Allocation for costs of Joint Products,

Byproducts, Scrap, Rework, and Spoilage

Abstract

This paper outlines the problem of cost allocation to joint

products, byproducts, rework, spoilage, and scrap. It briefs the
various methods that are used to spread over the joint costs
between joint products, byproducts, rework, spoilage, and
scrap. The paper also discusses when it is preferred to use one
method instead of another. Finally it concluded that it is vital
to refine the joint costs allocation systems to rationalize the
decision-making process.

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 contents

Introduction 1

Joint Products, Byproducts, Scrap, Rework, and 2

Spoilage defined

Why joint costs should be allocated to individual products? 3

Methods used to allocate joint costs 4

Market Based Methods 4

Sales value at split-off point 4

NRV method
5
Constant gross-margin percentage NRV 6

Physical measures method 6

Which method is preferred? Why? 7

Conclusion 8

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 Cost Allocation for
Joint Products, Byproducts, Scrap, Rework,
and Spoilage

Introduction:
One of the continuing unsolved problems of accounting is that of joint
costs of production. For their part, economists have been quick to point out
that, in many cases, cost allocations to joint products are arbitrary and thus
unjustified. Accountants have done much effort to define joint products,
major products, co-products, minor products, byproducts, and scrap, waste,
spoiled or defective products.

Companies may produce two or more products simultaneously in the

same process or processes. As global competition intensifies, companies are
producing an increasing variety of products and services. They are finding
that producing different products and services places varying demands on
their resources.

The need to measure more accurately how different products and

services use resources, has led companies to refine their costing systems. As
a result successful companies pay more attention to avoid over or under
costing. Companies do more efforts to avoid product-cost cross-
subsidization which might lead to either loosing market share or incurring
actual loss.

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Joint Products, Byproducts, Scrap, Rework, and
Spoilage defined
Joint products are produced as a direct result of the strategic
planning process of the company. These products are considered to be of
major importance to the company and, therefore, represent a significant
focus for management, accounting, and financial reporting. The accounting
allocation methods are discussed later in this paper.

Byproducts emerge from a common process along with primary

products but are not considered to be important or valuable enough to be a
major focus of management. Two methods for accounting for byproducts
can be followed, byproducts recognized at time production is completed in
the financial statements as (NRV) or revenues are not recognized until sale
of the byproduct occurs.

Scrap on the other part is the waste or the residual pieces / parts of the
material used in the production process. It is the material left over when
making a product and has low sales value compared with the sales value of
the product. Examples are short lengths from woodworking operations,
edges from plastic modeling operations, and frayed cloth and end cuts from
suit-making operations. Scrap has no cost and hence it can be considered as
revenue that should reduce the cost of either a specific job or the
manufacturing overhead in common when sold.

Rework is units of production that do not meet the standards required

by customers for finished units that are subsequently repaired and sold as
acceptable finished units. It is units of production that are inspected,
determined to be unacceptable, repaired, and sold as acceptable finished
goods. It can be distinguished as normal rework attributable to a specific job,
normal rework common to all jobs, and abnormal rework.

Normal rework cost attributable to a specific job are charged to that

job, when normal rework is common to all jobs, the costs are charged to
manufacturing overhead and spread, through overhead allocation, over all
jobs. As for abnormal rework the costs are charged to a loss account. The

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abovementioned classification is vital for rationalizing the decision-making
process.

Spoilage is units of production- whether fully or partially completed-

that do not meet the standards required by customers for good units that are
discarded or sold for reduced prices. Spoilage may be normal spoilage or
abnormal spoilage, normal spoilage is inherent in a particular production
process that arises even under efficient operating conditions. Costs of normal
spoilage are typically included as a component of the costs of good units
manufactured and the logic for this treatment is that good units can not be
made without also making some units that are spoiled. Normal spoilage rates
are computed by dividing units of normal spoilage by total good units
completed, not total actual units started in production because normal
spoilage is the spoilage related to the good units produced.

