One major decision a company has to make is to determine the point at which to sell their product—in other words, when it is no longer cost effective to continue processing the product before sale. For example, in refining oil, the refined oil can be sold at various stages of the refining process. The point at which some products are removed from production and sold while others receive additional processing is known as the split-off point. As you have learned, the relevant revenues and costs must be evaluated in order to make the best decision for the company.
In making the decision, a company must consider the joint costs, or those costs that have been shared by products up to the split-off point. In some manufacturing processes, several end products are produced from a single raw material input. For example, once milk has been processed it can be sold as milk or it can be processed further into cheese, yogurt, cream, or ice cream. The costs of processing the milk to the stage at which it can be sold or processed further are the joint costs. These costs are allocated among all the products that are sold at the split off point as well as those products that are processed further. Ice cream has the basic costs of the milk plus the costs of processing it further into ice cream.
As another example, suppose a company that makes leather jackets realizes it has a reasonable amount of unused leather from the cutting of the patterns for the jackets. Typically, this scrap leather is sold, but the company is beginning to consider using the scrap to make leather belts. How would the company allocate the costs incurred from processing and preparing the leather before cutting it if they decide to make both the jackets and the belts? Would it be financially beneficial to process the scrap leather further into belts?
Fundamentals of the Decision to Sell or Process Further
When facing the choice of selling or processing further, the company must determine the revenues that would be received if the product is sold at the split-off point versus the net revenues that would be received if the product is processed further. This requires knowing the additional costs of further processing. In general, if the differential revenue from further processing is greater than the differential costs, then it will be profitable to process a joint product after the split-off point. Any costs incurred prior to the split-off point are irrelevant to the decision to process further as those are sunk costs; only future costs are relevant costs.
Even though joint product costs are common costs, they are routinely allocated to the joint products. A potential reason for this treatment is the GAAP (generally accepted accounting principles) requirement that all production costs must be inventoried.
Be aware that some complexities can arise when allocating joint product costs. The first issue is that joint production costs can be allocated based on varying production and sales characteristics or assumptions. For example, a physical measurement method, a relative sales value method at the point of split-off, and a net realizable value method based on additional processing after the split-off point can all be used to allocate joint production costs.
A second complexity is that eliminating the production of one or more joint products will not always enable the company to reduce joint production costs. Because of the mechanics of the common cost allocation process, such an action will only work if reductions are made in all of the joint products collectively. If only some of the joint products are eliminated, the remaining joint product or products would absorb all of the joint product costs.
An example of this last issue might help clarify the point. Assume that you have a lumber production company that cuts trees, prepares board lumber for housing and furniture, and also prepares sawdust and wood scraps that is used in the production of particle board. Assume that in a given year the company experienced $1,100,000 in joint costs. Using one of the three previously mentioned cost allocation methods, the company allocated $1,000,000 in joint costs to the production of board lumber and $100,000 to the production of wood scraps and sawdust.
Assume that in the next year it also experienced $1,100,000 in joint costs. However, in that year, the company lost its buyer of wood scraps and sawdust, so it had to give both of them away, without generating any revenue. In this case, the company would still realize $1,100,000 in joint costs. However, the entire amount would be allocated to the production of the board lumber. The only way to reduce the joint costs is to realize joint costs of less than $1,000,000.
Luxury Leathers, Inc., produces various leather accessories, such as belts and wallets. In the process of cutting out the leather pieces for each product, 400,000 pounds of scrap leather is produced. Luxury has been selling this leather scrap to Sammy’s Scrap Procurement for $2.25 per pound. Luxury has an employee suggestion box and one of the suggestions was to use most of the scrap to make leather watch bands. The management of Luxury is interested in this idea as the machines necessary to produce the watch bands are the same as the ones used in making belts and would merely need reprogramming for the cutting and stitching processes on the watch bands. The process to attach the buckle would be the same for the watch bands as it was for the belts, thus this would require no additional worker training. Luxury would have additional costs for new packaging and for the supply and insertion of the pins that connect the band to the watch. The total variable cost to produce the watch band would be $2.85. Fixed costs would increase by $85,000 per year for the lease of the packaging equipment, and Luxury estimates it could produce and sell 100,000 watch bands per year. Finished watch bands could be sold for $15.00 each. Should Luxury continue to sell the scrap leather or should Luxury process the scrap into watch bands to sell?
Luxury should process the leather scrap further into watch bands. Not only does the act of processing the scrap further result in an increase in operating income, it offers Luxury another product line that may draw customers to its other products.
Ainsley’s Apples grows organic apples and sells them to national grocery chains, local grocers, and markets. Ainsley purchased a machine for $450,000 that sorts the apples by size. The largest apples are sold as loose apples to the various stores, the medium sized apples are bagged and sold to the grocers in their bagged state, and the smallest apples are sold to deep discounters or to a local manufacturing plant that processes the apples into applesauce. Ainsley is considering keeping the small apples and processing them into apple juice that would be sold under Ainsley’s own label to local grocers. The small apples currently sell to the deep discounters and local manufacturers for $1.10 per dozen. The variable cost to prepare the small apples for sale, including transporting the apples, is $0.30 per dozen. Ainsley can sell each gallon of organic apple juice for $3.50 per gallon. It takes two dozen small apples to make one gallon of apple juice. The cost to produce the organic apple juice will be $0.60 variable cost per gallon plus $200,000 fixed costs for the one-year lease of the equipment needed to make and bottle the juice. Ainsley normally harvests and sells 2,400,000 small apples per year. Should Ainsley continue to sell the small apples to local grocers and the applesauce manufacturer or should Ainsley process the apples further into organic apple juice?
Calculations of Sample Data
In order to decide whether or not to process the small apples or to process them further into applesauce, Ainsley conducts an analysis of the relevant revenues and costs for the two alternatives: sell at split-off or process further into applesauce.
Ainsley should continue to sell the apples at split-off rather than process them further, as selling them generates a $160,000 increase in operating income compared to only $90,000 if she processes the apples further.
Final Analysis of the Decision
When making the decision to sell or process further, the company also must consider that processing a product further may create a new successful market or it may undercut sales of already existing products. For example, a furniture manufacturer that sells unfinished furniture may lose sales of the unfinished pieces if it decides to stain some pieces and sell them as finished products.
Think It Through
Disposing of Coffee Grounds
Return to Why It Matters in this chapter. With the knowledge you have gained thus far, answer these questions:
- From your perspective, what are the alternatives for the used coffee grounds?
- For the alternatives listed in question 1, what information do you need to evaluate between the alternatives?
- What type of analysis would you do to choose between alternatives?
- What qualitative factors might influence your decision regarding which alternative to select?
- Do you think the quantitative and qualitative components both will lead you to the same decision? Why or why not?