To understand joint products and byproducts cost, one must have a firm understanding of the split-off point. This is the last point in a production process where it is impossible to determine the nature of the final products. All costs that have been incurred by the production process up until that point—both direct and overhead—must somehow be allocated to the products that result from the split-off point. Any costs incurred thereafter can be charged to specific products in the normal manner. Thus, a product that comes out of such a process will be composed of allocated costs from before the split-off point and costs that can be directly traced to it, which occur after the split-off point.
A related term is the byproduct, which is one or more additional products that arise from a production process, but whose potential sales value is much smaller than that of the principal joint products that arise from the same process. As we will see, the accounting for byproducts can be somewhat different.
The logic used for allocating costs to joint products and byproducts has less to do with some scientifically derived allocation method, and more with finding a quick and easy way to allocate costs that is reasonably defensible. The reason for using simple methodologies is that the promulgators of GAAP realize that there is no real management use for allocated joint costs—they cannot be used for determining breakeven points, setting optimal prices, or figuring out the exact profitability of individual products. Instead, they are used for any of the following purposes, which are more administrative in nature:
Bonus calculations – Manager bonuses may depend on the level of reported profits for specific products, which in turn are partly based on the level of joint costs allocated to them. Thus, managers have a keen interest in the calculations used to assign costs, especially if some of the joint costs can be dumped onto products that are the responsibility of a different manager.
Cost-plus contract calculations – Many government contracts are based on the reimbursement of a company’s costs, plus some predetermined margin. In this situation, it is in a company’s best interests to ensure that the largest possible proportion of joint costs are assigned to any jobs that will be reimbursed by the customer, while the customer will be equally interested, but due to a desire to reduce the allocation of joint costs.
Income reporting – Many organizations split their income statements into sublevels that report on profits by product line or even individual product. If so, joint costs may make up such a large proportion of total production costs that these income statements will not include the majority of production costs, unless they are allocated to specific products or product lines.
Insurance reimbursement – If a company suffers damage to its production or inventory areas, some finished goods or work-in-process inventory may have been damaged or destroyed. If so, it is in the interests of the company to fully allocate as many joint costs as possible to the damaged or destroyed stock, so that it can receive the largest possible reimbursement from its insurance provider.
Inventory valuation – It is possible to manipulate inventory levels (and therefore the reported level of income) by shifting joint cost allocations toward those products that are stored in inventory. This practice is obviously discouraged, since it results in changes to incomes that have no relationship to operating conditions. Nonetheless, one should be on the lookout for the deliberate use of allocation methods that will alter the valuation of inventory.
Transfer pricing – A company can alter the prices at which its sells products among its various divisions, so that high prices are charged to those divisions located in high-tax areas, resulting in lower reported levels of income tax against which those high tax rates can be applied. A canny cost accounting staff will choose the joint cost allocation technique that results in the highest joint costs being assigned to products being sent to such locations (and the reverse for low tax regions).
2 Methods For Allocating Joint and Byproduct Cost
There are only two methods for allocating joint and byproduct costs that have gained widespread acceptance:
Under this method, to calculate it [the joint and byproduct cost allocation], compile all costs accumulated in the production process up to the split-off point, determine the eventual sales value of all products created at the split-off point, and then assign these costs to the products based on their relative values. If there are byproducts associated with the joint production process, they are considered to be too insignificant to be worthy of any cost assignment, though revenues gained from their sale can be charged against the cost of goods sold for the joint products. This is the simplest joint cost allocation method, and particularly attractive, because the accountant needs no knowledge of any production processing steps that occur after the split-off point.
Potential Issues With This Methods
This different treatment of the costs and revenues associated with byproducts can lead to profitability anomalies at the product level:
- The determination of whether a product is a byproduct or not can be quite judgmental; in one company, if a joint product’s revenues are less than 10 percent of the total revenues earned, then it is a byproduct, while another company might use a 1 percent cutoff figure instead. Because of this vagueness in accounting terminology, one company may assign all of its costs to just those joint products with an inordinate share of total revenues, and record the value of all other products as zero. If a large quantity of these byproducts were to be held in stock at a value of zero, the total inventory valuation would be lower than another company would calculate, simply due to their definition of what constitutes a byproduct.
- Byproducts may be sold off only in batches, which may occur only once every few months. This can cause sudden drops in the cost of joint products in the months when sales occur, since these revenues will be subtracted from their cost. Alternatively, joint product costs will appear to be too high in those periods when there are no byproduct sales. Thus, one can alter product costs through the timing of byproduct sales.
- The revenues realized from their sale can vary considerably, based on market demand. If so, these altered revenues will cause abrupt changes in the cost of those joint products against which these revenues are netted. It certainly may require some explaining to show why changes in the price of an unrelated product caused a change in the cost of a joint product!
Solution!: The best way to avoid the three issues just noted is to AVOID the designation of any product as a byproduct!. Instead, every joint product should be assigned some proportion of total costs incurred up to the split-off point, based on their total potential revenues [however small they may be], and no resulting revenues should be used to offset other product costs. By avoiding the segregation of joint products into different product categories, we can avoid a variety of costing anomalies.
Method-2: Joint and Byproduct Cost Allocation Based On The Estimated Final Gross Margin Of Each Joint Product Produced
The calculation of gross margin is based on the revenue that each product will earn at the end of the entire production process, less the cost of all processing costs incurred from the split-off point to the point of sale. This is a more complicated approach, since it requires the accountant to accumulate additional costs through the end of the production process, which in turn requires a reasonable knowledge of how the production process works, and where costs are incurred.
Though it is a more difficult method to calculate, its use may be mandatory in those instances where the final sale price of one or more joint products cannot be determined at the split-off point (as is required for the first allocation method), thereby rendering the other allocation method useless.
The main problem with allocating joint costs based on the estimated final gross margin is that it can be very difficult to calculate if there is a great deal of customized work left between the split-off point and the point of sale. If so, it is impossible to determine in advance the exact costs that will be incurred during the remaining production process.
Solution!: In such a case, the only alternative is to make estimates of expected costs that will be incurred, base the gross margin calculations on this information, and accept the fact that the resulting joint cost allocations may not be provable, based on the actual costs incurred.