By-Product Costing and Joint Product Costing
A company needs to use joint costing or by-product costing if it has a central production process from which final products are split off during a later stage of production. The point at which the business can determine the final product is called the split-off point. There may even be several split-off points; at each one, another product can be clearly identified, and is physically split away from the production process, possibly to be further refined into a finished product. If the company has incurred any manufacturing costs prior to the split-off point, it must designate a method for allocating these costs to the final products. If the entity incurs any costs after the split-off point, the costs are likely associated with a specific product, and can be more readily assigned to them.
Besides the split-off point, there may also be one or more by-products. A by-product is a product that arises from a manufacturing process, but whose sales are minor in comparison to the sales of the primary products generated by the manufacturing process. Given the immateriality of by-product revenues and costs, byproduct accounting tends to be a minor issue.
If a company incurs costs prior to a split-off point, it must allocate them to products, under the dictates of both generally accepted accounting principles and international financial reporting standards. If you were not to allocate these costs to products, then you would have to treat them as period costs, and would charge them to expense in the current period. This may be an incorrect treatment of the cost if the associated products were not sold until some time in the future, since you would be charging a portion of the product cost to expense before realizing the offsetting sale transaction.
Allocating joint costs does not help management, since the resulting information is based on essentially arbitrary allocations. Consequently, the best allocation method does not have to be especially accurate, but it should be easy to calculate, and be readily defensible if it is reviewed by an auditor.
How to Allocate Joint Costs
There are two common methods for allocating joint costs. One allocates costs based on the sales value of the resulting products, while the other is based on the estimated final gross margins of the resulting products. The calculation methods follow:
- Allocate based on sales value. Add up all production costs through the split-off point, then determine the sales value of all joint products as of the same split-off point, and then assign the costs based on the sales values. If there are any by-products, do not allocate any costs to them; instead, charge the proceeds from their sale against the cost of goods sold. This is the simpler of the two methods.
- Allocate based on gross margin. Add up the cost of all processing costs that each joint product incurs after the split-off point, and subtract this amount from the total revenue that each product will eventually earn. This approach requires additional cost accumulation work, but may be the only viable alternative if it is not possible to determine the sale price of each product as of the split-off point (as was the case with the preceding calculation method).
Price Formulation for Joint Products and By-Products
The costs allocated to joint products and by-products should have no bearing on the pricing of these products, since the costs have no relationship to the value of the items sold. Prior to the split-off point, all costs incurred are sunk costs, and as such have no bearing on any future decisions – such as the price of a product.
The situation is quite different for any costs incurred from the split-off point onward. Since these costs can be attributed to specific products, you should never set a product price to be at or below the total costs incurred after the split-off point. Otherwise, the company will lose money on every product sold.
If the floor for a product’s price is only the total costs incurred after the split-off point, this brings up the odd scenario of potentially charging prices that are lower than the total cost incurred (including the costs incurred before the split-off point). Clearly, charging such low prices is not a viable alternative over the long term, since a company will continually operate at a loss. This brings up two pricing alternatives:
- Short-term pricing. Over the short term, it may be necessary to allow extremely low product pricing, even near the total of costs incurred after the split-off point, if market prices do not allow pricing to be increased to a long-term sustainable level.
- Long-term pricing. Over the long term, a company must set prices to achieve revenue levels above its total cost of production, or risk bankruptcy.
In short, if a company is unable to set individual product prices sufficiently high to more than offset its production costs, and customers are unwilling to accept higher prices, then it should cancel production – irrespective of how costs are allocated to various joint products and by-products.
The key point to remember about the cost allocations associated with joint products and by-products is that the allocation is simply a formula – it has no bearing on the value of the product to which it assigns a cost. The only reason we use these allocations is to achieve valid cost of goods sold amounts and inventory valuations under the requirements of the various accounting standards.