In many industries, a common manufacturing process generates multiple products, such products derived by this process are called Joint products or By-products.
It is in their very nature that Joint products or By-products can’t be produced individually. While manufacturing, there comes the point where those yielded products get differentiated from each other. That very point is called the Split-off point.
The products can be further processed as per convenience or can be sold after reaching the Split-off point. The cost that has incurred up to the Split-off point is called Joint Cost.
What are Joint Products and By-Products and how it is Related to Joint Cost:
Throughout the manufacturing process, mainly 3 types of products are generated:
- Joint products.
2. Waste or Scraps.
Joint Products: When the economic value of the products is significant to the respect of the total sales, those products are called Joint products. These are also known as Major products. Waste or Scraps: When the economic value of the products is negligible to the respect of total sales, those products are Wastes or Scraps.
By-Products: When the economic value of the products is neither significant nor negligible concerning total sales, those are called By-products. These are also known as Minor products.
Joint/By-products result from the common manufacturing process, though the accounting treatment for joint and by-products is different. The difference between these products is not keen enough because it depends on the products’ economic value.
How to apportion the joint costs to joint/by-products:
There are several methods to apportion joint costs. Those are explained below:-
- Method of Physical Unit: This method is applied when the joint products can be measured. The basic apportionment is done in the physical volume of units of the products found at the split-off point. Moreover, if any loss arises through the processing, that also gets apportioned the same way. This method can’t be used for any individual product. It is best to use it for all the joint products which have equal value.
- Method of Average Unit: This method is used for common and inseparable joint products. They even have to have a common unit. In this method, total costs are counted to calculate the average unit cost and total operating profit. It keeps the same unit cost for all the joint products. The formula to calculate the average unit cost is -> AVERAGE UNIT COST= JOINT COST/ TOTAL NUMBER OF UNITS PRODUCED.
- Survey Method: This is also known as the points value method or weighted average unit cost method. Before apportioning joint costs, the factors involved in the production and distribution of the joint products are considered. This is the reason why this method is called the survey method. Joint costs are apportioned based on the percentage of the point value given to the products according to their importance. The management mainly decides the importance with the help of departmental heads and technical advisors. They set the point of products by considering a few factors like quantities of the material, time, number of labors, quality of the joint products, etc.
- Standard Cost Method: In this method, the standard cost of every joint product is fixed. The apportionment of joint costs is done by considering the set standards. If a company uses this method to apportion the joint cost, it clearly prioritizes the process.
- Gross Margin Method: This method helps the management decide if the joint products undergo further processing. The decision depends on the contribution margin of a product.
- Joint Cost Method: In a manufacturing process, multiple joint products or major products are produced and several by-products or minor products. The joint cost is apportioned between these products based on their economic value. This method does not differentiate the joint products and the by-products. It rather treats by-products as joint products while apportioning the joint cost.
- Market Value Method: This method apportions the joint cost according to the market value of the joint products. The selling price of an individual product is the basis to calculate the apportioning ratio. It works on all the joint products that generate the same profit margin rate, and the cost of each of the joint products is based on their selling price.
What is cost allocation & the main objectives for allocation of Joint Costs:
Cost allocation is the process through which a business allocates funds during the process of budgeting. As a small business grows so different teams also form. For that, a new form of cost allocation is available, which is double or multiple allocations.
The Objectives for Allocations of Joint Cost:
- In a system of absorption costing, production cost must be a charge added to the product cost. When more than one product shares the same production cost, a basis for sharing out these costs must be devalued.
- The universal value of significant and insignificant rate is not set, so by sharing the joint cost, the profit of a certain product is judged by the management.
- To control the cost and make important decisions on this aspect, the joint cost has a lead role.
- The joint cost helps to set the finished goods’ valuation and keep the work in progress.
- It helps to meet the cost audit regulations.
- It helps to keep basic track of the correct determination of costs and justify the cost in price control.
- The selling price of the products is to be set depending upon the joint cost.
- Joint cost regulates the impact of the change in the mixed products and the variety of the output products.
The advantages and disadvantages of joint cost allocation:
Joint cost allocation has advantages for a growing company, but it may also get difficult. There are both advantages and disadvantages of this allocation.
- Allocation Based on Departmental Needs: When the funds are divided between different teams and departments, a small business can provide their funding based on the division’s needs. They can also shift the allocation over time if the condition changes. If the business needs a new division for inventory management, the company can look up to the budget that this division will need and allocate the space needed in its accounting tools which will keep the exact details of how the inventory management is using its budget. This process helps a business to improve its budgeting and precisely keeps track of department spending.
- Allocation Based on Company: Advantages of allocating expenses can be applied to company-wide budget plans. Small businesses can use multiple cost allocations to separate the funds for the whole company for the funds allocated for individual departments. This comes into use when budgeting overhead costs.
- Cost Management: When the budget gets apportioned for every department, companies get a clear overview of the most cost-efficient activities. It also helps businesses choose unique indicators that do not depend fully upon sales to decide the budgets for the department. Direct labor, machine time, square footage, and other indicators can be chosen per the need.
- Better Departmental Strategies: Once the funds are allocated to individual departments, they can calculate the budget already. That helps departments make effective plans and strategies to use the fund, and if extra funding is needed for specific products, they can request that too. This leads the department to make better decisions for the management purpose.
- Challenges in Setting the Variable Costs: Each department has different variable costs, and tracking these variable costs precisely can come up as a challenge. If setting the variable cost goes wrong, or the market change leads to an unexpected expense hike, then the product’s price will get misjudged, which might cause a shortage.
- Usage can go Under the Budget: If a company misjudges the cost allocated and instead allocates a larger budget than it needed, the actual use of the cost can go under budget. This can be seen in companies where the budgets get decided upon the usage instead of the other important factors. This makes the business suffer as a whole.
- The partiality of Departments: In the time of allocation, some departments might face partiality, where some departments get more than the others, especially when the cost manager tends to do favoritism. This biased situation can lead to an unhealthy work environment that affects the actual purpose of departments.
- Percentage of Budget can Mislead: If the cost allocation gets misguided, the company’s overall budget can go off the balance.
In this chapter, we learn about joint costs and how we can effectively manage and grow our business. In a single manufacturing process, multiple joints and by-products are generated.
This helps calculate the total cost price and selling price of those products and conjecture the profit overall.
It also helps to set the point on the products according to their economic value. It is a way to create a healthy work environment in organizations and have the plans and strategies to succeed.