Chapter Seven

Cost Allocation:
I. Joint products And Byproducts
Preceding chapters have emphasized costing for companies that produce only a single product
or companies that produce several products in separate processes. We now consider the
relatively more-complex case in which companies produce two or more products
simultaneously in the same process (es).
Joint costs are the costs of a production process that yields multiple products simultaneously.
Consider the distillation of coal, which yields coke, natural gas, and other products. The cost
of this distillation is called a joint cost. The splitoff point is the juncture in a joint production
process when two or more products become separately identifiable. An example is the point at
which coal becomes coke, natural gas, and other products. Separable costs are all costs-
manufacturing, marketing, distribution, and so on incurred beyond the splitoff point that are
assignable to each of the specific products identified at the splitoff point. At or beyond the
splitoff point, decisions relating to sale or further processing of each identifiable product can
be made independently of decisions about the other products.
Industries abound in which a production process simultaneously yields two or more
products, either at the splitoff point or after further processing. No individual product can be
produced without the accompanying products appearing, although in some cases the
proportions can be varied. For example, a refinery cannot only produce gasoline from crude
oil; it also simultaneously produces kerosene, benzene and naphtha. The focus of joint
costing is on assigning costs to individual products at the splitoff point. The focus here
contrasts with the focus in preceding chapters, which emphasized assigning costs to individual
products as assembly occurs.
The outputs of a joint production process can be classified into two general categories: outputs
with a positive sales value and outputs with a zero sales value. The term product describes
any output that has a positive sales value (or an output that enables an organization to avoid
incurring costs).The sales value can be high or low. When a joint production process yields
only one product with a high sales value, compared with the sales values of the other products
of the process, that product is called a main product. When a joint production process yields
two or more products with high sales values compared with the sales values of the other
products, those products are called joint products. The other products of a joint production
process that have low sales values compared with the sales value of the main product or joint
products are called byproduct. For example, if timber (logs) is processed into standard lumber
and wood chips, the standard lumber is a main product and the wood chips are the byproduct.
That’s because the standard lumber has a high sales value compared with the wood chips. If,
on the other hand, logs are processed into fine-grade lumber, standard lumber, and wood chips,
the fine-grade lumber and standard lumber are joint products, and the wood chips are the
byproduct. That’s because both the fine-grade lumber and the standard lumber have high sales
values compared with the wood chips. Some outputs of the joint production process have zero
sales value. For example, the offshore processing of hydrocarbons to obtain oil and gas also
yields water that has zero sales value and is recycled back into the ocean. Similarly, the
processing of mineral ore to obtain gold and silver also yields dirt that has zero sales value and
is recycled back into the ground. No journal entries are made in the accounting system to
record the processing of outputs with zero sales value, because there is no value to record.
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The distinctions represented are not always definite in practice. For example, some companies
may classify the kerosene obtained when refining crude oil as a byproduct because they
believe kerosene has low sales value relative to the sales values of gasoline and other products.
Other companies may classify kerosene as a joint product because they believe kerosene has
high sales value relative to the sales values of gasoline and other products. Moreover, the
classification of products – main, joint, or byproduct – can change over time, especially for
products such as lower-grade semiconductor chips whose market prices can increase or
decrease by, say, 30% or more in any one year. When prices of lower-grade chips are high,
they are considered joint products together with higher-grade chips; when prices of lower-
grade chips fall, the chips are considered byproducts. Be sure you understand how terms are
used and how products are classified by the company you are dealing with.
Why Allocate Joint Costs?
Here are some of the contexts that require joint costs to be allocated to individual products or
services:
1. Computation of inventoriable costs and cost of goods sold for financial accounting
purposes and reports for income tax authorities.
2. Computation of inventoriable costs and cost of goods sold for internal reporting
purposes. Such reports are used in division profitability analysis and affect evaluation
of division managers’ performance.
3. Cost reimbursement under contracts for companies that have a few, but not all, of their
products or services reimbursed under cost-plus contracts with, say, a government
agency.
4. Insurance-settlement computations for damage claims made on the basis of cost
information by businesses having joint products, main products, or byproducts.
5. Rate regulation for one or more of the jointly produced products or services that are
subject to price regulation. 2
6. Litigation in which costs of joint products are key inputs.
Approaches to Allocating Joint Costs
Two approaches are used to allocate joint costs.
 Approach 1. Allocate joint costs using market-based data such as revenues. This
chapter illustrates three methods that use this approach:
a. Sales value at splitoff method
b. Net realizable value (NRV) method
c. Constant gross-margin percentage NVR method
 Approach 2. Allocate joint costs using physical measures, such as the
weight (in, say, kilograms) or volume (in, say, cubic feet) of the joint products.
In preceding chapters, we used the cause-and-effect and benefits-received criteria for guiding
cost-allocation decisions. Joint costs do not have a cause-and-effect relationship with
individual products; that’s because the production process simultaneously yields multiple
products. Using the benefits-received criterion leads to a preference for methods under
approach 1. Revenues are, in general, a better indicator of benefits received than physical
measures. Mining companies, for example, receive more benefits from 1 ton of gold than they
do from 10 tons of coal. In the simplest joint production process, the joint products are sold at
the splitoff point without further processing. We begin with the simplest case (Example 1) to
illustrate the sales value at splitoff method and the physical-measure method. Then we
introduce joint production processes that yield products that require further processing beyond
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the splitoff point (Example 2). Example 2 illustrates the NRV method and the constant-gross
margin percentage NRV method. To help you focus on key concepts, we use numbers and
amounts in all examples in this chapter that are much smaller than the numbers that are
typically present in practice. To facilitate comparisons across the methods described earlier,
we report gross-margin percentages for individual products under each method.
Example 1: Farmers’ Dairy purchases raw milk from individual farms and processes it until
the splitoff point, when two products—cream and liquid skim—emerge. These two products
are sold to an independent company, which markets and distributes them to supermarket and
other retail outlets.
Summary data for May 2004 are
 Raw milk processed, 110,000 gallons; 10,000 gallons are lost in the production process
due to evaporation, spillage, and the like, yielding 25,000 gallons of cream and 75,000
gallons of liquid skim.
Production Sales
 Cream 25,000 gallons 20,000 gallons at Br.8 per gallon
 Liquid skim 75,000 gallons 30,000 gallons at Br.4 per gallon
 Inventories

