CHAPTER 5

Cost Allocation: Joint

Products and
Byproducts

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 Cost Allocation
Aim of this chapter is to:
 Explain the notions of „overhead costs‟,
„indirect costs‟, „direct costs‟, „traceable
costs‟ and „allocated costs‟.
 Explain how accountants choose to create
„cost centres or „cost pools‟ in which to gather
together cost data.
 Explain why and how costs may be allocated
from one cost pool or centre to another.
 Support department cost allocation 2
 Allocation of overhead costs

Cost Pool: Costs are grouped into pools according to the

activities, which drive them. In this al costs associated with
procurement i.e. ordering, inspection, storing etc would be
included in this cost pool and cost driver identified.
Cost allocation is “that part of cost attribution which
charges a specific cost to a cost centre or cost unit”.
A Cost Object: It is an item for which cost measurement is
required e.g. Product, job or a customer.
A Cost Driver: In an ABC system, the allocation basis that
are used for applying costs to services or procedures are
called cost drivers. It is a factor that causes a change in the
cost of an activity. 3
 Allocation of overhead costs

After having collected the overheads under proper standing

order numbers the next step is to arrive at the amount for
each department or cost centre.
For instance, the wages paid to maintenance workers as
obtained from wages analysis book can be allocated directly to
maintenance service cost centre. Similarly
indirect material cost can also be allocated to different cost
centres according to use by pricing stores requisitions.
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 Apportionment of overhead costs

Apportionment is “that part of cost attribution which shares

costs among two or more cost centres or cost units in
proportion to the estimated benefit received, using a proxy”.
Apportionment is done in case of those overhead items
which cannot be wholly allocated to a particular department.
For example, the salary paid to the works manager of the
factory, factory rent, general manager’s salary etc.

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 Apportionment of overhead costs

1.Primary distribution of overhead involves

allocation or apportionment of different items of
overhead to all departments of a factory. This is
also known as departmentalization of overheads.
2.Secondary distribution of overheads is the process
of apportionment of service department overheads
among the production departments.
Expenses directly incurred in the departments which are
jointly incurred for several departments have also to be
apportioned e.g. expenses on rent, power, lighting,
insurance etc. 6
Advantage of Departmentalization

(i) It segregates factory overhead costs and computes

the total cost of each service departments.
(ii) It makes possible the establishments of control to
keep costs at a minimum.
(iii) Ascertainment of cost of different departments helps
in computing the cost of different jobs or products
which pass through these departments .

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 Apportionment of overhead costs

Apportionment Basis Items of Overheads

Floor area Rent, rates and taxes paid for the
building, air conditioning, etc
No. of employees or Group insurance, canteen expenses,
E.S.I.
wages of each contribution, general welfare expenses,
department compensation and other fringe benefits,
supervisions etc.
Direct labour hours Works manager’s remuneration,
general overtime expenses, cost of
inter-department transfers etc.

Weight, volume, tonne, mile. Delivery expenses

Value or weight of direct material Stores overheads 8
 Apportionment of overhead costs
Apportionment of cost to
Service department costs Basis of apportionment
Maintenance department Hours worked for each
Department
Employment/personnel Rate of labour turnover or
department number of employees in each
department
Payroll or time department Direct labour hours, machine
hours number of employees
Stores keeping department No. of requisitions, quantity or
value of materials
Building service department Relative area of each department
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 Cont…
NB: Direct expenses are costs other than materials
or wages which are incurred for a specific product
or saleable service.
 Overhead is the expendture on labour, materials
or services which can not be economically
identified with a specific saleable cost unit.
 Common expenses have to be apportioned or
distributed over the departments on some equitable
basis.
 Absorption of overheads refers to allotment of overheads
to cost units.
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 Treatment of OVERHEADS

Administrative overheads are apportioned over

production and sales departments.
Administration overheads are recovered as a percentage
of works cost . If selling and distribution expenses are
small, they may be included in office expenses.
Selling costs or overhead expenses are those incurred for
the purpose of promoting the marketing and sales of
different products.
Distribution expenses are expenses relating to delivery
and dispatch of goods sold.
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 Accounting Treatment of Overheads

The following are the steps involved in accounting of

overheads :
(i) The overhead expenses incurred by various
departments are collected and accumulated under
appropriate standing order numbers in the overhead
expenses ledger.
(ii) Allocation of overheads to production and service
departments. 12
 Treatment of Overheads cont…
(iii) Apportionment of such overheads which can not be
allocated.
(iv) Re-appointment of service department expenses to
production departments.
(v) The total overhead expenses incurred by steps (i) to
(iv) above represents the total overhead cost of
production departments.
(vi) An overhead rate is to be computed for each
department on the basis of estimated, actual or normal
expenses and normal rate of working.

