Many industries, mainly chemical and food industry face a lot of problems in assigning cost to the joint and the by-products that get simultaneously produced from a common initial process. But in order to have maximum profitability from that product, we need to have a correct evaluation of it cost. Proper costing of the products will provide the company with proper stock evaluation and help in assessment of excise duty.
Joint products are produced as a direct result of the strategic planning process of the company. These products are of major importance to the company and, therefore, represent a significant focus for management, accounting, and financial reporting.
Byproducts emerge from a common process along with primary products but are not considered to be important or valuable enough to be a major focus of management. In other words, a product, which is secondary to the main product and obtained during the course of manufacture of recognized main product is called a by-product because of the relatively lower importance it has as compared with the main product or products. By-product cost is difficult to determine. The revenue, if any, from its sale is generally credited to the operation concerned or to the profit and loss account. By-product is usually subjected to further processing after separation from the main product.
The nature of Joint Product Output
Fixed and variable proportions:
Although joint products have a definite quantitative relationship to each other, this relationship may take different forms. The nature of the joint products output can either be in fixed or variable proportions. The relationship between the products is fixed if an increase in the output of one product of a group results in a proportionate increase in the output of the other products. In contrast, if the increase in output of one product results in either a decrease or has no effect on the output of one or more of the remaining products then the relationship between the outputs is one of variable proportions. This variation in output proportions may only be controlled within certain limits and only arises in certain processes.
Intermediate and final products:
Joint products arise from a common process or series of processes, the latter giving rise to intermediate products. Intermediate products can be defined as those products to be further treated and processed to produce main product, where the main products in a multi-purpose operation may take the form of intermediate products at a certain stages of production and finished products at the final stage of production.
Joint and Separation costs:
The fundamental feature of joint product is that they incur joint cost up to a certain stage of production, known as the split off point, where they become recognizable as separate products. The costs incurred in the joint process cannot be separately traced to the individual product outputs.
Subsequent to the split-off point any cost incurred e.g. the additional processing costs, can be identified with specific products and may be termed separable or attributable cost. For a cost to be separable, it must be possible to trace it with reasonable certainty to a single product.
Identification of Joint and By-Products:
Recognition of joint products and by-products, is purely by relative commercial values. Further, such relative values are not permanent as their relative importance of joint and by-products is evanescent in nature, as can be seen by the following two examples.
In the sugar industry, till about four decades back, press mud was just a waste product of nuisance value, that needed continuos disposal at additional costs or else it will create contamination. Subsequently, through research, it was found that the press mud contained rich nutrients which stimulate plant growth, as a result of which it became a commercially valuable product.
In caustic soda industry, the primary process yields three products: caustic soda, chlorine and hydrogen. The demand for products, were not commensurate with the output. Out of the three Chlorine was a toxic waste and had to be disposed off in accordance with the environmental regulations, at a high cost. Hence, Chlorine was deemed as a burden on the main products. A major transformation took place due to technological advancement, due to which chlorine became a staple product for the entire range of PVC products. Overnight the caustic soda industry itself became "Caustic Chlor industry", indicating the near commercial equality of the products.(Joint product) Due to subsequent further developments, the "Caustic Chlor industry" transformed into "Chlor Alkalic" industry, thus completing the transformation from a waste to high value main product.
Methods of Apportionment of Joint Costs:
The existing methods for apportionment of joint products in the industry are:
Market value basis: Under this method, joint costs are allocated on the basis of their relative sales value. The implication of this method is that joint products should absorb joint costs according to their ability to pay as reflected by the market values of the individual products.
Four differing application of the sales value method are as follows-
Market value after further processing i.e. the final sales value.
While apportioning the cost on the basis of final sales value the costs are ascertained in the proportion of final sales value after further processing beyond the split off point. When there is a wide parity in selling prices of final products, this method is to be adopted. While choosing a selling price, it is important to choose a representative period considering the normal cycle of fluctuations. Such a representative figure may be the daily average of the past month or quarterly average as may be appropriate. In case the products are sold to different markets, the adjusted market value, eliminating freight and brokerage or commission elements or any other cost is to be taken.
Net Realisable value: It is the final sales value after deducting the further processing costs. In cases when the process streams require further processing after the split-off point, then the costs incurred (a measure of the value added) after split off points are determined and deducted from the final net sales value to deduce the basis for apportionment of joint cost among the products.