Beginning Ending
Inventory Inventory
Raw milk 0 gallons 0 gallons
Cream 0 gallons 5,000 gallons
Liquid skim 0 gallons 45,000 gallons
 Cost of purchasing 110,000 gallons of raw milk and processing it until the splitoff
point to yield cream and liquid skim, Br.400, 000.
How much of the Br.400,000 joint costs should be allocated to the cost of goods sold of 20,000 gallons
of cream and 30,000 gallons of liquid skim, and how much should be allocated to the ending inventory
of 5,000 gallons of cream and 45,000 gallons of liquid skim? The joint production costs of Br.400, 000
cannot be traced to either product. That’s because the products are not separated until the splitoff point.
Joint-cost-allocation methods can be used for determining the costs of cream and liquid skim sold and
for costing the inventories of cream and liquid skim.
1. A Sales Value at Splitoff Method
The sales value at splitoff method allocates joint costs to joint products on the basis of the
relative total sales value at the splitoff point of the total production of these products during the
accounting period. We illustrate the allocation of joint costs to individual products in
proportion to total sales value at splitoff for Example 1:
Liquid
Cream Skim Total
1. Sales value of total production at splitoff point
(cream, 25,000 gallons X Br.8/gallon;
liquid skim, 75,000 gallons X Br.4/gallon) Br.200,000 Br.300,000 Br.500,000
2. Weighting (Br.200,000 ÷ Br.500,000; Br.300,000÷ Br.500,000) 0.40 0.60
3. Joint costs allocated (cream, 0.40 X Br.400,000;
liquid skim, 0.60 X Br.400,000) Br.160,000 Br.240,000 Br.400,000
4. Joint production cost per gallon
(cream, Br.160,000÷ 25,000 gallons;
liquid skim, Br.240,000 ÷ 75,000 gallons) Br.6.40/gal. Br.3.20/gal.
This method uses the sales value of the entire production of the accounting period. The reason is
that the joint costs were incurred on all units produced, not just the portion sold during the

3
current period. Exhibit 7-1 presents the product-line income statement using the sales value at
splitoff method. Both cream and liquid skim has gross-margin percentages of 20%.
You can now see why the sales value at splitoff method follows the benefit-received criterion of cost
allocation: Costs are allocated to products in proportion to their expected revenues. This method is both
straightforward and intuitive. The cost-allocation base (total sales value at splitoff) is expressed in
terms of a common denominator (the amount of revenue) that is systematically recorded in the
accounting system. To use this method, a company needs the market selling prices for all products at
the splitoff point.

Exhibit 7-1 Joint Costs Allocated Using Sales Value at Splitoff Method: Farmers' Dairy
Product-Line Income Statement for May 2004
Liquid
Cream Skim Total
Revenues (cream, 20,000 gal. X Br.8/gal.;
liquid skim, 30,000 gal. X Br.4/gla.) Br.160,000 Br.120,000 Br.280,000
Costs of goods sold (joint costs)
Production costs (cream, 0.40 X Br.400,000;
liquid skim, 0.60 X Br.400,000) 160,000 240,000 400,000
Deduct ending inventory
(cream, 5,000 gal. X Br.6.40/gal.;
liquid skim, 45,000 gal. X Br.3.20/gal.) 32,000 144,000 176,000
Cost of goods sold (joint costs) 128,000 96,000 224,000
Gross margin Br. 32,000 Br. 24,000 Br. 56,000
Gross-margin percentage 20% 20% 20%
Physical-Measure Method
The physical-measure method allocates joint costs to joint products on the basis of the relative weight,
volume, or other physical measure at the splitoff point of the total production of these products during
the accounting period. In Example 1, the Br.400, 000 joint costs produced 25,000 gallons of cream and
75,000 gallons of liquid skim. Using the number of gallons produced as the physical measure, joint
costs are allocated as follows:
Liquid
Cream Skim Total
1. Physical measure of total production (gallons) 25,000 75,000 100,000
2. Weighting (cream, 25,000 gallons ÷ 100,000 gallons;
liquid skim 75,000 gallons ÷ 100,000 gallons) 0.25 0.75
3. Joint costs allocated (cream, 0.25 X Br.400,000;
liquid skim, 0.75 X Br.400,000) Br.100,000 Br.300,000 Br.400,000
4. Joint production cost per gallon (cream, Br.100,000÷
25,000 gallons; liquid skim, Br.300,000 ÷ 75,000 gallons) Br.4/gal. Br.4/gal.
Exhibit 7-2 presents the product-line income statement using the physical-measure method.
The gross-margin percentages are 50% for cream and 0% for liquid skim.

Exhibit 7-2 Joint Costs Allocated Using Physical-Measure Method: Farmers' Dairy
Product-Line Income Statement for May 2004

