60 Evaluate and Determine Whether to Sell or Process Further
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.
You are watching: In a sell or process further decision, joint costs are:
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?
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.
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?
Key Concepts and Summary
Deciding to do more work on a product to develop it into a new product is a choice between alternatives.Choosing whether to sell a product as is or to process it further involves comparing the selling price without further processing (at split-off) to the net price (selling price less additional processing costs) that would be obtained if the product were processed further.An important consideration in these types of decisions is the realization that the costs incurred up to the split-off point are irrelevant to the decision.
(Figure)Mallory’s Video Supply has changed its focus tremendously and as a result has dropped the selling price of DVD players from $45 to $38. Some units in the work-in-process inventory have costs of $30 per unit associated with them, but Mallory can only sell these units in their current state for $22 each. Otherwise, it will cost Mallory $11 per unit to rework these units so that they can be sold for $38 each. How much is the financial impact if the units are processed further?
$5 per unit profit$16 per unit profit$3 per unit loss$12 per unit loss
In general, if the differential revenue from processing further 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, and only future costs are relevant costs. Joint product costs are common costs that are incurred simultaneously to produce a variety of end products. Even though they are common costs, they are routinely allocated to the joint products.