There are a few situations where multiple saleable products are created as part of a production process, and for which there are no demonstrably clear-cut costs beyond those incurred for the main production process. When this happens, the cost accountant must determine a reasonable method for allocating these costs.
The first step in this allocation process is to determine the “split off” point, which is the last point in the production process where one still cannot determine the final product. For example, a batch of sugar, water, and corn syrup can be converted into any of a number of hard candy products, up until the point where the slurry is shifted to a slicing machine that cuts up the work-in-process into a final and clearly identifiable product. From this point onwards in the production process, we can either have a main product and an incidental side product (known as a “byproduct”), or several major products (which are known as “joint” products). The accounting for these different types of final products is somewhat different.
The simplest cost allocation method is to determine the proportion of total revenue that each product coming from a joint production process will generate, and then apportion all joint costs based on the relative proportions of revenue that are to be earned by each product. For example, if Product A earns $10 and Product B earns $5, then 2/3 of the total joint cost will be allocated to Product A and 1/3 of the total joint cost will be allocated to Product B. Byproducts are assumed to have such a minor incidental impact on revenues that it is simpler to apportion no costs to them at all; instead, any revenues gained from the sale of byproducts will be credited to the cost of goods sold.
This assumption that byproducts have minimal value can be flawed in some circumstances. For example, the metal scrap that arises from a stamping operation may be accumulated for several months, at which point enough has been accumulated that a reasonable amount of revenue is realized. Because no cost has been assigned to the metal scrap, there is no cost to offset this modest surge in revenues, which therefore creates an unexpected jump in gross margins in the period when the sale of scrap occurs. This can be a particular problem if a company designates a byproduct as being anything resulting in a moderately large proportion of total production, such as 5-10%; the revenue to be gained from such a large quantity of byproduct, against which no costs are charged, can cause quite a dramatic change in the reported gross margin level. To avoid this problem, it is best to charge some cost to all products coming from a joint manufacturing process, even if they are byproducts.
An alternative calculation for joint costs is to estimate the final gross margin of each joint product, which is based on the final sale price less the amount of costs incurred by each product between the split-off point and the point of sale. This is a more complicated approach to the allocation problem, and can be especially difficult to calculate if the costs incurred after the split-off point are so variable that they are difficult to estimate in advance. Consequently, the simpler method of basing joint cost allocations only on revenues earned by each joint product is the preferred approach.