A joint cost is a cost incurred in a single production process that produces two or more products at the same time. Up to a certain stage, called the split-off point, the products cannot be made separately: crude oil is refined into gasoline, diesel and other products; a dairy turns raw milk into cream and skim milk; a sawmill produces lumber of several grades from one log. The cost of the raw material and processing up to split-off is the joint cost.
The products that emerge are called joint products when each has significant value, and by-products when their value is minor. Because no single product causes a joint cost, it can only be shared among the products by allocation. This matters for inventory valuation and for reporting product profitability, but joint costs are irrelevant to many decisions about what to do with each product after split-off. Joint costs are a type of common cost.
Joint costs in plain terms
Think of a butcher who buys a whole pig. From one animal come chops, bacon, ham and sausages. The price of the pig cannot honestly be traced to the chops or to the bacon; it bought all of them at once. Yet to value the stock and price the cuts, the butcher needs some way of sharing the cost.
Any sharing method is a convention, not a fact. A sensible approach gives more of the cost to the cuts that sell for more, so that every cut shows a reasonable profit. But once the pig is bought, its cost is the same whatever the butcher decides to do with each cut.
Methods of allocating joint costs
- Physical units method. Joint cost is shared in proportion to a physical measure such as weight, volume or units at split-off.
- Sales value at split-off method. Joint cost is shared in proportion to each product's market value at the split-off point. It is widely preferred because it allocates cost according to each product's ability to bear it.
- Net realizable value method. Where products have no market at split-off, each product's final sales value minus the separable costs of processing it further, its net realizable value, is used instead.
- Constant gross margin method. Cost is allocated so that every product earns the same gross margin percentage.
Worked example
A chemical process costs $120,000 and yields 6,000 pounds of product A, which sells for $20 a pound at split-off, and 4,000 pounds of product B, which sells for $15.
| Method | Product A | Product B |
|---|---|---|
| Physical units (60% / 40%) | $72,000 | $48,000 |
| Sales value at split-off ($120,000 / $60,000) | $80,000 | $40,000 |
Under the physical units method, B is charged $12 a pound, leaving a margin of only $3 on a $15 sale, while A appears very profitable. Under sales value, both products show the same one-third gross margin. The total cost allocated is $120,000 either way; only the split differs.
Joint costs and decisions
For a decision to sell a product at split-off or process it further, the joint cost is a sunk cost: it has already been incurred and will not change. Only the incremental cost of further processing and the extra revenue it brings are relevant. If product B could be refined further for $2 a pound and then sell for $19, the extra revenue of $4 a pound exceeds the $2 cost, so further processing adds $8,000 of profit on 4,000 pounds, regardless of how much joint cost was allocated to B.
Managers can be misled if they treat allocated joint cost as avoidable. Under the physical units allocation above, B looks barely profitable, but dropping it would not save any of the $120,000 joint cost and would lose B's $60,000 of revenue.
By-products and reporting
By-products, such as sawdust from a sawmill, usually receive no share of joint cost. Their net revenue is either reported as other income when sold or deducted from the joint cost of the main products. For external reporting, allocated joint costs flow into inventory and then cost of goods sold, and companies should apply their chosen method consistently. Joint cost accounting is common in process costing industries such as oil refining, chemicals, meat packing, mining and agriculture.