FORE School of Management
WMG Batch 21
Management Accounting Project
Prof. K B Singh
We would like to take this opportunity to express our gratitude to Prof. K B Singh for
encouraging us to do this project in order to understand Management Accounting concepts in a
We would also like to give our sincere thanks for his cordial support, valuable information and
guidance, which helped us in completing this task..
PURPOSE OF COST ALLOCATION
TYPES OF COST ALLOCATION
GENERAL CHARACTERISTICS OF JOINT PRODUCTION
2. ACCOUNTING FOR JOINT PRODUCT COSTS……………………………………………………..9
3. EFFECT OF JOINT PRODUCT COSTS ON COST CONTROL AND DECISION MAKING………12
4. SALES VALUE AT SPLIT OFF METHOD…………………………………………..…..……………14
5. PHYSICAL-MEASURE METHOD……………………………………………………...……………..16
6. NET REALIZABLE VALUE METHOD…………………………………………………..…………..18
7. ANT GROSS-MARGIN PERCENTAGE NRV METHOD…………………….………………...……21
8. CHOOSING AN ALLOCATION METHOD…………………………………………………..………23
9. JOINT-COST ALLOCATION AND PERFORMANCE EVALUATION………………………..……25
10. ACCOUNTING FOR BYPRODUCTS………………………………………………………………26
COST ALLOCATION IN GENERAL
Cost allocation is fundamentally a problem of linking
(1) some cost or groups of costs with
(2) one or more cost objectives, such as prod-ucts, departments, and divisions.
Ideally, costs should be assigned to the cost objective that caused it. In short, cost allocation tries to
identify (1) with (2) via some function representing causation.
Linking costs with cost objectives is accomplished by selecting cost drivers. When used for allocating
costs, a cost driver is often called a cost-allocation base. Major costs, such as newsprint for a newspaper
and direct professional labour for a law firm, may each be allocated to departments, jobs, and projects on
an item-by-item basis, using obvious cost drivers such as tonnes of newsprint con-sumed or directlabour-hours used. Other costs, taken one at a time, are not important enough to justify being allocated
individually. These costs are pooled and then allocated together. A cost pool is a group of individual
costs that is allocated to cost objectives using a single cost driver. For example, building rent, utilities
cost, and janitorial services may be in the same cost pool because all are allocated on the basis of square
metres of space occupied. Or a university could pool all the operating costs of its registrar’s office and
allocate them to its colleges on the basis of the number of students in each faculty. In summary, all costs
in a given cost pool should be caused by the same factor. That factor is the cost driver.
Many different terms are used by companies to describe cost allocation in practice. You may encounter
terms such as allocate, attribute, reallocate, trace, assign, distribute, redistribute, load, burden, apportion,
and reapportion, which can be used interchangeably to describe the allocation of costs to cost objectives
Three Purposes of Allocation
Managers within an organizational unit should be aware of all the consequences of their decisions, even
consequences outside of their unit. Examples are the addition of a new course in a university that causes
additional work in the registrar’s office, the addition of a new flight or an additional passenger on an
airline that requires reservation and booking services, and the addition of a new specialty in a med-ical
clinic that produces more work for the medical records department.
In each of these situations, it is important to assign to the organizational unit the direct incremental costs
of the decision. Using the distinction noted in Chapter 4, managers assign direct costs without using
allocated costs. The allocation of costs is necessary when the linkage between the costs and the cost
objective is indirect. In this case, a basis for the allocation, such as direct-labour-hours or tonnes of raw
material, is used even though its selection is arbitrary.
A cost allocation base has been described as incorrigible, since it is impossible to objectively determine
which base perfectly describes the link between the cost and the cost objective. Given this subjectivity in
the selection of a cost-allocation base, it has always been difficult for managers to determine “When
should costs be allo-cated?” and “On what basis should costs be allocated?” The answers to these questions depend on the principal purpose or purposes of the cost allocation.