Liquid
Cream Skim Total
Revenues (cream, 20,000 gal. X Br.8/gal.;
liquid skim, 30,000 gal. X Br.4/gla.) Br.160,000 Br.120,000 Br.280,000
Costs of goods sold (joint costs)
Production costs (cream, 0.25 X Br.400,000;
liquid skim, 0.75 X Br.400,000) 100,000 300,000 400,000
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Deduct ending inventory
(cream, 5,000 gal. X Br.4/gal.;
liquid skim, 45,000 gal. X Br.4/gal.) 20,000 180,000 200,000
Cost of goods sold (joint costs) 80,000 120,000 200,000
Gross margin Br. 80,000 Br. 0 Br. 80,000
Gross-margin percentage 50% 0% 28.6%
Under the benefits-received criterion, the physical-measure method is less preferred than the
sales value at splitoff method. Why? Because it has no relationship to the revenue-producing
power of the individual products. Consider a gold mine that extracts ore containing gold,
silver, and lead. Use of a common physical measure (tons) would result in almost all costs
being allocated to lead—the product that weighs the most but has the lowest revenue-
producing power. In this case, the method of cost allocation is inconsistent with the reason for
the mine owner incurring mining costs—to find gold and silver, not lead.
Obtaining comparable physical measures for all products is not always straightforward.
Consider the joint costs of producing oil and gas; oil is a liquid and gas is a vapor. To use a
physical measure, such as barrels, in this context requires technical assistance from petroleum
engineers on how to convert the vapor into a measure that can be added to barrels of oil. For
example, gas could be converted to barrels of oil based on the energy equivalent of the gas and
oil. Technical personnel outside of accounting may be required when using some physical
measures to allocate joint costs. Determining which products of a joint process to include in a
physical-measure computation can greatly affect the allocations between or among those
products. Outputs with no sales value (such as dirt in gold mining) are always excluded.
Although many more tons of dirt than gold is produced, costs are not incurred to produce
outputs that have zero sales value. Byproducts with low sales values relative to the joint
products or the main product also are often excluded from the denominator used in the
physical-measure method. The general guideline for the physical-measure method is to include
only the joint-product outputs in the weighting computations.
1.b Net Realizable Value (NRV) Method
In many cases, products are processed beyond the splitoff point to bring them to a marketable
form or to increase their value above their selling price at the splitoff point. To illustrate, let’s
extend the Farmers Dairy example.
Example 2: Assume the same data as in Example 1 except that here both cream and liquid
skim can be processed further:
 Cream Butter cream: 25,000 gallons of cream are further processed to yield 20,000
gallons of buttercream at additional processing costs of Br.280, 000. Butter cream,
which sells for Br.25 per gallon, is used in the manufacture of butter-based products.
 Liquid Skim Condensed Milk: 75,000 gallons of liquid skim are further processed to
yield 50,000 gallons of condensed milk at additional processing costs of Br.520, 000.
Condensed milk sells for Br.22 per gallon.
Sales during the accounting period were 12,000 gallons of butter cream and 45,000 gallons of
condensed milk. Inventory information follows:
Beginning Ending
Inventory Inventory
Raw milk 0 gallons 0 gallons
Cream 0 gallons 0 gallons
Liquid skim 0 gallons 0 gallons
Butter cream 0 gallons 8,000 gallons
Condensed milk 0 gallons 5,000 gallons

5
The net realizable value (NRV) method allocates joint costs to joint products on the basis of
the relative NRV – the final sales value minus the separable costs – of the total production of
the joint products during the accounting period. The NRV method is typically used in
preference to the sales value at splitoff method only when we don’t know the market selling
prices for one or more products at splitoff. Joint costs in this example are allocated as follows:

Condensed
Butter cream Milk Total
1. Final sales value of total production
(butter cream, 20,000 gallons x Br.25/gallon;
condensed milk, 50,000 gallons x Br.22/gallon) Br.500,000 Br.1,100,000 Br.1,600,000
2. Deduct separable costs to complete and sell 280,000 520,000 800,000
3. Net realizable value at splitoff point Br.220,000 Br. 580,000 Br.
800,000
4. Weighting (Br.220,000 ÷ Br.800,000; Br.580,000 ÷ Br. 800,000)0.275 0.725
5. Joint costs allocated (buttercream, 0.275 x Br.400,000;
condensed milk, 0.725 x Br.400,000) Br.110,000 Br. 290,000 Br. 400,000
6. Production cost per gallon
(butter cream, [Br.110,000 + Br.280,000] ÷ 20,000 gallons;
condensed milk, [Br.290,000 + Br. 520,000] ÷ 50,000 gallons) Br.19.50/gal. Br.16.20/gal.
Exhibit 7-3 presents the product-line income statement using the estimated NRV method. The
gross-margin percentages are 22.0% for butter cream and 26.4% for condensed milk.
Exhibit 7-3 Joint Costs Allocated Using NRV Method: Farmers' Dairy Product-Line
Income Statement for May 2004
Condensed
Butter cream Milk Total
Revenues (Buttercream, 12,000 gal. x Br.25/gal.;
condensed milk, 45,000 gal. x Br.22/gal.) Br.300, 000 Br.990, 000 Br.1, 290,000
Costs of goods sold
Joint costs (buttercream, 0.275 x Br.400,000;
condensed milk, 0.725 x Br.400,000) 110,000 290,000 400,000
Separable costs 280,000 520,000 800,000
Cost of goods available for sale 390,000 810,000 1,200,000
Deduct ending inventory
(buttercream, 8,000 gal. x Br.19.50/gal.;
condensed milk, 5,000 gal. x Br.16.20/gal.) 156,000 81,000 237,000
Cost of goods sold 234,000 729,000 963,000
Gross margin Br. 66,000 Br.261,000 Br. 327,000
Gross-margin percentage 22.0% 26.4% 25.3%
The NRV method is often implemented using simplifying assumptions. For example,
companies that frequently change the number of processing steps beyond the splitoff point
often assume a specific set of such steps. Also, if the selling prices of joint products vary
frequently, a given set of selling prices may be consistently used throughout the accounting
periods.
Because the sales value at splitoff method does not require knowledge of the processing
steps beyond the splitoff point, it is less complex than the NRV method. However, using the
sales value at splitoff method is not always feasible. That’s because there may not be market
prices for at least one of the products at the splitoff point. Market prices may only be
available after processing occurs beyond the splitoff point.
1.c Constant Gross-Margin Percentage NRV Method

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The constant gross-margin percentage NRV method allocates joint costs to joint products in
such a way that the overall gross-margin percentage is identical for the individual
products. This method entails three steps. Exhibit 7-4 shows these three steps for allocating
the Br.400,000 joint costs between buttercream and condensed milk in the Farmer’ Dairy
example. As we describe each step, refer to Exhibit 7-4 for an illustration of the step.
 Step 1: Compute the overall gross-margin percentage for all joint products together.
Note, Exhibit 7-4 uses the final sales value of the total production during the
accounting period, Br.1,600,000, not the total sales of the period, to calculate the
overall gross-margin percentage of 25%.
 Step 2: Multiply the overall gross-margin percentage and the final sales values of each
product to calculate the gross-margin for each product. Subtract the gross-margin for
each product from the final sales value of each product to obtain the total costs that
each product will bear.
 Step 3: Deduct the separable costs from the total cost that each product will bear to
obtain the joint-cost allocation.
The joint costs allocated to a product can be negative under this method. Some products
may receive negative allocations of joint costs to bring their gross-margin percentages up
to the overall average. Exhibit 7-5 presents the product-line income statement for the
constant gross-margin percentage NRV method.
The constant gross-margin percentage NRV method is different in one fundamental way from
the two other market-based joint-cost-allocation methods described earlier. The sales value at
splitoff method and the NRV method allocate only the joint costs to the joint products.
Neither method takes account of profits earned either before or after the splitoff point when
allocating the joint costs. In contrast, the constant gross-margin percentage NRV method is
both a joint-cost method and profit-allocation method. The total difference between the sales
value of production of all products and the separable cost of all products includes both (a) the
joint costs and (b) the total gross margin. Gross margin is allocated to the joint products under
the constant gross-margin method to determine the joint-cost allocations so that each product
has the same gross-margin percentage.
Exhibit 7-4
Step 1

