Chapter 11: Allocation of Joint Costs and Accounting for By-Product/Scrapim 1

Chapter 11: Allocation of Joint Costs and Accounting for By-Product/ScrapIM 1

Learning Objectives

After reading and studying Chapter 11, you should be able to answer the following questions:

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?

Terminology

Approximated net realizable value at split-off allocation: a method of allocating joint costs to joint products using a simulated net realizable value at the split-off point; approximated value is computed as final sales price minus incremental separate costs

By-product: an incidental output of a joint process; it is salable, but the sales value is not substantial enough for management to justify undertaking the joint process; it is viewed as having a higher sales value than scrap

Joint costs: costs incurred for material, labor, and overheadduring a joint process up to the split-off point

Joint process: a process during which one product cannot be manufactured without producing others

Joint product:a primary output of a joint process; each joint product individually has substantial revenue-generating ability

Net realizable value (NRV):anamount equal to the product’s sales revenue at split-off less preparation and disposal costs

Net realizable valueapproach: a method of accounting for by-products or scrap that requires that the net realizable value of these products be treated as a reduction in the cost of the primary products

Net realizable value at split-off allocation: a method of assigning joint costs to joint products basedon the sales value at split-off minus all costs necessary to prepare and dispose of the products; it requires that all joint products be salable at the split-off point

Physical measure allocation: a method of allocating a joint cost to products that uses a common physical characteristic as the proration base

Realized valueapproach: a method of accounting for by-products or scrap that does not recognize any value for these products until they are sold; the value recognized upon sale can be treated as other revenue or income

Sales value at split-off allocation: a method of assigning joint costs to joint products based on the relative sales value of the products at the split-off point as the proration base; use of this method requires that all joint products be salable at the split-off point

Scrap: an incidental output of a joint process; it is salable but the sales value from scrap is not enough for management to justify undertaking the joint process; it is viewed as having a lower sales value than a by-product; leftover material that has a minimal but distinguishable disposal value

Separate costs:costs incurred in later stages of production that are assignable to specific primary products

Split-off point: the point at which the outputs of a joint process are first identifiable as individual products

Waste: a residual output of a production process that has no sales value

Lecture Outline

LO.1: How are the outputs of a joint process classified?

Introduction
Many companies produce and sell multiple products.
A joint process is a manufacturing process that simultaneously produces more than one product line.
Classification of joint process output is based on management judgment about the relative sales value of the outputs and can vary from company to company.
Joint cost refers to the costs incurred for material, labor, and overhead during a joint process up to the split-off point.
Although joint costs must be allocated to the primary products to determine financial statement valuations, such allocations should not be used in making internal decisions.
Separate costsare costs incurred in later stages of production that are assignable to specific primary products.
This chapter discusses joint manufacturing processes, their related product outputs, and the accounting treatment of the costs of those processes.
Outputs of a Joint Process
The products resulting from a joint process and having a sales value are classified as joint products, by-products, or scrap.
Joint products are the primary outputs of a joint process, each of which has substantial revenue-generating ability.
Joint products are also called primary products, main products, and co-products.
By-products are incidental outputs of a joint process; they are salable, but the sales value of by-products is not substantial enough for management to justify undertaking the joint process; they are viewed as having a higher sales value than scrap.
Scrap is an incidental output of a joint process; it is salable, but the sales value from scrap is not enough for management to justify undertaking the joint process; it is viewed as having a lower sales value than a by-product; leftover material that has a minimal but distinguishable disposal value.
Waste is a residual output of a production process that must be disposed of because it has no sales value.
Over time, a product classification may change because of technology advances, consumer demand, or ecological factors.
New joint products may be developed from a product as illustrated in text Exhibit 11-1 for soybeans.
Joint process output is classified based on management’s judgment about the relative sales values of outputs.
The Joint Process
Joint products are typically manufactured in companies using mass production processes and a process costing accounting method.
Text Exhibit 11-2 describes the outputs produced from steer processing.
Thesplit-off point is the point at which the outputs of a joint process are first identifiable as individual products.
Financial reporting requires that all necessary and reasonable costs of production be attached to products.
Joint costsmust be allocated to the primary outputs of the production process for inventory valuation purposes.
Costs incurred after split-off are assigned to the separate products for which those costs are incurred.
Text Exhibit 11-3illustrates a joint process with multiple split-off points and the allocation of costs to products.
Allocated joint costs should not be used in making decisions about further processing of joint products.

LO.2: What management decisions must be made before beginning a joint process?

