Joint Product

Joint products are two or more products of significant value that are produced together from the same raw materials and the same process, and that cannot be identified as separate products until a certain stage, called the split-off point. Classic examples include gasoline, diesel, jet fuel and other products refined from crude oil; cuts of meat, hides and other products from processing cattle; milk processed into cream and skim milk; and lumber and wood chips from logs. Because the products emerge together, the business cannot make more of one without also making the others.

The costs incurred before the split-off point, such as the cost of crude oil and refining, are called joint costs. They are a special case of common costs, shared by all the joint products. In economics, the same situation is described as joint supply. Joint products are distinguished from by-products, which are produced in the same process but have relatively low sales value compared with the main products, such as sawdust in a sawmill.

For financial reporting, joint costs must be allocated to the joint products so that each can be valued in inventory and charged to cost of goods sold when sold, as required under absorption costing. Since there is no physically correct way to divide joint costs, accountants use one of several accepted methods:

• The physical units method allocates joint costs in proportion to a physical measure, such as weight, volume or barrels, at the split-off point.
• The sales value at split-off method allocates joint costs in proportion to the market value of each product at split-off.
• The net realizable value method allocates joint costs in proportion to each product's final sales value minus the separable costs of processing it further after split-off.
• The constant gross margin method sets joint cost allocations so that every product earns the same gross margin percentage overall.

A dairy spends $60,000 a month on raw milk and initial processing, which produces 10,000 litres of cream and 30,000 litres of skim milk at split-off. Cream can be sold at split-off for $4.00 per litre and skim milk for $1.00 per litre.

• Under the physical units method, cream is 25 percent of the volume and receives $15,000 of joint cost, while skim milk receives $45,000.
• Under the sales value at split-off method, cream's sales value is $40,000 and skim milk's is $30,000, a total of $70,000. Cream receives 40/70 of the joint cost, about $34,286, and skim milk receives about $25,714.

The two methods produce very different product costs. Under physical units, skim milk earns a loss of $15,000, because it is charged $45,000 against $30,000 of sales, while cream appears highly profitable. Under sales value, both products show the same gross margin percentage at split-off, about 14 percent. Many accountants prefer sales-value-based methods because they allocate costs according to each product's ability to bear them.

An important rule for management decisions is that joint costs are irrelevant to the question of whether to sell a joint product at split-off or process it further. Joint costs are incurred whatever is decided after split-off, so for that decision they behave like a sunk cost. The correct comparison is between the extra revenue from further processing and the extra, separable cost of that processing. If the dairy could turn its cream into butter that sells for $70,000 at an additional cost of $22,000, further processing increases profit by $70,000 minus $40,000 minus $22,000, or $8,000, regardless of how joint costs were allocated. This kind of analysis is closely tied to the idea of opportunity cost and to marginal cost thinking.

All joint cost allocations are, to some extent, arbitrary. They are useful for inventory valuation and for complying with reporting rules, but they should not be used to decide whether to stop producing a joint product, since dropping one product rarely saves the joint costs. Allocations can also make some products appear unprofitable when they actually contribute to covering joint costs. Clear documentation of the method chosen, and its consistent use, matters for comparability in cost accounting and for audit.