Final sales value of total production during the accounting period:

(20,000 gal. X Br.25/gal.) + (50,000 gal. X Br.22/gal. Br.1,600,000
Deduct joint and separable costs (Br.400,000 + Br.280,000 + Br.520,000) 1,200,000
Gross margin Br. 400,000
Gross-margin percentage (Br.400,000 ÷ 1,6000,000) 25%
Step 2
Condensed
Buttercream Milk Total
Final sales value of total production during
total accounting period:
(buttercream, 20,000 gal. X Br.25/gal.)
condensed milk, 50,000 gal. X Br.22/gal.) Br.500,000 Br.1,100,000 Br.1,600,000
Deduct gross margin, using overall
gross-margin percentage (25%) 125,000 275,000 400,000
Cost of goods available for sale 375,000 825,000 1,200,000

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Step 3

Deduct separable costs to complete and sell 280,000 520,000 800,000

Joint costs allocated Br. 95,000 Br. 305,000 Br. 400,000

Exhibit 7-5
Condensed
Buttercream Milk Total
Revenues (buttercream, 12,000 gal. x Br.25/gal.;
condensed milk, 45,000 gal. x Br.22/gal.) Br.300,000 Br.990,000 Br.1,290,000
Costs of goods sold
Joint costs (Exhibit 7-4) 95,000 305,000 400,000
Separable costs 280,000 520,000 800,000
Cost of goods available for sale 375,000 825,000 1,200,000
Deduct ending inventory
(buttercream, 8,000 gal. x Br.18.75/gal.;a
condensed milk, 5,000 gal. x Br.16.50/gal.)b 150,000 82,000 232,500
Cost of goods sold 225,000 742,500 967,500
Gross margin Br. 75,000 Br.247,500 Br. 322,000
Gross-margin percentage 25% 25% 25%
a
Br.375,000 ÷ 20,000 gallons = Br.18.75/gallon.
b
Br.825,000 ÷ 50,000 gallons = Br.16.50/gallon.
Choosing a Method
Which method of allocating joint costs should be used? Use the sales value at splitoff method
when selling-price data are available (even if further processing is done). Reasons for using
the sales value at splitoff method include:
1. It measures the value of the joint product immediately at the end of the joint process.
The sales value at splitoff is the best measure of the benefits received as a result of joint
processing relative to the other methods of allocating joint costs.
2. No anticipation of subsequent management decisions. The sales value at splitoff
method does not require information on the processing steps after splitoff, if there is
further processing. In contrast, the NRV method and constant gross-margin percentage
NRV method require information on (a) the specific sequence of further processing
decisions (b) the separable costs of further processing, and (c) the point at which individual
products are sold.
3. Availability of a meaningful basis to allocate joint costs to products. The sales value at
splitoff method and the other market-based methods have a meaningful basis to allocate
joint costs to products, which is revenues. In contrast, the physical-measure method may
lack a meaningful basis that can be used to allocate joint costs to individual products.
4. Simplicity. The sales value at splitoff method is simple. In contrast, the NRV and
constant gross-margin percentage NRV methods can be complex for processing operations
having multiple products and multiple splitoff points. This complexity is increased when
management makes frequent changes in the specific sequence of post splitoff processing
decisions or in the point at which individual products are sold.

8
When selling prices of all products at the splitoff point are not available, other joint-cost-
allocation methods are used. The NRV method attempts to approximate the sales value at
splitoff by subtracting separable costs incurred after the splitoff point on each product from
selling prices. The NRV method assumes that all the markup or profit margin is attributable to
the joint process and none of the markup is attributable to the separable costs. Profit, however,
is attributable to all phases of production and marketing, not just the joint process. Despite its
complexities, the NRV method is used when selling prices at splitoff are not available. It is a
better measure of benefits received compared with the constant gross-margin percentage NRV
method and the physical-measure method.
The main advantage of the constant gross-margin percentage NRV method is that it is easy
to implement. This method treats the joint products as though they comprise a single product
by calculating an aggregate gross-margin percentage. The method then applies this gross-
margin percentage to each product and backs into the joint costs allocated to each product.
This method avoids the complexities inherent in the NRV method to measure the benefits
received by each of the joint products at the splitoff. The main issue with the constant gross-
margin percentage NRV method is the assumption that all the products have the same ratio of
cost to sales value. A constant ratio of cost to sales value across products is very uncommon
in companies that produce multiple products that do not involve joint costs.
Although there are difficulties in using the physical-measure method—the lack of congruence
with the benefits-received criterion and the possible lack of a meaningful common
denominator for allocating the joint costs—there are instances when it may be preferred.
Consider rate regulation. Market-based measures are difficult to use in the context of rate or
price regulation. It is circular reasoning to use selling prices as a basis for setting prices (rates)
and at the same time use selling prices to allocate the costs on which prices (rates) are based.
To avoid this circular reasoning, the physical-measure method may be used in rate regulation.
Not Allocating Joint Costs
The preceding methods for allocating joint costs to individual products are all somewhat
arbitrary, so some companies do not allocate joint costs to products. Instead, they carry their
inventories at NRV. Income on each product is recognized when production is completed.
Industries that use variations of this no-allocation approach include meatpacking, canning, and
mining.
Accountants do not ordinarily carry inventories at NRV. That’s because by carrying inventory
at NRV, income is recognized before sales are made. In response, some companies using this
no-allocation approach carry their inventories at NRV minus an estimated operating income
margin. The result is that in the year of production, all of the joint costs of that accounting
period are matched against the estimated revenues from the production of that accounting
period. When any end-of-period inventories are sold in the next period, the cost of goods sold
will be the NRV minus the estimated operating income margin shown for the ending inventory
of the previous accounting period.
Irrelevance of Joint Costs for Decision Making
Should the joint costs allocated to the joint products be used in making pricing decisions for
each joint product? No. Why not? Because all joint-cost allocations to products are somewhat
arbitrary. There is no cause-and-effect relationship that identifies the resource demanded by
each joint product that can then be used as a basis for pricing. The way it is in much of joint-
costing, selling prices drive joint-cost allocations; cost allocations do not drive pricing.
Sell or Process Further