The Joint Process Decision
Text Exhibit 11-4 presents the four management decision points in a joint production process:
Management must decide whether the total expected revenues from the sale of the joint process output are likely to exceed the total expected processing costs of the output. Other potential costs must be considered in determining if the revenues are expected to exceed the costs;
Managers must compare the net income from this use of resources to the net income that would be provided by all other alternative uses of company resources if total anticipated revenues from the “basket” of products exceed the anticipated joint and separate costs. Management would then decide that this joint production process is the best use of capacity and would begin production if joint process net income is greater than the net income that would be provided by other uses;
Management must decide how to classify joint process outputs; and
Some will be primary; others will be by-product, scrap, or waste.
Management must then decide whether any (or all) of the joint process output will be sold (if marketable) at split-off or whether it will be processed further.
Such decisions should be made only after considering whether the expected additional revenues from further processing are higher than the expected additional costs of further processing.
Managers must have a reasonable estimate of each joint output’s selling price in order to make decisions at any potential point of sale. Expected selling prices should be based on both cost and market factors.

LO.3: How is the joint cost of production allocated to joint products?

Allocation of Joint Cost
Text Exhibit 11-5 provides data for Harkins Poultry, a company that manufactures three primary products from a joint process. This case is used in the chapter to demonstrate alternative methods of allocating joint processing costs.
Physical measure allocation
Physical measure allocation is a method of allocating common costs to products that uses a common physical characteristic as the proration base.
Physical measurement allocation, unlike monetary measure allocation, provides an unchanging yardstick of output.
Physical measures are useful in allocating joint cost to products that have extremely unstable selling prices.
A primary disadvantage of the method is that it ignores the revenue-generating ability of individual joint products.
This allocation process treats each weight unit of output as equally desirable and assigns each the same per unit cost.
Text Exhibit 11-6 illustrates this method of allocation.
Journal entries for incurring the joint processing cost, allocating it to the joint products, and recognizing the separate processing cost are provided in the text immediately following the exhibit.
Monetary measure allocation
General
The primary benefit of monetary over physical measure allocations is that the monetary measure approach recognizes the relative ability of each product to generate a profit at sale.
A problem with monetary measure allocations is that the basis used is dynamic.
Accountants customarily ignore price-level fluctuations.
Monetary measure allocation uses the following steps to prorate joint costs to joint products:
Step 1: Choose a monetary allocation base;
Step 2: List eachproduct’s base values;
Step 3: Sum the values in step 2 to obtain a total value for the list;
Step 4: Divide each individual value in step 2 by the total in step 3 to obtain a numerical proportion for each product. (The sum of these proportions should total 100 percent);
Step 5: Multiply the joint cost by each proportion to obtain the amount to be allocated to each product; and
Step 6: Divide each product’s prorated joint cost by the number of product units to obtain a cost per unit for valuation purposes.
Sales value at split-off
The sales value at split-off allocation is a method of assigning joint cost to joint products based on the relative sales values of the products at the split-off point.
Use of this method requires that all joint products are marketable at split-off.
Text Exhibit 11-7 illustrates this method of allocation.
Journal entries are similar to those illustrated earlier.
Net realizable value at split-off
The net realizable value at split-off allocation is a method of allocating joint cost to joint products based on the sales value at split-off minus all costs necessary to prepare and dispose of the products.
Use of this method requires that all joint products be salable at split-off.
Text Exhibit 11-8 illustrates this method of allocation.
Approximated net realizable value at split-off
The approximated net realizable value at split-off allocation is a method of allocating joint cost to joint products that uses a simulated net realizable value at the split-off point.
Approximated value is computed as final sales price minus incremental separate costs.
Thus, decisions made about further processing affect the values used to allocate joint cost under this method.
An underlying assumption of this method is that the incremental revenue from further processing is equal to or greater than the incremental costs of further processing.
Text Exhibit 11-9 illustrates this method of allocation.
Text Exhibit 11-10 shows that the example company can process some joint products further to create additional types of output. However, this further processing does not change the allocation of joint cost previously made to the joint products.
In summary:
Each method discussed allocates a different amount of joint cost to the joint products and results in a different per-unit cost for each product and, accordingly, has its own advantages and disadvantages; and
For most companies, approximated NRV at split-off provides the most logical joint cost assignment.
This is because, for each joint product, approximated NRV captures the intended level of separate processing, costs of separate processing, expected selling costs of each joint product, and the expected selling price of each joint product. Thus, approximated NRV is the best measure of the expected contribution of each product line to the coverage of joint costs.
The method is, however, more complex than the other methods because estimations must be made about additional processing costs and potential future sales values.