Costs are allocated for three main purposes:
1. To obtain desired motivation. Cost allocations are sometimes made to influence management behaviour
and thus promote goal congruence and managerial effort. Consequently, in some organizations there is
no cost allocation for legal or internal auditing services or internal man-agement consulting services
because top management wants to encourage their use. In other organizations there is a cost allocation
for such items to spur managers to make sure the benefits of the specified services exceed the costs.
2. To compute income and asset valuations. Costs are allocated to products and projects to measure
inventory costs and cost of goods sold. These allo-cations frequently service financial accounting
purposes. However, the resulting costs are also often used by managers in planning, perfor-mance
evaluation, and to motivate managers, as described above.
3. To justify costs or obtain reimbursement. Sometimes prices are based directly on costs, or it may be
necessary to justify an accepted bid. For example, government contracts often specify a price that
includes reimbursement for costs plus some profit margin. In these instances, cost allocations become
substitutes for the usual working of the mar-ketplace in setting prices.
The first purpose specifies planning and control uses for allocation. The sec-ond and third show how
cost allocations may differ for inventory costing (and cost of goods sold) and for setting prices.
Moreover, different allocations of costs to products may be made for various purposes. Thus, full costs
may guide pric-ing decisions, manufacturing costs may be appropriate for asset valuations, and some
“in-between” costs may be negotiated for a government contract. Ideally, all three purposes would be
served simultaneously by a single cost allo-cation. But thousands of managers and accountants will
testify that for most costs, this ideal is rarely achieved. Instead, cost allocations are often a source of
discontent and confusion for the affected parties. Allocating fixed costs usually causes the great-est
problems. When all three purposes cannot be attained simultaneously, the man-ager and the accountant
should start attacking a cost allocation problem by trying to identify which of the purposes should
dominate in the particular situation at hand.
Often inventory-costing purposes dominate by default because they are exter-nally imposed. When
allocated costs are used in decision making and performance evaluation, managers should consider
adjusting the allocations used to satisfy inventory-costing purposes. Often the added benefit of using
separate allocations for planning and control and inventory-costing purposes is much greater than the
Three Types of Allocation
As Exhibit shows, there are three basic types of cost allocations:
1. Allocation of joint costs to the appropriate responsibility centres. Costs that are used jointly by more
than one unit are allocated based on cost-driver activity in the units. Examples are allocating rent to
departments based on floor space occupied, allocating amortization on jointly used machinery based on
machine-hours, and allocating general adminis-trative expense based on total direct cost.
2. Reallocation of costs from one responsibility centre to another. When one unit provides products or
services to another, the costs are transferred along with the products or services. Some units, called
service depart-ments, exist only to support other departments, and their costs are totally reallocated.
Examples include personnel departments, laundry departments in hospitals, and legal departments in
3. Allocation of costs of a particular organizational unit to its outputs of products or services. The
paediatrics department of a medical clinic allocates its costs to patient visits, the assembly department
of a manufacturing firm to units assembled, and the tax department of a CA firm to clients served. The
costs allocated to products or services include those allo-cated to the organizational unit in allocation
types 1 and 2.
All three types of allocations are fundamentally similar. Let us look first at how service department
costs are allocated to production departments
General Characteristics of Joint Production
Joint products are two or more products produced simultaneously by the same process.
Joint products become separate and identifiable at the split-off point.
A. Cost Separability and the Need for Allocation
1. Joint costs are the total of the raw material, labor, and overhead costs incurred up to the initial splitoff point.
a. Joint costs can be allocated to the final product only in some arbitrary manner because such costs
cannot be traced directly to the products they benefit.
b. Joint cost allocation is performed to meet the requirements of financial reporting (GAAP) and federal
income tax law for income measurement and inventory valuation. In addition, joint cost allocation is
useful in costing for government cost-type contracts and in justifying prices for legislative or
c. Joint cost allocation is much less useful for cost control and managerial decision making.
Examples of Joint Cost Situations
2. Separable costs are those costs incurred after the split-off point; they can be easily traced to individual
B. Distinction and Similarity Between Joint Products and By-Products
1. The distinction between joint products and by-products rests solely on the relative importance of their
2. A by-product is a secondary product whose total sales value is relatively minor in comparison with the
sales value of the main product (joint product).