Gross Margin Percentage: When the products have same profitability on sales, Joint costs shall be allocated on the basis of Gross Margin Percentage.
Market value at the point of separation: Joint costs apportionment on the basis of sales value of the products is followed when no other rational basis for apportionment of join cost is available and joint products are sold without further processing at split off point.
Limitations: If costs are assigned on the basis of sales value then products which are produced in lesser amounts or have lesser value than the other joint products, then the cost absorbed by them would be considerably lesser than the other joint products. Whereas, there are many cases in which the costs incurred by a product of lesser sales value (quantity x selling price) are much higher than the costs incurred by products of higher sales value. For example, let us consider the air separation industry where, although argon is produced in the least amount, the energy required in order to separate argon is highest. Moreover in the air separation industry energy costs form a large portion of the total costs. Hence we can conclude from the above that argon should absorb the highest cost but if we assign the cost on the basis of sales value, its cost would be the least.
Physical Measurement Basis: Sometimes when the products obtained have a common source material and none of these products can be classified as by-product, in such situations the consumption of the materials (utilities, raw materials, etc.) by individual products from common input, is measured by physical units such as weight, volume, etc. The joint costs are to be allocated to individual products on the basis of this measurement.
This method is suitable under circumstances where the units of measurement of the final products are the same or capable of being measured in similar units.
In industries where joint products emerge in different physical state and are therefore measured in differing physical units, a problem arise in establishing a common denominator. However, even in case where the outputs emerges as solids, liquids and gases, a common unit or physical co-efficient such as weight, can normally be found as a conversion factor (the weight of a gas is calculated given the volume, temperature and pressure).
Apportionment on the basis of volume of production of joint products:
Joint cost can be allocated to individual units on the basis of volume only when the units of measurement of the products are same or similar in nature and all the products have nearly equal importance.
Apportionment on the basis of Physical Volume and Physical Co-efficient: When physical co-efficient of products is significant in determining the value of the joint products, the same may be taken as a factor for apportionment of joint cost. For example, calorific value per unit volume for joint products in case of petroleum industry, food ingredients in food processing industry etc. may be the basis of apportionment.
If the physical co-efficient under consideration varies with the change of raw material and other process parameters, then in such cases the physical co-efficient should be measured for the output produced within a limited time in a controlled conditions so that basis of apportionment does not represent wrong basis.
For an industry, especially Chemical Industry, where inputs used follow strict norm and process conditions are streamlined according to the requirement of standard processing environment, the standard indices of co-efficient arrived at un-biased sampling technique may be used.
Techno Commercial Factor evaluation base:
When the joint costs are affected by more than one factor then assigning costs solely on the basis of only one factor may lead to inappropriate cost allocation. Therefore, in such situations the weighted average of the key evaluators can be taken as a base.
Basis of apportionment cannot be wholly market based or purely physical based. So a combination of both should be used, taking into account the multiple forces that have impact on production and sale and then duly assigning weights to each of the several factors.
For example, in the caustic soda industry, the primary process, where the three products occur: Caustic, Chlorine and Hydrogen, a stoichiometric ratio of the three products is used for separating the costs.
For Instance of the two products A and B jointly produced, A may be more difficult to produce but B relatively easy. From the marketing angle the reverse is the case. Hence management may assign points say, on a scale of 10 as below.
Hence, joint cost to be distributed between A and B on the basis of 12/22 and 10/22 respectively.
One drawback of this method could be that the rating is done by the management and therefore, it is mainly based on the management's perception which might lead to certain discrepancies in the system.
Input based cost drivers for apportionment of joint cost:
There may be one or more cost drivers that impact the production cost significantly. For example, cost of energy is the main cost in the compression of air for producing oxygen, nitrogen and Argon and there is no other raw material cost. Hence a fair basis for distribution of the joint cost over the various products could be the cost driver of energy.
It can be seen that there is an inverse relationship between the output proportion yielded and the energy required to separate a product. Hence Argon representing the smallest output of 1% bears the majority of cost.
Rank Number
In oil refinery, a number of individual products are obtained from the crude oil.
Generally, more importance is given to the profit arising out of a barrel of crude oil and hence, joint costs are usually not allocated. J.J.Butler suggested a method in which he proposed that management should identify all the feasible alternative combination of the input and rank them as follows:
Rank Number = Total Profit of the combination
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Number of units of base input required
He treats the basic input as a scarce resource and believes that the objective of the firm should be to yield the greatest return from the scarce resources. The advantage of this method over the market value method is that the value addition becomes a key factor in allocation of joint costs.