9
The decision to incur additional costs for further processing should be based on the
incremental operation income attainable beyond the splitoff point. Example 2 assumed it was
profitable for both cream and liquid skim to be further processed, respectively, into
buttercream and condensed milk. The incremental analysis for these decisions to process
further is
Further Processing Cream in to Butter cream
Incremental revenues
(Br.25/gallon x 20,000 gallons) – (Br.8/gallon X 25,000 gallons) Br.300,000
Deduct incremental processing costs 280,000
Increase in operating income from buttercream Br.20,000
Further Processing Liquid Skim into Condensed Milk
Incremental revenues
(Br.22/gallon x 50,000 gallons) – (Br.4/gallon X 75,000 gallons) Br.800,000
Deduct incremental processing costs 520,000
Increase in operating income from condensed milk Br.280,000
In this example, operating income increases for both products, so the manager should process
cream into buttercream and liquid skim into condensed milk. The Br.400,000 joint costs
incurred up to splitoff—and how they are allocated—are irrelevant in deciding whether to
process further. Why irrelevant? Because the joint costs of Br.400,000 are the same whether
or not further processing occurs.
Incremental costs are the additional costs incurred for an activity, such as processing further.
Do not assume all separable costs in joint-cost allocations are always incremental costs. Some
separable costs may be fixed costs, such as lease costs on buildings where the further
processing is done; some separable costs may be sunk costs, such as depreciation on the
equipment that converts cream into buttercream; some separable costs may be allocated costs,
such as corporate costs allocated to the condensed milk operations. None of these costs will
differ between the alternatives of selling products at the splitoff point or processing further.
Joint-Cost Allocation and Performance Evaluation
The potential conflict between cost concepts used for decision making and cost concepts used
for evaluating the performance of managers could also arise in sell-or-process-further
decisions. To see how, let’s continue with Example 2. Suppose allocated fixed costs of further
processing cream into buttercream equal Br.45,000 and that these costs will only be charged to
buttercream and to the manager’s product-line income statement if buttercream is produced.
How might this affect the decision to process further?
As we have seen, on the basis of incremental revenues and incremental costs, Farmers’ Dairy’s
operating income will increase by Br.20,000 by processing the cream into butter-cream.
However, producing the buttercream also results in an additional charge for allocated fixed
costs of Br.45,000. If the manager is evaluated on a full-cost basis (that is, after allocating all
costs), processing cream into buttercream will lead to the manager’s performance-evaluation
measure being lower by Br.25,000 (incremental operating income, Br.20,000, - allocated fixed
costs, Br.45,000). Therefore, the manager may be tempted to sell cream directly and not
process it into buttercream.
A similar conflict can also arise with respect to production of joint products. Consider again
Example 1. Suppose Farmers’ Dairy has the option of selling raw milk at a profit of Br.20,000.
From a decision-making standpoint, Farmers should process raw milk into cream and liquid
skim because the total revenues from selling both joint products (Br.500,000) exceed the joint
costs (Br.400,000) by Br.100,000 (which is greater than the Br.20,000 Farmers’ Dairy would

10
make if it did not process). Suppose, however, the cream and liquid skim product lines are
managed by different managers, each of whom is evaluated based on a product-line income
statement. If the physical-measure method of joint-cost allocation is used and the selling price
per gallon of liquid skim falls below Br.4.00 per gallon, the liquid skim product line will show
a loss (from Exhibit 6-5, revenues will be less than Br.120,000, but cost of goods sold will be
unchanged at Br.120,000). The manager of the liquid skim line will prefer, from his
performance-evaluation standpoint, to not produce the liquid skim and sell the raw milk
instead.
This conflict between decision making and performance evaluation is less severe if Farmers
uses any of the market-based methods of joint-cost allocations-sales value at split off, NRV, or
constant gross-margin percentage NRV. That’s because each of these methods allocates costs
on the basis of revenues that generally lead to positive incomes for each joint product.
ACCOUNTING FOR BYPRODUCTS
Joint production processes may yield not only joint products and main products but byproducts
as well. Although byproducts have much lower sales values than the sales values of joint or
main products, the presence of byproducts in a joint production process can affect the
allocation of joint costs. Let’s consider a two-product example consisting of a main product
and a byproduct.
Example: 3 The Meat works Group processes meat from slaughterhouses. One of its
departments cuts lamb shoulders and generates two products:
 Shoulder meat (the main product)- sold for Br.60 per pack
 Hock meat (the byproduct)- sold for Br.4 per pack (net of any selling costs)
Data under each column indicate the number of packs for this department in July 2004 are
Beginning Ending
Production Sales Inventory Inventory
Shoulder meat 5,000 4,000 0 1,000
Hock meat 1,000 300 0 700
The joint manufacturing costs of these products in July 2004 were Br.250, 000, comprising
Br.150, 000 for direct materials and Br.100, 000 for conversion costs. Both products are sold
at the splitoff point without further processing, as Exhibit 16-10 shows.
Two byproduct accounting methods are presented. Method A, the production method,
recognizes byproducts in the financial statements at the time production is completed. Method
B, the sale method, delays recognition of byproducts until the time of sale. Recognition of
byproducts at the time of production is conceptually correct. Recognition at the time of sales
often occurs in practice when the birr amounts of byproducts are immaterial. Exhibit 7-6
presents the income statement of the Meatworks Group under both methods.
Exhibit 7-6 Income Statement of Meatworks Group for July 2004

BYPRODUCT ACCOUNTING METHOD

Method A: Method B:
Recognized Recognized
at Production at Sale
Revenues
Main product: shoulder meat (4,000 packs
X Br.60/pack) Br.240,000 Br.240,000
Byproduct: Hock meat (300 packs X Br.4/pack) --- 1,200

11
 Total revenues 240,000 241,200
Costs of goods sold
Total manufacturing costs 250,000 250,000
Deduct byproduct revenue (1,000 packs X Br.4/pack) 4,000 --- .

