Cash Manufacturing Overhead If only specific jobs create by-products or scrap Proceeds reduce work in process for the specific job The journal entries using the NRV approach are: Scrap Inventory Work in Process Cash Scrap Inventory Impact of Realized Value and NRV © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

28. Joint Costs in Service Organizations • Joint costs include • Advertising for multiple products • Printing for multipurpose documents • Events held for multiple purposes • Not required to allocate joint costs • Allocation base • Physical (number of locations) • Monetary (sales volume) © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

29. Joint Costs in Not-for-Profit Organizations • Joint costs related to • Fund-raising • Organizational programs (program activities) • Conducting an administrative function • Joint costs must be allocated for NPFs and state and local government entities • Method must be rational and systematic • Clearly show the amount spent for various activities • Three tests for allocation—purpose, audience, and content • If tests not met, the costs are fund-raising • Compensation tied to contributions is automatically fund-raising • Purpose is to ensure that users of financial statements can identify fund-raising costs © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

30. Questions • What is a joint product? • How are costs allocated to joint products? • What accounting methods are used to record the proceeds from the sale of by-products? © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

31. Potential Ethical Issues • Product decisions based on sum of joint and separate processing costs • Misclassifying a joint product as by-product or scrap • Misclassifying products as waste and selling “off the books” • Manipulating joint costs in ending inventory • Using sales values of by-products and scrap to manipulate overhead allocation rates • Disposing of hazardous waste in a harmful way • Misallocating costs to programs or management activities to reduce fund-raising costs reported by a not-for-profit organization © 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.