LO.4: How are by-product and scrap accounted for?

Accounting for By-Product and Scrap
General
Because the distinction between by-product and scrap is one of degree, these categories are discussed together by presenting several of the treatments found in practice.
The appropriate choice of method depends on the magnitude of the net realizable value of the item and the need for additional processing beyond split-off.
As the sales value of the by-product increases, so does the need for inventory recognition.
Sales value of the by-product is generally recorded under either the NRV approach or realized value approach.
Text Exhibit 11-11 provides data for a by-product that is produced by Harkins Poultry.
Net realizable value (NRV) approach
The net realizable value (or offset) approach is a method of accounting for by-products or scrap that requires the net realizable value of such products to be treated as a reduction in the cost of the primary products.
The NRV is debited to inventory and one of two accounts may be credited:WIP Inventory – Joint Products or Cost of Goods Sold.
Although reducing joint cost by the NRV of the by-product/scrap is the traditional method used to account for such goods, it is not necessarily the best method for internal decision making or the management of by-products/scrap.
The NRV method does not indicate the revenues, expenses, or profits from the by-product and thus does not provide sufficient information for managerial decision making.
When management considers by-product/scrap to be a moderate source of income, the accounting and reporting methods used should help managers monitor production and further processing of the by-product/scrap.
Realized value approach
The realized value (or other income) approach is a method of accounting for by-product/scrap that does not recognize any value for these products until they are sold; the value recognized at the time of sale can be treated as other revenue or as other income.
The total sales price of the by-product/scrap is shown on the income statement as other revenue under the “other revenue” method.
Additional processing or disposal costs of the by-product/scrap are included with the cost of producing the primary products, so little useful information is provided to management since the cost of producing the by-product/scrap is not matched with the revenues generated by those items.
The net by-product revenue is presented as an enhancement of net income in the period of sale as “other income” under the “other income” method.
By-product/scrap revenue is matched with related storage, further processing, transportation, and disposal costs.
Since detailed information on financial responsibility and accountability is provided, control and performance may be improved.
Text Exhibit 11-12 shows four comparative income statements using different methods of accounting for the by-product/scrap income for the example company.
With the trend toward more emphasis on cost and quality control, companies are becoming more aware of the potential value of by-product, scrap, and waste and are devoting time and attention to developing those innovative revenue sources.
By-Product and Scrap in Job Order Costing
Job order costing systems can have by-products or scrap even though joint products are not normally associated with such systems.
The value of by-product/scrap in a job order costing system should be credited to manufacturing overhead if the by-products/scrap value is created by a significant proportion of all jobs undertaken.
The by-product/scrap value, in contrast, can be credited to the specific jobs in process if only a few specific jobs generate a disproportionate share of the by-products/scrap.

LO.5: How should not-for-profit organizations account for the cost of a joint activity?

Joint Costs in Service Businesses and Not-for-Profit Organizations
Joint costs in service businesses and not-for-profit (NFP) organizations often do not relate to production processes but to marketing and promotion activities such as:
advertising multiple products;
printing multipurpose documents; or
holding multipurpose events.
Service businesses may allocate joint costs using either a physical or monetary base.
Joint costs for service businesses usually relate to advertisements rather than to a process.
Service businesses may decide it is not necessary to allocate joint costs.
Although service businesses may decide that allocating joint cost is not necessary, financial accounting requires that not-for-profit organizations allocate joint costs among the activities of fund-raising, offering an organizational program (program activities), or conducting an administrative function (management and general activities).
No specific allocation method is prescribed; only that the method used must be rational and systematic, result in reasonable allocations, and be applied in the same manner under similar situations.
A major purpose of this allocation process is to ensure that external users of financial statements are able to determine clearly the amounts spent by the organization for various activities—especially fundraising.
There are three tests that must be met for allocation; if all the tests are not met, all the costs associated with the joint activity must be charged to fundraising:
The purpose test must demonstrate that the activity’s purpose includes accomplishing some program or management/general function.
A critical element under the purpose test is the compensation test. If a majority of compensation or fees for anyone performing a part of the activity is tied to contributions raised, the activity automatically fails the purpose criterion and all costs of the activity must be charged to fundraising.
The audience test must demonstrate that the NFP chose the audience because it is suitable for accomplishing the activity’s program or management/general functions.
The content test must demonstrate that the activity’s content supports program or management/general functions.

Multiple Choice Questions