Methods of Costing By-Products: PART 4

The accepted methods for costing by-products fall into two categories:

Category 1:
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 cost of the main product. In some cases, costs subsequent to split-off point may be offset against the by-product revenue. For inventory costing, any independent value may be assigned to the by product. The methods most commonly used in industry are:

Method 1: Recognition of Gross Revenue
Method 2: Recognition of Net Revenue
Method 3: Replacement cost method

Category 2:

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:

Method 4: Market value method or reversal cost method

Recognition of Gross Revenue Method--By Products Costing:

This method is 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 procedure 4 (by product revenue deducted from the production cost), although a sales value rather than a cost is deducted from the production cost of the main product.

By-Product Revenue as Other Income
By-Product Revenue as Additional Sales Revenue
By Product Revenue as a Deduction from the Cost of Goods Sold
By Product Revenue deducted from Production Cost
1.By-Product Revenue as Other Income:
To explain this procedure the following example is presented:

Example:
Sales (Main Product, 10,000 units @ $2) $20,000
Cost of goods sold:
Beginning inventory (1,000 units @ $1.5) $1,500
Total production cost (11,000 units @ $1.5) $16,500
-------
Cost of goods avail able for sale $18,000
Ending inventory (2,000 units @ $1.5) $3,000
-------
$15,000
--------
Gross profit 5,000
Marketing and administrative expenses $2,000
--------
Operating income $3,000
Other income: Revenue from sale of by-product $1,500
--------
Income before income tax $4,500
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2. By-Product Revenue as Additional Sales Revenue:
In this case, the income statement above would show the $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.

3. By Product Revenue as a Deduction from the Cost of Goods Sold:
In this case, $1,500 revenue from the by product would be deducted from the $15,000 cost of goods sold figure, thereby reducing the cost and increasing the gross profit and operating income. The income before income tax remains at $4,500.

4. 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 would appear as follows:

Sales (Main Product, 10,000 units @ $2) $20,000

Cost of goods sold:
Beginning inventory (1,000 units @ $1.35) $1,350
Total production cost (11,000 units @ $1.5) $16,500
Revenue from sale of by product $1,500
---------
Net production cost $15,000
Cost of goods available for sale 12000units @1.3625 average cost
$16350
Ending inventory (2,000 units @ $1.3625) $2,725
-------
$13,625
----------
Gross profit $6,375
Marketing and administrative expenses $2,000
----------
Operating income $4,375
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The preceding method required no complicated journal entries. The revenue received from by product sales is debited to cash or accounts receivable. In the first three cases, income from sales of by product is credited; in the fourth case, the production cost of the main product is credited.