3. Relationships between joint products and by-products change over time as technology and markets
a. By-products may become more and more important, eventually becoming joint products.
b. When the relative importance of individual products changes, the products need to be reclassified and
the costing procedures need to be changed.
2. ACCOUNTING FOR JOINT PRODUCT COSTS
Different methods used for joint product costs and the differences between them:
1. Joint cost allocations must be done for financial reporting purposes: to value inventory and to
determine income. An allocation method must be found, though arbitrary, to allocate the joint costs as
reasonably as possible.
2. The joint cost allocation approaches include the following:
a. Benefits-received approaches, which include the following methods:
o Physical units method
o Weighted average method
b. Allocation based on the relative market value, using the following methods:
o Sales-value-at-split-off method
o Net realizable value method
o Constant gross margin percentage method
B. Benefits-Received Approaches
1. Physical Units Method
a. Under the physical units method, units of physical output, such as heat content, volume, or weight, that
measure the benefits received are used to distribute joint costs. This method allocates to each joint
product the same proportion of joint costs as the underlying proportion of units.
Example: Manufacturers of forest products use the physical units method to apply the average
conversion cost to all finished products, regardless of their type, grade, or market value.
b. Disadvantages of the physical units method include the following:
It ignores the fact that not all costs are directly related to physical quantities.
It may result in incorrect managerial decisions because high profit may be reflected from the sale of
high-grade products, with low profit or losses reflected from the sale of low-grade products.
2. Weighted Average Method
The weighted average method uses the weight factors to include such diverse elements as amount of
material used, difficulty to manufacture, time consumed, difference in type of labor used, and size of
Weighted physical units = Number of units × Weight factor
Example: The canning industry uses weight factors to distinguish between can sizes or quality of
product. The weighted average method allocates relatively more of the joint cost to the high-grade
products because they represent more desirable and profitable products.
C. Allocation Based on Relative Market Value
The methods in this approach try to assign costs based on the product’s ability to absorb joint costs. They
are based on the assumption that the joint costs would not be incurred unless the products yield enough
revenues to cover all costs plus a reasonable profit.
The relative market value approach of allocation is better than the physical units approach if (1) the
physical mix of output can be altered by incurring more (or less) total joint costs, and (2) this alteration
produces more (or less) total market value.
1. Sales-Value-at-Split-Off Method
a. The sales-value-at-split-off method allocates joint cost based on each product’s proportionate share of
market or sales value at the split-off point.
b. In this method, the higher the market value, the greater the joint cost assigned to the product.
3. Net Realizable Value Method
a. The net realizable value method allocates joint costs based on hypothetical sales values because there
may not be a ready market for the product at the split-off point.
b. This method is particularly useful when one or more products cannot be sold at the split-off point but
must be processed further.
Hypothetical sales value = Market price – Further processing costs after split-off point
4. Constant Gross Margin Percentage Method
a. The constant gross margin percentage method allocates joint costs such that the gross margin percentage
is the same for each product.
b. This method assumes that the further processing yields an identical profit percentage across all
c. Using the constant gross margin percentage method, the joint cost allocation steps include the
Grand gross margin percentage =
(Total revenue – Total costs)
Joint product gross margin = Market price × Grand gross margin
Joint cost allocated to product = Market value – Gross margin – Separable costs
The limitations of allocation based on relative market value include the following:
All methods are based on price. If price is used to determine cost, then those costs cannot be used to
determine price. The decision would be circular.
Changes in relative market prices will cause changes in the costs allocated to the product, even when there
has been no change in total costs or the method of production.
Using allocation based on relative market value produces the same margin per dollar of allocated cost. This
could be misleading to management if the impression is created that all products are equally profitable.
3. EFFECT OF JOINT PRODUCT COSTS ON COST CONTROL AND DECISION MAKING
Joint product costing may affect cost control and decision making in the following areas: output decisions,
further processing of joint products, and pricing jointly produced products.