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 Joint and By-products

Joint costs are the costs of a production process that yields

multiple products simultaneously.
When a joint production process yields two or more
products with high total sales values compared with the
total sales values of other products are called joint
products.
The products of a joint production process that have low
total sales values compared with the total sales value of
the main product /joint products are called byproducts.
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 Approaches to Allocating Joint Costs

Under the 1st approach(1) Three methods are used:

 1. Sales value at split-off method
 2. Net realizable value (NRV) method
 3. Constant gross-margin percentage NRV
method
Under Approach 2: Allocate joint costs using
physical measures, such as the
 weight,
 quantity (physical units), or
 volume of the joint products. 15
 The sell or process further

The term joint costs is used to describe all the

manufacturing costs incurred prior to the point where
the joint products are identified as individual products,
referred to as the split-off point.
At the split-off point some of the joint products are in
final form and salable to the consumer, whereas others
require additional processing.
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 Sell or process further
In many cases, however, the company might have an
option: it can sell the goods at the split-off point or
process them further in the hope of obtaining additional
revenue.
In connection with this type of decision, called the “sell-
or-process- further” decision, joint costs are considered
irrelevant, since the joint costs have already been
incurred at the time of the decision, and therefore
represent sunk costs.
The decision will rely exclusively on additional revenue
compared to the additional costs incurred due to further
processing. 17
 Cont…
Example 5.6. The Lin Company produces three
products, A, B, and C, from a joint process.
Joint production costs for the year were
$120,000. Product A may be sold at the split-off
point or processed further.
The additional processing requires no special
facilities, and all additional processing costs are
variable. Sales values and cost needed to
evaluate the company’s production policy
regarding product as follow:
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Sell or process further decisions*

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CONT…

Should product A be sold at the split-off point

or processed further?

To answer this question, consider the three

decision-making approaches discussed
earlier in the chapter, that is, the total
project approach, the incremental approach,
and the opportunity cost approach.
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1. Total project approach

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 2. Incremental cost approach

The difference column above is essentially the basis for the

incremental approach, which compares incremental revenue

with the incremental costs. In this case:

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3. Concept of opportunity cost *

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 ADDING OR DROPPING A PRODUCT
LINE

The decision whether to drop an old product line

or add a new one must take into account both
qualitative and quantitative factors.
However, any final decision should be based
primarily on the impact the decision will have
on contribution margin or net income.
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 Example 5.7.

The ABC grocery store has three major

product lines: produce, meats, and canned
food.
The store is considering dropping the meat
line because the income statement shows
that it is operating at a loss.
Note the income statement for these product
lines below:
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Cont…

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 Cont…

In this example, direct fixed costs are those costs

that are identified directly with each of the
product lines, whereas allocated fixed costs are
the amount of common fixed costs allocated to the
product lines using some base such as space
occupied.
The amount of common fixed costs typically
continues regardless of the decision and thus
cannot be saved by dropping the product line to
which it is distributed.
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The Total Approach

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Using opportunity cost Approach

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 UTILIZATION OF SCARCE
RESOURCES
In general, the emphasis on products with higher Contribution
margin maximizes a firm’s total net income, even though
total sales may decrease. This is not true, however, where
there are constraining factors or scarce resources.
The constraining factor is the factor that restricts or limits the
production or sale of a given product. The constraining
factor may be machine hours, labor hours, or cubic feet of
warehouse space.
In the presence of these constraining factors, maximizing total
profits depends on getting the highest contribution margin
per unit of the factor (rather than the highest contribution
margin per unit of product output).
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Cont…

Example 5.8. Assume that a company produces

two products, A and B, with the following
contribution
A B

margins
Sales per unit:$8 24
Variable costs 6 20
Contribution 2 4
margin
Annual fixed costs = $42,000

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 CONT…

As is indicated by CM per unit, B is more profitable

than A since it contributes more to the company’s
total profits than A ($4 vs. $2).
But let us assume that the firm has a limited
capacity of 10,OOO labor hours. Further,
assume that A requires 2 labor hours to produce
and B requires 5 labor hours. 32
CONT….

One way to express this limited capacity

is to determine the contribution margin
per labor hour:
A B

Contribution Margin per unit $2 $4

Labor hours required per units 2 5
CM per labor hour $1 $0.5
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Cont…

Another way to look at the problem is to

calculate total CM for each product.

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