Net manufacturing costs 246,000 250,000

Deduct main-product inventory 49,200a 50,000b
Cost of goods sold 196,800 200,000
Gross margin Br. 43,200 Br. 41,200
Gross-margin percentage 18.00% 17.08%
Inventoriable costs (end of period):
Main product: shoulder meat Br. 49,200 Br. 50,000
Byproduct: Hock meat (700 packs X Br.4/packs)c 2,800 0
a
(1,000 ÷ 5,000) x net manufacturing cost = (1,000 ÷ 5,000) X Br.246,000 = Br.49,200.
b
(1,000 ÷ 5,000) x total manufacturing cost = (1,000 ÷ 5,000) X Br.250,000 = Br.50,000.
c
Recorded at selling prices.

Method A: Byproducts Recognized at Time Production is Completed

This method recognizes the byproduct in the financial statements – the 1,000 packs of hock
meat – in the month it is produced, July 2004. The NRV from the byproduct produced is
offset against the costs of the main product. The following journal entries illustrate this
method:
1. Work in Process 150,000
Accounts Payable 150,000
To record direct materials purchased and
used in production during July.
2. Work in Process 100,000
Various accounts 100,000
To record conversion costs in the production process
during July; examples include energy, manufacturing
supplies, all manufacturing labor, and plant depreciation.
3. Byproduct Inventory –Hock Meat (1,000 packs x Br.4/pack) 4,000
Finished Goods – Shoulder meat (Br.250,000 -- Br.4,000) 246,000
Work in process (Br.150,000 + Br.100,000) 250,000
To record cost of goods completed during July.
4. a. Cost of Goods Sold [(4,000 packs ÷ 5,000 packs) X Br.246,000] 196,800
Finished Goods – Shoulder Meat 196,800
To record the cost of the main product sold during July.
b. Cash or Accounts Receivable (4,000 packs x Br.60/pack) 240,000
Revenues – Shoulder Meat 240,000
To record the sales of the main product during July.
5. Cash or Accounts Receivable (300 packs x Br.60/pack) 1,200
By product Inventory –Hock Meat 1,200
To record the sales of the byproduct during July.
This method reports the byproduct inventory of hock meat in the balance sheet at its Br.4 per
pack selling price [(1,000 packs - 300 packs) x Br.4/pack = Br.2,800].
One variation of this method would be to report byproduct inventory at its NRV reduced
by a normal profit margin. When the byproduct inventory is sold in a subsequent period, the
income statement would match the selling price with the “net” selling price reported for the
byproduct inventory.
Method B: Byproducts Recognized at Time of Sale
This method makes no journal entries until sale of the byproduct occurs. Revenues of the
byproduct are reported as a revenue item in the income statement at the time of sale. These

12
revenues are either grouped with other sales, included as other income, or deducted from costs
of goods sold. In the Meatworks Group example, byproduct revenues in July 2004 are
Br.1,200 (300 packs x Br.4/pack) because only 300 packs of the hock meat are sold in July (of
the 1,000 packs produced). The journal entries are
1. and 2. Same as for method A
3. Finished Goods – Shoulder Meat 250,000
Work in process 250,000
To record cost of goods completed during July.
4. a. Cost of Goods sold [(4,000 Packs ÷
5,000 Packs) x Br.250,000] 200,000
Finished Goods-Shoulder Meat 200,000
To record the cost of the main product sold during July.
b. Same as for method A.
5. Cash or Accounts Receivable 1,200
Revenues – Shoulder Meat 1,200
To record the sales of the byproduct during July
Method B is used in practice primarily on the grounds that the dollar amounts of byproducts
are immaterial. However, this method permits managers to “manage” reported earnings by
timing when they sell byproducts. Managers may store byproducts for several periods and
give revenues and income a “small boots” by selling byproducts accumulated over several
periods when revenues and profits from the main product or joint products are low.

II. Allocating Costs from One Department to Another.

There are several issues to consider when allocating costs:
 Should different methods of allocation be used for fixed costs and for variable
costs,
 Should budgeted rates or actual rates be used, and
 Should budgeted quantities or actual quantities be used?
Single-Rate and Dual-Rate Methods
The single-rate allocation method pools all costs in one cost pool and allocates theses costs
to cost objects using the same rate per unit of the single allocation base. There is no distinction
between costs in a cost pool in terms of cost behavior, such as fixed costs versus variable
costs.
The dual-rate cost allocation method classifies costs in each cost pool into to sub cost pools,
a variable cost pool and a fixed cost pool. Each of these pools uses a different cost allocation
base.
Example:
Sand Hill Co. has a Central Computer Department; the department has two users,
Microcomputer Division and Peripheral Equipment Division. The following data apply to the
coming budget year.
Fixed costs of operating the computer facility in the
6000-18000hr relevant range Br3, 000,000/year
Total capacity available 18,000hrs
Budgeted long-run usage
Microcomputer Division 8,000hrs
Peripheral Equipment Division 4,000hrs
Total 12,000hrs
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Budgeted variable cost per hour $200/hour used
Assume during the year the Microcomputer uses 9,000 hrs and Peripheral Equipment uses
3,000 actual hours.
1. Single Rate Allocation Method
Total cost pool =3,000,000+200*12,000 5,400,000
Budgeted usage 12,000hrs

Budgeted totals rate per hour= 5,400,000 = Br.450/hr

12,000hrs
Allocation rate for Microcomputer Division Br. 450/hr
Allocation rate for Peripheral Division Br. 450/hr
Microcomputer=9000*450= Br. 4,050,000.
Peripheral Equipment= 3000*450= Br.1, 350,000.

