Joint Cost Allocation
Joint product costs can be allocated using three different methods. They are Physical Measure of Output, Relative Sales value, and Net Realizable Value. This paper explores each of these methods briefly. The physical Measure of Output method allocates the joint costs based on the physical aspects of the products. Attributes can be measured in weight, length, volume, or units. Physical Measure of Output is a simple method that can be used by any manufacturing facility. However, issues arise where the joint products do not have a common unit of output. Secondly, the method does not consider the profitability of each product. Physical Measure of Output method results in costs that may cause management to make poor decisions (Kline, Liao & Schiff 2013).
The relative Sales Value method allocates the joint costs based on the amount the company can obtain by selling each joint product at the split-off point. Products with higher sales value are allocated higher costs. Unfortunately, it may not actually be possible to sell the products at the split-off point. Such products undergo further processing (Schneider 2012) which means that RSV is an unrealistic method because it focuses on products that have no actual sales value.
The net Realizable Value method allocates joint costs after considering the costs incurred to process the products after split-off. The NRV is obtained by deducting the separable costs from the final value of the product. The product with the highest NRV is allocated the highest cost. Of the three, NRV is the most realistic method. I would advise manufacturing companies to use NRV.
Absorption Costing
Absorption Costing is one of the methods used to allocate joint costs in a manufacturing facility. The final product cost is a sum of all costs incurred during the period divided by the number of units produced. Companies using this method include the fixed and variable costs in valuing inventory. Absorption Costing usually results in high-value inventory. This paper explores the advantages and disadvantages of Absorption Costing.
Advantages
Manufacturing companies that use absorption costing is able to show only the per-unit fixed cost during a period which is possible since the period’s cost of goods sold includes both fixed and variable costs. Goods not sold during the period still carry fixed costs but it is not included in the P&L statement. Secondly, valuing inventory using Absorption Costing allows marketing teams to consider all inventory costs while making pricing decisions (Schneider 2012) which is contrary to Variable costing where only the variable costs incurred are included in inventory valuation. Finally, Absorption Costing is the recommended inventory valuation model by GAAP. Manufacturing firms that use this method are not required to re-adjust their P&L for external users. Should a company choose to use any other costing method, GAAP requires them to re-adjust to Absorption costing before presenting financial information to external users.
Disadvantages
Absorption Costing is unfit for management decisions. It includes the fixed cost in product cost, which ideally should not be the case. Firms incur fixed costs whether or not a product is manufactured. Thus, decisions to discontinue a product based on Absorption Costing are likely to be wrong. Secondly, Absorption Costing results in inflated profit figures for the business because of excluding part of the period fixed costs in the period expenses (Kline, Liao & Schiff 2013).
Recommendation
The advantages of Absorption costing outweigh the disadvantages. I would recommend that companies use the Absorption Costing method for day-to-day business decisions. However, if there is a need to discontinue a product, the decision should not be made based on this method.
References
Kline, S., Liao, W. & Schiff, A. (2013). Cost accounting for managerial planning, decision making and control. Sydney: Cognella Academic Publishing.
Schneider, A. (2012). Management accounting. Mason, Ohio: Thomson/South-Western.