The physical units method is usually applied to the joint products which are similar in state and have a standard unit of measurement. In this method, the apportionment of the joint cost is done through relative quantity or weight of the joint products, at the split-off-point. The method chosen depends on the nature of the products and the information available https://accounting-services.net/ at the split-off point. The physical quantities method allocates joint costs based on a physical measure of output. This is one of the simplest methods where joint costs are allocated to different products based on the proportion of sales revenue of each product in total sales revenue. This is also known as market value method as this is a convenient approach.
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This method apportions the total production cost to the various products on the basis of a predetermined standard or index of production. Consider a business carrying out the process requiring the joint cost amounting to USD 10,000. The products do not have selling prices at the time of split-off points. This method of cost allocation is suitable where the sales price is not available for the products on the split-off point. Hence, the business can’t produce a single product when the process is for the production of a joint product.
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The cost accountant might use the physical units method to allocate joint costs based on the number of units produced for each joint product. For the by-product, the cost accountant might use the net realizable value method to allocate costs based on the market value of the by-product. The cost accountant must first identify the joint products (hardwood and softwood) and the by-product (wood chips) produced in manufacturing. They must then allocate the joint costs, such as the cost of raw materials and direct labor, to each joint product based on the proportion of the resources used in their production.
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- If the total value of the joint product is significant, then additional analytical detail can improve decision making by management.
- The materials encourage parents to counsel children about the dangers of drug abuse and inform them about how to detect it.
- For example, the cost of fertilizing and harvesting sunflowers qualifies as a common cost.
Since the whole wheat is a joint cost that produced two outputs after the split-off. Separating by-product costs is important for accurately determining the cost of production for the main product and for the by-product. This information can be used to decide which products to produce and sell and determine each product’s profitability.
Physical units method
This method also ensures that joint costs allocated to each product will not exceed sales revenue for each product (unless total joint costs are higher than total revenue). However, the allocation of joint costs to individual products is an issue of much concern to individual firms as there is no uniform policy for allocation of such costs. The individual firms adopt joint cost allocation policy as convenient to them, depending on their suitability.
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They all use some measure of production to do this, for example number or volume. An NFP’s management has the responsibility to assess joint activities for these criteria to ensure they are met and that joint costs are accounted for under the current accounting standards. If material, an auditor has the responsibility to perform procedures to obtain audit evidence about the amounts and disclosures for joint costs.
These methods are mainly classified onto engineering and non-engineering methods. Nonengineering methods are mainly based on the market share of the product; the higher market share, the higher proportion assigned to it e.g. net realizable value. In this method, the proportions are determined based on the sales value proportions. In the engineering based method, proportions are found based on physical quantities and measurements such as volume, weight, etc.
In summary, understanding joint and by-product costing is important in manufacturing for accurate costing, profitability analysis, tax compliance, financial reporting, and resource management. The chief characteristic of the joint product costing is that the cost of these different products results in an indivisible sum for all products, rather than in individual amounts for each product. The classic example of joint products is found in the meatpacking industry, where various cuts of meat and by-products are processed from one original carcass with one lump sum cost.
However in practice, there may be products with different measurements of units and in that case, it will not be possible to allocate joint costs under this method. Also, this method assumes that each joint product is equally valuable in terms of price and identity. Therefore, the prime concern in respect of joint products remains adequate and proper allocation of the joint costs. In practice, there are different methods followed to allocate the joint costs. For example, the Internal Revenue Service (IRS) requires companies to report the cost of goods sold (COGS) on their tax returns in the United States. The COGS must accurately reflect the costs incurred in producing the goods sold, including the costs of joint and by-products.
Moreover, the allocation process can be complicated and may require estimates and assumptions, which introduces a margin of error. This complexity underscores the importance of using consistent and logical methods to ensure the reliability of cost information for decision-making purposes. Joint costs pertain to the shared costs of producing main products up to the split-off point.
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Most of the time a physical basis is used to allocate joint costs because it is less subjective than the value basis. The simplest way of doing this is by allocating a fixed percentage to each unit (e.g., 1% Of joint costs per unit). More sophisticated methods allocate different proportions of the cost to each product based on sales value. These methods of cost allocation include allocation based on the gross margins and the allocation based on the sales values of the joint products.