2. Dual-rate Allocation Method

Allocation of Fixed Costs to:
Microcomputer Division = 8000/1200hrs * 3,000,000 = Br. 2,000,000/year.
Peripheral Equipment Division = 4000/12000hrs * 3,000,000 = Br. 1,000,000/year.
Microcomputer: 2,000,000 + (200*9000) = Br. 3,800,000.
Peripheral Equipment: 1,000,000 + (200*3000) = Br. 1,600,000.

III. Allocating Common Costs

A common cost is a cost of operating a facility, activity, or like cost object that is shared by
two or more users.
Consider Ayele, a senior student in Addis Ababa University who has been invited to an
interview with an employer in Mekele. The round trip Addis-Mekele airfare costs
Br.1, 200. A week prior to leaving Ayele is also invited to an interview with an employer in
Dessie. The Addis-Dessiee round trip airfare costs Br. 800. Ayele decided to combine the two
recurring trips into an Addis-Mekele-Dessie trip that will cost $1,500 in airfare. The Br1, 500
is a common cost that benefits both prospective employers.
Two methods of allocating this common cost are:
1. Stand-Alone Cost-Allocation Method
This method uses information pertaining to each user of a cost object as a separate
entity to determine the cost-allocation weights.
For the common cost $1,500, information about the separate (stand alone) round-trip
airfares ($1200, and $800) is used to determine the allocation weights.
Mkele employer: $1,200 * 1,500 = 0.60*1,500= $900
$1,200 + $ 800
Dessie employer: $800 * 1,500 = 0.4 * 1,500 = $600
$800 + $1,200
Advantage: Fairness occurs because each employer bears a proportionate share of total costs
in relation to their individual stand-alone costs.
2. Incremental Cost Allocation Method
 This method ranks the individual users of a cost object and then uses this
ranking to allocate costs among those users.

14
  The first ranked user of the cost object is termed the primary user. The second
ranked user is termed the incremental party and is allocated the additional cost
that arises from there being two users instead of only the primary user.
Assume in the example the Mekele fight is viewed as the primary party. Ayele’s
rational is that he had already committed to go to Mekele before accepting the
invitations to interview in Dessie. The cost allocation would be:

Party Cost Allocated Costs remaining to be

Allocated to other parties

Mekele (primary) $1,200 $300 ($1,500 - $1,200)

Dessie (incremental) 300 0
Had the Dessie employer been chosen as the primary party, the cost allocations would
have been Dessie $800 and Mekele $700(1500-800).

Under the incremental method, the primary party typically receives the highest allocation of
the common costs. Most users in common cost situations propose themselves as the
incremental party.

IV. Allocating Support Department Costs

Departmentalization means dividing the plant into segments called departments or cost pools
to which expenses are charged. In a factory, the manufacturing process consists of a series of
operations performed in cost centers. In general, departments are divided into two categories:
1. Production department
2. Service departments
1. Production departments:
Are departments that perform the actual manufacturing activities. They physically change the
products being processed.
2. Service departments:
Not work directly on the product rather they serve the needs of production and other service
departments.
Examples of service department include factory building maintenance department, personnel
department, fire fighting department, department that generate power of the factory, clinic, etc.
Because the production departments receive the benefit of the work performed by the service
departments, the total cost of production must include not only the costs charged directly to the
production department but also a portion of the costs of operating the service departments.
Therefore, the total product costs should include a share of service department costs.
Departmentalization of FOH is useful for the following reasons:
 It provides more accurate costing of jobs and products
 Responsible control of overhead costs is possible
 It provides useful data for planning and analytical decision- making process
Distributing Service Department Costs
The cost of operating each service departments should be distributed in proportion to the
benefits received by the various service as well as production departments.
Though there is no standard allocation bases, the most usually used bases to distribute service
department costs include the following:
15
 Service dept. Base for distribution
Building maintenance………………Floor space occupied by other depts.
Inspection &packing……………… Production volume
Personnel……………………………Number of workers
Purchasing…………………………..Number of purchase order
Stores……………………………….Units of materials requisitioned
Methods of Distributing Service Department Costs
After the distribution bases have been selected the next step is to distribute the total cost of
each service department to the other departments. There are three common distribution
methods:
1. Direct method
2. Sequential or step down method
3. Algebraic method
1. Direct method:
This method transfers service department costs directly and only to producing departments. It
gives no recognition to services provided to other services departments. The method can be
justified for product costing if there is no material difference in the
cost of producing department when the expenses of service department are not prorated to
other service departments. However, this method fails to measure the total cost for individual
service departments when such information is needed for cost planning & control purposes.
2. Sequential or step down method
This method transfers service department costs to producing departments and some service
departments. It gives some recognition to service provided to other service departments. Here
a decision must be made with respect to the service departments that should be closed first,
because no further distributions are made to a service department once its costs have been
distributed. Usually, expenses are transferred in the order of the amount of service rendered,
with the expenses of the department rendering the greatest amount of service to service
department transferred first. If such information is not available, the department, which has the
largest total expense may be distributed first assuming that the department with the largest
amount of expense rendered the greatest amount of service.
3. Algebraic method
The proration of service department expenses to other service departments may be incomplete
if a department provides services to department from which it receives services. Because using
the procedures discussed above, one department would be closed out before the other and
therefore before receiving any portion from the other. But this method takes into consideration
that some service department not only may provide service to, but may also receive service
from, other service department. So this method transfers service department costs to both
producing departments and benefiting service departments.

16
Example 1
XYZ Manufacturing Company has three service and four Production Departments. The service
departments are power, personnel, and maintenance whereas department A, department B,
department C, and department D are production departments.