A. Output Decisions
1. Output decisions are normally based on the comparison of total cost of the joint products and the
combined sales revenues for measuring profitability at any given point.
2. If management cannot change the product mix or the product mix is determined by customer demand,
cost allocation is useless for output decisions because the entire package has to be produced.
B. Further Processing Decisions
1. In making decisions on whether to sell a joint product at split-off or to process it further, only the costs
and revenues incurred after the split-off point are pertinent.
2. Joint costs include those costs incurred prior to the split-off point and, thus, are considered sunk costs
with respect to further processing decisions (that is, the joint cost is not a relevant cost).
C. Pricing Joint Products
Methods used to set joint product prices include:
1. Sales or market price method
a. This method maintains a constant relationship of cost to market prices, but it cannot be used to set prices
since price has to be known in order to determine cost.
b. The method is circular but useful in limited situations.
Example: The meat-packing industry uses the market value of by-products as an important determinant of
the main product’s price.
Example: The natural gas industry uses it to justify prices and existing price relationships to regulatory
bodies. Joint cost allocation is used to determine inventory values, not as a basis to determine a cost to be
used in price regulation.
2. Historical market differentials between products method
When market differentials are stable over time, this method provides a guide to pricing individual products by
giving figures comparable to those of competitors.
D. Pricing Based on Cost of Further Production
This method differs from the benefits-received approaches because it does not assign average cost based on
physical or weighted units. It is different from the relative market value because the joint product itself
does not have a market value.
Example: The practice of organ transplant sets the costs of the jointly available organs based on the
eventual cost of the subsequent transplant operation.
To compare methods, 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 supermarkets and other retail outlets.
In May 2012, Farmers’ Dairy processes 110,000 gallons of raw milk. During processing, 10,000 gallons
are lost due to evaporation and spillage, yielding 25,000 gallons of cream and 75,000 gallons of liquid
skim. Summary data follow:
Exhibit: depicts the basic relationships in this example.
How much of the $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? We begin by illustrating the two methods that
use the properties of the products at the splitoff point, the sales value at splitoff method and the physicalmeasure method.
4. SALES VALUE AT SPLIT OFF METHOD
The sales value at split off method allocates joint costs to joint products produced during the accounting
period on the basis of the relative total sales value at the split off point. Using this method for, Exhibit,
Panel A, shows how joint costs
Are allocated to the individual products to calculate cost per gallon of cream and liquid skim for valuing
ending inventory. this method uses the sales value of the entire production of the accounting period
(25,000 gallons of cream and 75,000 gallons of liquid skim), not just the quantity sold(20,000 gallons of
cream and 30,000 gallons of liquid skim). The reason this method does not rely solely on the quantity
sold is that the quantity sold is that the joint costs were incurred on all units produced , not just the
portion sold during the current period.
Exhibit –panel B , presents the product line income statement using the sales value at split off method .
note that the gross margin percentage for each product is 20% because the sales value at splits off method
allocates joint costs to each product in proportion to the sales value of total production production (cream:
$160,000 , $200,000 = 80%; liquid skim $240,000 , $300,000 = 80%). Therefore, the gross-margin
percentage for each product manufactured in May 2012 is the same: 20%.
Note how the sales value at splitoff method follows the benefits-received criterion of cost allocation: Costs
are allocated to products in proportion to their revenue-generating
Joint-Cost Allocation and Product-Line Income Statement Using Sales Value at Splitoff Method:
Farmers’ Dairy for May 2012
power (their expected revenues). The cost-allocation base (total sales value at splitoff) is expressed in terms
of a common denominator (the amount of revenues) that is systemati-cally recorded in the accounting
system. To use this method, selling prices must exist for all products at the splitoff point.