Abnormal spoilage, on the other hand is spoilage that would not arise
under efficient operating conditions. It is not inherent in a particular
production process. Abnormal spoilage is usually regarded as avoidable and
controllable. Line operators and other plant personnel can generally decrease
or eliminate abnormal spoilage by identifying reasons for machine
breakdowns, accidents, and the like, and taking steps to prevent their
recurrence.

To highlight the effect of abnormal spoilage costs, companies

calculate the units of abnormal spoilage and the cost of abnormal spoilage in
a loss from abnormal spoilage account, which appears as a separate line item
in the income statement.

Why joint costs should be allocated to individual

products?

There are some reasons that require joint costs to be allocated to

individual products:

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 (1) To reimburse cost incurred under contracts for companies that
have few of their services or products reimbursed under cost-plus
contracts with government agency for example.
(2) To compute and calculate inventorial costs and cost of goods sold
for internal reporting purposes. These reports affect evaluation of
division managers’ performance and thus are used in division
profitability analysis.
(3) Also inventorial costs and cost of goods sold are used for financial
accounting purposes and reporting purposes for income tax
authorities.
(4) To regulate rates for one or more of the jointly produced products
or services that is subject to price regulation.
(5) As a basis for settlement insurance claims such as damage claims
made on the basis of cost information by businesses having joint
products, main products, or byproducts.

Methods used to allocate joint costs

The following problem involves the case of a manufacturer of soy-
bean oil principally. Assume that the relationship between the market value
of oil and meal remains fairly constant-ranging, say, between ratios of 80-20
and 50-50, over a period of several years, for each 60 pounds of raw material
placed in the productive process. Management has instituted the policy of
treating these two commodities as joint products and of allocating the joint
costs between oil and meal, for the purpose of calculating the amount of
profit (or loss) on each of these two items. The problem then becomes one of
accounting for the distribution of joint costs.

There are mainly two approaches to allocate joint costs

(1) Market Based Methods.

 Sales value at split-off point.

The sales value at split-off point method allocates joint costs to
joint products on the basis of the relative total sales value at the split-
off point of the total production of these products during the
accounting period. It is clear that this method follows the benefits-

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received criterion of cost allocation (costs are allocated to products in
proportion to their expected revenues).

As such this method is simple, straightforward, and intuitive.

To apply this method, a company needs the market selling prices for
all products at the split-off point. This method considers market
factors by recognizing that joint or primary products produced from a
joint or common process have different values. Market factors affect
both the selling price of soy-beans and the decision to purchase and
crush soy-beans into meal and oil.

Consequently, joint products with higher sales value are

allocated relatively more joint cost than joint products with lower
sales values. The value at split-off point method takes into
consideration market factors when valuing the various joint or
primary products produced from a common or joint process. In some
cases, one or more of the joint (primary) products produced may not
be salable at the split-off point but must be processed further before a
sales value is available.
Using the value at split-off point method, we can substitute the
estimated sales value for the actual sales value at split-off point. The
estimated sales value at split-off point is found by computing the total
sales value of a joint (primary) product at the point closest to the split-
off point and then subtracting the appropriate further processing cost
from this total. This modified approach accommodates situations
where sales values are not available at the split-off point. However it
does not properly recognize the value added by the further processing
cost.

As a general rule, adding cost to a product also adds value, in

turn increasing its selling price. The greater the further processing cost
is for a joint (primary) product, the more the final selling price is a
result of that further processing cost. The result is that the estimated
value at the split-off point, for those products that have significant
further processing costs, is overstated by the gross profit associated
with the further process cost. This weakness can be overcome by
using the net estimated total sales value at the split-off point. This is
computed by subtracting both the further cost and the gross profit
associated with the further processing cost from the sales value closest
to the split-off point.

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 Net realizable value (NRV) method.

Products may be processed beyond the split-off point in many

cases to bring these products to a marketable form or to increase their
value above their selling price at the split-off point. The net realizable
value (NRV) method allocates joint costs to joint production 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.

This method is typically used in preference to sales value at

split-off method only when we do not know the market selling prices
for one or more products at split-off.