The direct FOH charges expected to be made to the departments are as follows.
Power. …………Br 30,000 Dept .A………………$50,000
Maintenance………20,000 Dept B………………...40,000
Personnel………… 10,000 Dept C………………...60,000
Dept D……………...…90,000
The power department serves all departments of the company and its costs are allocated using
kilowatts. Number of employees served and square feet are the bases to distribute personnel
and maintenance department costs, respectively.
Kilowatts consumed:
Maintenance……10,000 Dept B……… 18,000
Personnel………..10,000 Dept C………20,000
Dept A…………..12,000 Dept D………50,000
Floor in square feet:
Personnel………..5,000 Dept B……….6, 000
Dept A…………..5,000 Dept C………..4,000
Dept D………5,000
Number of employees served:
Dept A………30 Dept C………20
Dept B………10 Dept D……….40
Assume that Department A and D use the direct labor hours Department B uses machine hours
and Department C uses direct labor cost to apply FOH .The estimated direct labor hours for
dep’t A&D were 30,800& 30,000,respectively. Machine hours for dep’t B was 3275 and the
estimated direct labor cost for dep’t C was $120,000.
Required:
Distribute the service dep’t costs and calculate the departmental FOH rate using:
1. Direct method
2. Step down method

17
 XYZ Manufacturing Company
Distribution of estimated service department cost and calculation of departmental factory
Power Maintna personnel Dep’t Dep’t Dep’t Dep’t Total
nce A B C D
Total dep’tal FOH before
distribution service dep’ts cost $30,000 $20,000 $10,000 $50,000 $40,000 $60,000 $90,000 $300,000
Distribution of service dep’t
costs:
-Power (Base per Kw hrs) =
30,000 =0.30
100,000
Dep’t A...12,000×$0.30…….. ……… ……… ……… 3,600
Dep’t B…18,000×$0.30…….. ……… ……… ……… 5,400
Dep’t C…20,000×$0.30…….. ……… ……… ……… 6,000
Dep’t D…50,000×$0.30……... ………. ………. ……… 15,000
100,000
-Maintenance :( Base = Square
feet, & the rate is = $20,000=1
20,000
-Dep’t A.. 5,000×$1…………. ……… ………. ………... 5,000
-Dep’t B .. 6,000 x $1……….. ……… ……… ............... 6,000
-Dep’t C.. 4,000 x $ 1………… ……… ……… ............... 4,000
Dep,t D..5,000x $ 1…………. ……….. ………. ............... 5,000
20,000
-Personnel: (Base: No of
employees Served) . Rate per
employee = $10,000 = $100
100
Dep’t A, 30 B,10 C, 20 D,40… ……….. ………. ……….. 3,000 1,000 2,000 4,000

Total service Dep’t costs

distributed…………………….. ……….. ………. ………... $11,600 $12,400 $12,000 $24,000
Total dep’tal FOH after
distribution of service ……….. ………. ………... $61,600 $52,400 $72,000 $114000 $300,000
departments………...
Bases for predetermined FOH
rate:
Direct labor hours (estimated)... ……….. ………. ………... 30,800 ………. ……….. 30,000
Machine hours (estimated)…… ……….. ………. ………... ………. 3,275
Direct labor cost (estimated)…. ……….. ………. ………... ………. ………. $120000
FOH rate= estimated FOH ……….. ………. ……….. $2/DL $16/ 60%of $3.80/
estimated base hrs machen DL cost DL hrs
hrs

overhead rates (direct distribution method)

XYZ Manufacturing Company

18
 Distribution of estimated service department cost and calculation of departmental
factory
Power Mainten personnel Dep’t Dep’t Dep’t Dep’t Total
ance A B C D
Total dep’tal FOH before
distribution service dep’ts cost $30,000 $20,000 $10,000 $50,000 $40,000 $60,000 $90,000 $300,000
Distribution of service dep’t
costs:
-1st Power (Base per Kw hrs)
= 30,000 = $0.25
120,000
Maintenance-10,000×0.25…... ……… 2,500
Personnel -10,000×$0.25…….. ……… ……… 2,500
Dep’t A...12,000×$0.25………. ……… ……… ……… 3,000
Dep’t B…18,000×$0.25…….. ………. ………. ……… ……… 4,500
Dep’tC…20,000×$0.25….…… ……… ………. ……… ……… ……… 5,000…
Dep’t D…50,000×$0.25.……... ……… ______ ……… ……… ……… ……….. 12,500
-2nd Maintenance :( Base = 22,500
Square feet)
Rate per Sq. ft= $22,500 =$0.90 ……… ……… 4,500 4,500 5,400 3,600 4,500
25,000
rd
3 personnel (Base number of _______
employees)
Rate per employee =17,000 17,000
100
= $170 5,100 1,700 3,400 6,800
Total service dep’t costs
distributed…………………….. ……….. ………. ……….. $12,600 $11,600 $12,000 $23,800 ________
Total dep’tal FOH after
distribution of service dep’ts ……….. ………. ………... $62,600 $51,600 $72,000 $113800 300,000

Bases for predetermined FOH:

Direct labor hours (estimated)... ……….. ………. ………... 30,800 ……… ……… 30,000
Machine hours (estimated)…… ……….. ………. ………... ……… 3,275
Direct labor cost (estimated)…. ……….. ……… ………... ……… ……… $120000
FOH rate= estimated FOH 2.03/ 15.76/ 60% of 3.79/DL
estimated base DL hrs machen DL/ cost hrs
hrs
overhead rates (Sequential distribution method)

Algebraic method
You are given the following data for AAA Company
19
 Services provided by
Services provided to: cost Service Dep’t - A Service Dep’t - B
- Service Dep’t - A $10,000 -- 20%
- Service Dep’t - B 20,000 35% --
Production Dep’t - 1 14,000 15% 45%
Production Dep’t - 2 6,000 50% 35%
Required: Allocate service dep’t costs using algebraic method.
Solution: Let X = total cost of service dep’t - A & Y = total cost of service dep’t - B.
X = $ 10,000 + 0.2y ……………. e1
Y = $20,000 + 0.35x …………….e2
Where, e1 and e2 refers to equation 1 and equation 2 respectively
- Substituting Y = $20,000 + 0.35, into e1, we get:
X = $10,000 + 0.2 (20,000 + 0.35X)
X = $10,000 + $4000 + 0.07x
X = 0.07x=$14,000 = 0.93x= $14,000 = X = 14,000 = $15,054
0.93
Then: Y = $20,000 + 0.35 (15.054) = Y = $25.269
Distribution of service department cost:
Total
Producing Dep’t Service Dep’t

1 2 A B
Departmental FOH-before distribution of $14,000 $6,000 $10,000 $20,000 $50,000
service dep’t costs

Distribution of service dep’t costs

- Dep’t – A 2,258 $7527 - 5269
- Dep’t – B 11,371 8844 5054 -
FOH after distribution of
service dep’t cost $27,629 $22,371

20