5. PHYSICAL-MEASURE METHOD
The physical-measure method allocates joint costs to joint products produced during the accounting period
on the basis of a comparable physical measure, such as the relative weight, quantity, or volume at the
splitoff point. In Example 1, the $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, Exhibit 16-4, Panel A,
shows how joint costs are allocated to individual products to calculate the cost per gallon of cream and
Because the physical-measure method allocates joint costs on the basis of the number of gallons, cost per
gallon is the same for both products. Exhibit 16-4, Panel B, presents the product-line income statement
using the physical-measure method. The gross-margin percentages are 50% for cream and 0% for liquid
Under the benefits-received criterion, the physical-measure method is much less desirable than the sales
value at splitoff method, because the physical measure of the individual products may have no relationship
to their respective revenue-generating abilities. 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-generating power. In the case of
metals, the method of cost allocation is inconsistent with the main reason that the mining company is
incurring mining costs—to earn revenues from gold and sil-ver, not lead. When a company uses the
physical-measure method in a product-line income statement, products that have a high sales value per ton,
like gold and silver, would show a large “profit,” and products that have a low sales value per ton, like
lead, would show sizable losses.
Obtaining comparable physical measures for all products is not always straight-forward. Consider the joint
costs of producing oil and natural gas; oil is a liquid and gas is a vapor. To use a physical measure, the oil
and gas need to be converted to the energy equivalent for oil and gas, British thermal units (BTUs). Using
some physical measures to allocate joint costs may require assistance from technical personnel out-side of
Determining which products of a joint process to include in a physical-measure com-putation can greatly
affect the allocations to those products. Outputs with no sales value
(such as dirt in gold mining) are always excluded. Although many more tons of dirt than gold are
produced, costs are not incurred to produce outputs that have zero sales value. Byproducts are also often
excluded from the denominator used in the physical-measure method because of their low sales values
relative to the joint products or the main prod-uct. The general guideline for the physical-measure
method is to include only the joint-product outputs in the weighting computations.
6. NET REALIZABLE VALUE 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. For example, when crude oil is
refined, the gasoline, kerosene, benzene, and naphtha must be processed further before they can be
sold. To illustrate, let’s extend the Farmers’ Dairy example.
Example 2: Assume the same data as in Example 1 except that both cream and liquid skim can
be processed further:
Buttercream: 25,000 gallons of cream are further processed to yield 20,000 gallons of
buttercream at additional processing costs of $280,000. Buttercream, which sells for $25 per gallon, is
used in the manu-facture of butter-based products.
Condensed Milk: 75,000 gallons of liquid skim are further processed to yield 50,000
gallons of condensed milk at additional process-ing costs of $520,000. Condensed milk sells for $22
Sales during May 2012 are 12,000 gallons of buttercream and 45,000 gal-lons of condensed milk.
Exhibit 16-5, Panel A, depicts how (a) raw milk is converted into cream and liquid skim in the joint
production process, and (b) how cream is separately processed into butter-cream and liquid skim is
separately processed into condensed milk. Panel B shows the data for Example 2.
The net realizable value (NRV) method allocates joint costs to joint products produced during the
accounting period on the basis of their relative NRV—final sales value minus separable costs. The
NRV method is typically used in preference to the sales value at splitoff method only when selling
prices for one or more products at splitoff do not exist. Using this method for Example 2, Exhibit 166, Panel A, shows how joint costs are allocated to indi-vidual products to calculate cost per gallon of
buttercream and condensed milk.
Exhibit 16-6, Panel B presents the product-line income statement using the NRV method. Grossmargin percentages are 22.0% for buttercream and 26.4% for condensed milk.
The NRV method is often implemented using simplifying assumptions. For example, even when
selling prices of joint products vary frequently, companies implement the
NRV method using a given set of selling prices throughout the accounting period Similarly, even
though companies may occasionally change the number or sequence of processing steps beyond the
splitoff point in order to adjust to variations in input quality or local conditions, they assume a specific
constant set of such steps when implementing the NRV method
7. CONSTANT GROSS-MARGIN PERCENTAGE NRV METHOD
The constant gross-margin percentage NRV method allocates joint costs to joint prod-ucts produced
during the accounting period in such a way that each individual product achieves an identical grossmargin percentage.