The NRV method is often implemented using simplifying

assumptions. Thus if the selling prices of joint products vary
frequently, a given set of selling prices may be consistently used
throughout the accounting period. Since the sales value at split-off
point method does not require knowledge of the processing steps
beyond the split-off point, it is less complex than the NRV method
simply because market prices may only be available after processing
occurs beyond the split-off point.

 Constant gross-margin percentage NRV method.

This method allocates joint costs to joint products in such a way

that the overall gross-margin percentage is identical for the individual
products. The constant gross-margin percentage NRV method takes
account of profits earned either before or after the spli-off point when
allocating the joint costs unlike the sale value at split-off method and
the NRV methods.

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 (2) Physical Measures such as the weight, length,
or volume.

The physical-measure method allocates joint costs to

joint products on the basis of the relative weight, volume, or
other physical measure at the split-off point of the total
production of these products during the accounting period.

Under the benefits received criterion, the physical-measure

method is less preferred than the sales value at split-off method
because it has no relationship to the revenue producing power of the
individual products.

Which method is preferred? Why?

The sales value at split-off point method is the most reliable

method if it is available for some reasons:

(1) It has a meaningful basis for joint cost allocation which is

revenues.
(2) The sales value at split-off method is straight forward and
simple to apply.
(3) It measures the value of the joint product immediately at
the end of the joint process.
(4) This method does not require information on the
processing steps after split-off point, if there is further
processing.

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 The NRV method assumes that all markup or profit margin is
attributable to the joint process not to the separable costs. NRV
can be used when selling prices at split-off are not available.
Thus this method tries to approximate the sales value at split-off
point by subtracting separable costs incurred after the split-off
point on each product from selling prices.

The constant gross-margin percentage method is easy to

implement. This method avoids the complexities in NRV
method since it assumes that all products have the same ratio of
cost to sales value.

The physical measures method can be used in rate regulation.

However there are difficulties in using this method for other
decisions.

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Conclusion

One must finally conclude that the problem of allocating joint costs
per se is not that easy from a theoretical point of view. It is impossible to
determine what costs should be matched against the income resulting from
the manufacture of by-products and joint products. Procedures for allocating
joint costs are based on certain standards of reasonableness; and the results
are justified in the light of present-day market values, productive
technology, and business experience.

The techniques for allocation of joint costs must be improved;

otherwise, the conclusions obtained from various methods of joint cost
distribution have no foundation of proof and consequently will affect the
decision-making process rationality. Accountants will then have to resort to
the basic criterion of all successful business enterprise, namely, that total
revenue of the organization-in the long run- must cover the total costs of
production.

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References:

(1) Balachandran, B. and Ramakrishnan, R., “ Joint Cost Allocation: A

Unified Approach,” The Accounting Review (January 1981) p.85.
(2) Cheatham, C. and Green, M., “ Teaching Accounting for
Byproducts,” Management Accounting (Spring 1988) p.14.
(3) David J. Williams; John O.S. Kennedy, “A Unique Procedure for
Allocating Joint Costs from a Production Process ” Journal of
Accounting Research, Vol. 21, No2 (Autumn, 1983).
(4) Gerald H. Lawson, “ Joint Cost Analysis as an Aid to Management-
A Further Note” , The Accounting Review, Vol.32,No. 3 (Jul., 1957),
pp.431-433.
(5) Harold G. Avery, “Accounting for Joint Costs” , The Accounting
Review, Vol. 26, No. 2 (Apr., 1951), pp232-238.
(6) Lowenthal, F., “ Multiple Split-off points” Issues in Accounting
Education, (Fall 1986) p.302.
(7) R.P.Manes; Vernon L. Smith , “ Economic Joint Cost Theory and
Accounting Practice”, The Accounting Review, Vol.40, No.1 (Jan.,
1965),pp. 31-35.
(8) Stout, D. and Wygal, D.,” Making Byproducts a Main Product of
discussion: A Challenge to Accounting Educators” Journal of
Accounting Education (1989) p.219.

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