Why Joint Costs Are Irrelevant for Decision Making

Learning Objective 5 Explain why joint costs are irrelevant in a sell-or-process-further decision

Chapter 12 introduced the concepts of relevant revenues, and relevant costs, which are expected future revenues and expected future costs that differ among alternative courses of action. We apply these concepts to decide whether a joint product or main product should be sold at the splitoff point or processed further.

Sell-or-Process-Further Decisions

Consider Farmland Dairy’s decision to either sell the joint products, cream and liquid skim, at the splitoff point or to further process them into buttercream and condensed milk. In Example 2, it was profitable to further process both cream and liquid skim into buttercream and condensed milk, respectively. The incremental operating income from processing beyond the splitoff point is as follows:

A table shows incremental operating income from processing beyond the splitoff point for Farmland Dairy

The table depicts further processing cream into buttercream and further processing liquid skim into condensed milk. The details of the table are as follows:

  1. Further processing cream into buttercream
    • Incremental revenues, the quantity 25 dollars per gallon times 20,000 gallons minus the quantity 8 dollars per gallon times 25,000 gallons: 300,000 dollars
    • Deduct incremental processing costs: 280,000 dollars
    • Increase in operating income from buttercream: 20,000 dollars
  2. Further processing liquid skim into condensed milk
    • Incremental revenues, the quantity 22 dollars per gallon times 50,000 gallons minus the quantity 4 dollars per gallon times 75,000 gallons: 800,000 dollars
    • Deduct incremental processing costs: 520,000 dollars
    • Increase in operating income from condensed milk: 280,000 dollars

In this example, the operating income increases by further processing each product, so the manager decides to process cream into buttercream and liquid skim into condensed milk. Note that the $400,000 joint costs incurred before the splitoff point are irrelevant in deciding whether to process further. Why? Because the joint costs of $400,000 are the same whether the products are sold at the splitoff point or processed further. What matters is the incremental income from additional processing.

Incremental costs are the additional costs incurred for an activity, such as further processing. Do not assume all separable costs in joint-cost allocations are incremental costs. Some separable costs may be fixed costs, such as the lease cost on buildings where the further processing is done; some separable costs may be sunk costs, such as depreciation on the equipment that converts cream into buttercream; and some separable costs may be allocated costs, such as corporate costs allocated to the condensed milk operations. None of these costs will differ between the alternatives of selling products at the splitoff point or processing further; therefore, they are irrelevant.