The method works backward in that the overall gross margin is computed first. Then, for each
product, this gross-margin per centage and any separable costs are deducted from the final sales value
of production in order to back into the joint cost allocation for that product. The method can be
broken down into three discrete steps. Exhibit 16-7, Panel A, shows these steps for allocating the$400,000
joint costs between buttercream and condensed milk in the Farmers’ Dairy exam- ple. As we describe each
step, refer to Exhibit 16-7, Panel A, for an illustration of the step
Compute overall gross margin percentage. The overall gross-margin percentage for all joint
products together is calculated first. This is based on the final sales value of total production during the
accounting period, not the total revenues of the period. Note, Exhibit 16-7, Panel A, uses $1,600,000,
the final expected sales value of the entire output of buttercream and condensed milk, not the
$1,290,000 in actual sales revenue for the month of May
Compute total production costs for each product. The gross margin (in dollars) for each product is
computed by multiplying the overall gross-margin percentage by the product’s final sales value of total
production. The difference between the final sales value of total production and the gross margin then
yields the total production costs that the product must bear
Step 3: Compute allocated joint costs. As the final step, the separable costs for each product are
deducted from the total production costs that the product must bear to obtain the joint-cost allocation
for that product.
Exhibit 16-7, Panel B, presents the product-line income statement for the constant gross margin
percentage NRV method.
The constant gross-margin percentage NRV method is the only method of allocating joint costs under
which products may receive negative allocations. This may be required in order to bring the grossmargin percentages of relatively unprofitable products up to the overall average. The constant grossmargin percentage NRV method also differs from the other two market-based joint-cost-allocation
methods described earlier in another fundamental way. Neither the sales value at splitoff method nor the
NRV 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 allocates both joint costs and
profits: Gross margin is allocated to the joint products in order to determine the joint-cost allocations so
that the resulting gross-margin percentage for each product is the same.
8. CHOOSING AN ALLOCATION METHOD
Which method of allocating joint costs should be used? The sales value at splitoff method is preferable
when selling-price data exist at splitoff (even if further processing is done). Reasons for using the sales
value at splitoff method include the following:
1. Measurement of the value of the joint products at the splitoff point. Sales value at splitoff is the best
measure of the benefits received as a result of joint
processing relative to all other methods of
allocating joint costs. It is a meaningful basis for allocating joint costs because generating revenues is the
reason why a company incurs joint costs in the first place. It is also sometimes possible to vary the
physical mix of final output and thereby produce more or less market value by incurring more joint
costs. In such cases, there is a clear causal link between total cost and total output value, thereby further
validating the use of the sales value at splitoff method.
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 and
constant gross-margin percentage NRV methods require information on (a) the specific
sequence of further processing decisions, (b) the separable costs of further processing, and (c) the point
at which individ-ual products will be sold.
Availability of a common basis to allocate joint costs to products. The sales value at splitoff method (as
well as other market-based methods) has a common basis to allo-cate joint costs to products, which is
revenue. In contrast, the physical-measure at splitoff method may lack an easily identifiable common
basis to allocate joint costs to individual products.
Simplicity. The sales value at splitoff method is simple. In contrast, the NRV and con-stant gross-margin
percentage NRV methods can be complex for processing operations having multiple products and
multiple splitoff points. This complexity increases when management makes frequent changes in the
specific sequence of post-splitoff processing decisions or in the point at which individual products are
When selling prices of all products at the splitoff point are unavailable, the NRV method is commonly
used because it attempts to approximate sales value at splitoff by subtracting from selling prices
separable costs incurred after the splitoff point. 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. More
of the profit may be attributable to the joint process if the separable process is relatively routine, whereas
more of the profit may be attributable to the separable process if the separable process uses a special
patented technology. Despite its complexities, the NRV method is used when selling prices at splitoff are
not available as it provides a better measure of benefits received compared with the con-stant grossmargin percentage NRV method or the physical-measure method.
