Definition and Explanation
The term by-products is generally used to denote one or more products of relatively small total value that are produced simultaneously with a product of greater total value. The product with the greater value, commonly called the “main product”, is usually produced in greater quantities than the by-products. Ordinarily, the manufacturer has only limited control over the quantity of the by-product that comes into existence.
However, the introduction of more advanced engineering methods, such as in the petroleum industry has permitted greater control over the quantity of residual products. In fact, one company, which formerly paid a trucker to haul away and dump certain waste materials, discovered that the waste was valuable as fertilizer, and this by-product is now an additional source of income for the entire industry.
Methods of costing by-products
The accepted methods for costing by-products fall into two categories:
1. Non-cost or sales value method
A joint production cost is not allocated to the by-product. Any revenue resulting from sales of the by-product is credited either to income or to the cost of the main product. In some cases, costs subsequent to split —off may be offset against the by-product revenue. For inventory costing, an independent value may be assigned to the by-product. The methods commonly used in industry are:
Method-1 is a typical non-cost procedure in which the final inventory cost of the main product is overstated to the extent that some of the cost belongs to the by-product. However, this shortcoming is somewhat removed in method-1 (d), although a sales value rather than a cost is deducted from the production cost of the main product.
(a): By product revenue as other income
To illustrate this procedure, the following income statement is presented:
(b): By-product revenue as additional sales revenue
In this case, the income statement above would show that $1,500 revenue from sales of the by-product as an addition to sales of the main product. As a result, total sales revenue would be $21,500 and gross profit and operating income would increase accordingly. All other figures would remain the same.
(c): By-product revenue as a deduction from the cost of sold
In this case, the $1,500 revenue from the by-product would be deducted from the $15,000 cost of goods sold figure, thereby deducting the cost and increasing the gross profit and operating income. The income before tax remains at $4,500.
(d): By-product revenue deducted from production cost
In this case, the $1,500 revenue from by-product sales is deducted from the $ 16,500 total production cost, giving a new production cost of $15,000. This revised cost results in a new average unit cost of $1.3625 for the main product. The final inventory will consequently be $2,725 instead of $3.000. The income statement appears as follows:
The preceding methods require no complicated journal entries. The revenue received from by-product sales in debited to cash (or account receivable). In the first three cases, income from sales of the by-product is credited in the fourth case; the production cost of the main product is credited.
Revenue from sales of the by-product less the cost of placing the by-product on the market (marketing and administrative expenses) and less any additional processing cost of the by-product is shown on the income statement in a manner similar to that indicated in Method-1.
Method-2 recognize the need for assigning some cost to the by-product, it does not attempt. however, to allocate any main product cost to the by-product. Any expenses involved in further processing or marketing the by-product are recorded in separate accounts. All figures are shown on the income statement, following one of the procedures described in method-1.
Journal entries in method-2 would involve charges to by-product revenue for the additional work required and perhaps for factory overhead. The marketing and administrative expense might also be allocated the by-product on some predetermined basis.
Some firms carry an account called by-product to which all additional expenses are debited and all income statement is credited. The balance of this account would be presented in the income statement, following one of the procedures outlined in method-1. However, accumulated manufacturing costs applicable to by-product inventory should be reported on the balance sheet.
2. Cost Methods
Some portion of the joint production cost is allocated to the by-product. Inventory costs are based on this allocated cost plus any subsequent processing cost. In this category, the following method is used:
The replacement cost method
The replacement cost method ordinarily is applied by firms, whose by-products are used within the plant, thereby avoiding the necessity of purchasing certain materials and supplies from outside suppliers. The production cost of the main product is credited for such materials, and the offsetting debit is to the department that uses the by-product. The cost assigned to the by-product is the purchase or replacement cost existing in the market.
This method is common in the steel industry. Although many by-products are sold in the open market, other products, such as blast furnace gas and coke oven gas, are mixed and used for heating in open-hearth furnaces. The waste heat from open hearths is used again in the generation of steam needed by the various producing departments. The resourceful use of these by-products and their accounting treatment are indicated by the following procedure used by a steel company:
- Coke oven by-products are credited to the cost of coke at the average sales price per unit for the month.
- Coke oven and blast furnace gas are credited respectively to the cost of coke and the cost of pig iron at a computed value based on the cost of fuel oil yielding equivalent heat units.
- Tar and pitch used as fuel credited respectively to the cost of coke at a computed value based on the cost of fuel oil yielding equivalent heat units.
- Scrap steel remelted is credited to the cost of finished steel at market cost of equivalent grades purchased.
- Waste heat from furnaces used to generate steam is credited to the steel ingot cost at a computed value based on the cost of coal yielding equivalent heat units.
Reversal cost method
Reversal cost method is based on the theory that the cost of a by-product is related to its sales value. It is a step towards the recognition of a by-product cost prior its split off from the main product. It is also the nearest approach to methods employed in joint product costing.
The reversal cost(market value) method is basically similar to the last technique illustrated above in method-1. However, it reduces the manufacturing cost of the main product not by the actual revenue received, but by an estimate of the by-product value at the time of recovery.
This estimate must be made prior to split off from the main product. Dollar recognition depends on the stability of the market as to price and stability of the by-product; however, control over quantities is important. The by-product account is charged with this estimated amount and the production (manufacturing) cost of the main product is credited.
Any additional costs of materials, labor or factory overhead incurred after the by-product is separated from the main product are charged to the by-product. The marketing and administrative expense might also be allocated to the by-product on some equitable basis.
The proceeds from sales of the by-product are credited to the by-product account. The balance in this account can be presented on the income statement in one of the ways outlined for method-1, except that the manufacturing cost applicable to by-product inventory should be reported in the balance sheet.
The reversal cost (market value) method of ascertaining the main product and by-product costs may be illustrated as shown below:
This illustration indicates that an estimated value of the by-product at split off point results when estimated gross profit and production cost after split off are subtracted from the by product’s ultimate market value. Alternatively, if the by-product has a market value at that split off point, the by-product account is charged with this market value and the main products production cost would be credited.
It is also possible to use the total market values of the main product and the by-product at the split off point as a basis for assigning a share of the prior to split off cost to the by-product, applying: the events offsetting credit to the production cost of the main product. In any subsequent to split off cost related to the by-product would be charged to the by-product.