The potential conflict between cost concepts used for decision making and cost concepts used for evaluating the performance of managers often arises in sell-or-process-further decisions Continuing with Example 2, suppose the fixed corporate and administrative costs allocated to further processing cream into buttercream is $30,000 and that these costs will be allocated to buttercream and to the manager’s product-line income statement only 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, Farmland’s operating income will increase by $20,000 by processing cream into buttercream. However, producing buttercream results in an additional charge of $30,000 for allocated fixed costs. If the manager is evaluated on a full-cost basis (after allocating all costs), processing cream into buttercream will lower the manager’s performance-evaluation measure by $10,000 . Therefore, the manager may be tempted to sell the cream at the splitoff point and not process it into buttercream.
A similar conflict can also arise with joint products. In Example 1, suppose Farmland Dairy can sell raw milk at a profit of $20,000. From a decision-making standpoint, the company maximizes operating income by processing raw milk into cream and liquid skim because total revenues from selling both joint products ($500,000, see Exhibit 17-3) exceed joint costs ($400,000) by $100,000, which is greater than the $20,000 profit from selling raw milk. Suppose, however, the cream and liquid-skim product lines are managed by different managers, each evaluated on product-line profitability. 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 17-4 revenues will be less than $120,000, but cost of goods sold will be unchanged at $120,000). From a performance-evaluation standpoint, the manager of the liquid-skim line will prefer to not produce liquid skim but rather to sell raw milk.
Farmland Dairy’s performance-evaluation conflicts will be less severe if it uses 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 each joint product having positive income.