The constant gross-margin percentage NRV method makes the simplifying assump-tion of treating the
joint products as though they comprise a single product. This method calculates the aggregate grossmargin percentage, applies this gross-margin percentage to each product, and views the residual after
separable costs are accounted for as the implicit amount of joint costs assigned to each product. An
advantage of this method is that it avoids the complexities inherent in the NRV method to measure the
benefits received by each of the joint products at the splitoff point. The main issue with the con-stant
gross-margin percentage NRV method is the assumption that all products have the same ratio of cost to
sales value. Recall from our discussion of activity-based costing (ABC) in Chapter 5 that such a situation
is very uncommon when companies offer a diverse set of products.
Although there are difficulties in using the physical-measure method—such as lack of congruence with
the benefits-received criterion—there are instances when it may be preferred. Consider rate or price
regulation. Market-based measures are difficult to use in this context because using selling prices as a
basis for setting prices (rates) and at the same time using selling prices to allocate the costs on which
prices (rates) are based leads to circular reasoning. To avoid this dilemma, the physical-measure method
is useful in rate regulation.
9. 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 us continue with Example 2. Suppose allocated fixed corporate and administrative costs of further
processing cream into buttercream equal $30,000 and that these costs will be allocated only to
buttercream and to the manager’s product-line income statement if buttercream is produced. How might
this policy affect the decision to process further?
As we have seen, on the basis of incremental revenues and incremental costs, Farmers’ operating income
will increase by $20,000 if it processes cream into butter-cream. However, producing the buttercream
also results in an additional charge for allocated fixed costs of $30,000. If the manager is evaluated on a
full-cost basis (that is, after allocating all costs), processing cream into buttercream will lower the
manager’s performance-evaluation measure by $10,000 (incremental operating income, $20,000 allocated fixed costs, $30,000). Therefore, the manager may be tempted to sell cream at splitoff 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 $20,000. From a decisionmaking standpoint, Farmers’ would maximize operating income by processing raw milk into cream and
liquid skim because the total revenues from selling both joint products ($500,000, see Exhibit 16-3, p.
581) exceed the joint costs ($400,000, p. 580) by $100,000. (This amount is greater than the $20,000
Farmers’ Dairy would make if it sold the raw milk instead of processing it.) 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 $4.00 per gallon, the liquid-skim product line
will show a loss (from Exhibit 16-4, p. 582, revenues will be less than $120,000, but cost of goods sold
will be unchanged at $120,000). The manager of the liquid-skim line will prefer, from his or her
performance-evaluation stand-point, to not produce liquid skim but rather to sell the raw milk.
This conflict between decision making and performance evaluation is less severe if Farmers’ Dairy uses
any of the market-based methods of joint-cost allocations—sales value at splitoff, NRV, or constant
gross-margin percentage NRV—because each of these methods allocates costs using revenues, which
generally leads to a positive income for each joint product.
10. ACCOUNTING FOR BYPRODUCTS
Joint production processes may yield not only joint products and main products but also byproducts.
Although byproducts have relatively low total sales values, 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 (also see the Concepts in Action feature on p. 590).
Example 3: The Westlake Corporation processes timber into fine-grade lumber and wood chips that
are used as mulch in gardens and lawns. Information about these products follows:
Fine-Grade lumber (the main product)—sells for $6 per board foot (b.f.)
Wood chips (the byproduct)—sells for $1 per cubic foot (c.f.)
Data for July 2012 are as follows:
The Westlake Corporation processes timber into fine-grade lumber and wood chips that are used as
mulch in gardens and lawns. Information about these products follows:
Fine-Grade lumber (the main product)—sells for $6 per board foot (b.f.)
Wood chips (the byproduct)—sells for $1 per cubic foot (c.f.)
Data for July 2012 are as follows
Comparative Income Statements for Accounting for Byproducts
1. Management Accounting By Paresh Shah
2. Management Accounting: Information for Decision-Making and Strategy Execution
Anthony A. Atkinson (Author), Robert S. Kaplan (Author), Ella Mae Matsumura (Author), S. Mark