Choosing an Allocation Method

Learning Objective 4 Identify situations when the sales value at splitoff method is preferred when allocating joint costs

Which method of allocating joint costs should be used? When selling-price data exist at the splitoff, the sales value at splitoff method is preferred, even if further processing is done. The following are the reasons:

  1. MEASURE OF BENEFITS RECEIVED. The sales value at splitoff is the best measure of the benefits received by joint products relative to all other methods of allocating joint costs (such as the physical method) because a company incurs joint costs to generate revenues at the splitoff point. Sometimes, increasing or decreasing joint costs affects the physical mix and market value of joint products. In such cases, there is a clear causal link between total cost and sales value at splitoff.*
  2. INDEPENDENT OF FURTHER PROCESSING DECISIONS. The sales value at splitoff method does not require information on the processing steps after splitoff. 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 individual products will be sold.
  3. COMMON ALLOCATION BASIS. As with other market-based approaches, in the sales value at splitoff method, revenue is a convenient common basis for allocating joint costs. In contrast, the physical measure at splitoff method may lack an easily identifiable common basis for cost allocation.
  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 operations with multiple products and multiple splitoff points. This complexity increases when managers make frequent changes to the sequence of post-splitoff processing decisions or to the point at which individual products are sold.

When selling prices of all products at the splitoff point are unavailable, the NRV method is the best alternative. It attempts to approximate the sales values at splitoff by subtracting from final selling prices the separable costs incurred after the splitoff point. The NRV method assumes that all the markup (profit margin) is attributable to the joint process and none to the separable processes and costs. This is unrealistic if, for example, a firm uses special patented technology in its separable process or innovative marketing to generate significant profits. Despite this limitation, the NRV method is commonly used when selling prices at splitoff are not available as it provides a better measure of the benefits received than either the constant gross-margin percentage NRV method or the physical-measure method.

The constant gross-margin percentage NRV method treats the joint products as though they are a single product. It calculates the aggregate gross-margin percentage, applies this percentage to each product, and views the residual after subtracting separable costs as the amount of joint costs assigned to each product. Unlike the NRV method, it does not measure the benefits received by each joint product at the splitoff point. A positive feature of the constant gross-margin percentage method is the recognition that the profit margin is attributable to both the joint process and the separable process after splitoff. But its weakness is the assumption that the profit margin (and ratio of costs to revenues) is identical across products. Recall from our discussion of activity-based costing (ABC) in Chapter 5 that such a situation is uncommon when companies offer a diverse set of products.

Although there are difficulties in using the physical-measure method—such as not reflecting benefits-received—there are instances when it may be preferred, such as when prices are volatile or the process after splitoff is long or uncertain, and a comparable physical measure for all products is available. This is the case, for instance, in the chemical and oil refining industries. The physical-measure method is also useful when joint cost allocations are used as the basis for setting market prices, as in rate regulation. It avoids the circular reasoning of using selling prices to allocate costs on which prices (rates) are based.

Not Allocating Joint Costs

Some companies choose to not allocate joint costs to products due to the complexity of their production or extraction processes and the difficulty of gathering a sufficient amount of data to allocate the costs correctly. For example, a survey of nine sawmills in Norway revealed that none of them allocated joint costs. The study’s authors noted that the “interviewed sawmills considered the joint cost problem very interesting, but pointed out that the problem is not easily solved.”*

Rather than allocating joint costs, some companies, such as in the meatpacking, canning, and mining industries, simply subtract joint costs from total revenues in their management accounts and value inventories at NRV. Recording inventories at NRV recognizes income on products before they are sold. To deal with this problem, some companies record inventories at NRV minus an estimated operating income margin. When any end-of-period inventories are sold in the next period, the cost of goods sold equals this carrying value. This approach is akin to the “production method” of accounting for byproducts, described later in this chapter.