By-Product Costing
The by-products are normally additional output in the production of main products. The costing of by products is not very important with respect to profit optimization due to relatively low sales value. However, the standardization of treatment of by-product costs is important from the point of cost accounting.
A uniform system of treatment of cost accounting for by-product is generally followed. Sales value of by-products less further processing cost administrative expenses and selling and distribution expenses is credited to the total cost of main product.
In case realization from the by-product is not significant, the amount realized may be treated as other income and directly credited to P & L Account.
Proposed Method
In oil/ petrochemical industry on fractional distillation of oil, several fractions are obtained at different temperatures. Apportioning the costs in such an environment is very difficult. One method that could be used to allocate various costs could be as follows:
The major recurring costs incurred in an oil industry would be that of fuel, raw material and utilities (such as steam). As we know different fractions are obtained at different temperatures, if we assume that a particular fraction A is obtained at 40 deg C and other fractions B and C, are obtained at 180 and 250 deg C respectively. The amount of fuel required to raise the temperature of oil to 40 deg C (say X) can be obtained knowing the calorific value of the fuel used. Now since there are three fractions in our example we divide X/3 and allocate this amount to all the three fractions. Similarly in order to raise the temperature further from 40 deg C to 180 deg C can be found out (say Y) and Y/2 would be allocated to B and C. Further the fuel required to raise temperature to 250 deg C (say Z) can be allocated wholly to C. This way the amount of fuel used is:
A -> X/3
B-> X/3 + Y/2
C-> X/3 + Y/2 + Z
Now we can define a factor
â•’ = (Revenue per unit base input*)/(Amount of fuel used)
*Base input in this particular case would be oil.
For further clarity we assume arbitrary numerical values. The total amount of fuel used is 6 kg.
X = 3 kg
Y= 2 kg
Z= 1 kg
Therefore the fuel allocated to the three products would be:
A = 1 kg
B= 2 kg
C= 3 kg
Assuming that 1lit input produces 0.2 lit A, 0.4 lit B, 0.3 lit C and the costs per lit are Rs. 110, 115 and 120 respectively, then the revenue per lit earned by the three products would be as follows:
A = (0.2 * 110) = 22
B = (0.2 * 115) = 23
C = (0.3 * 120) = 36
Therefore â•’A = (22)/ (1) = 22
â•’B = (23)/ (2) = 11.5
â•’C = (36)/ (3) = 12 Total = 45.5
Now assuming for 1 lit of input the total cost of fuel required and steam required is Rs. 30, then the cost apportioned would be as follows:
A = (22 * 30)/ (45.5) = Rs. 14
B = (11.5 * 30)/ (45.5) = Rs. 8
C = (12 * 30)/ (45.5) = Rs. 8
In this method we have allocated the costs on the basis that whichever product earns the maximum revenue, the maximum cost would be borne by that particular product.
Another method to allocate the cost could be allocating on the basis that whichever product uses the least resources the least amount of cost would be borne by it. In this case we would take (1/â•’) to allocate the cost.
Citing the previous example:
(1/â•’A) = 0.045, (1/ â•’B) = 0.087, (1/â•’C) = 0.083
A = 6, B = 12, C = 12
The method of allocating cost for joint products may vary from company to company. The method suggested by us tries to take into account the value of the product as well as the resources consumed in order to generate that value. Whereas, other methods discussed above take only one of the factors into account for allocating the costs.
Generalization of the above formulae:
Number of fractions = n
Temperatures = T1 to Tn
Fuel Consumed = x1 to xn
Where, x1 = x1/n
x2 = x1/n + x2/n-1,
x3 = x1/n + x2/n-1 + x3/n-2
xn = x1/n + x2/n-1………………………xn-1/2 + xn
Limitations
The values assumed are arbitrary values and not actual values. So the applicability of this method after assuming actual values remains to be seen.
Further research and analysis is required in order to more accurately allocate the costs.
Conclusion
Cost Accounting for a process industry is very difficult. Allocation of costs is completely a managerial decision and varies from industry to industry. There could be better methods to allocate costs but generally for the sake of brevity and due to the inconsequential costs incurred by joint products before splitting off, these issues are ignored. Although addressing to such issues can lead to better cost allocation thereby allowing companies to price their products more competitively.
