E16-26 Joint-cost allocation, process further.

Sinclair Oil & Gas, a large energy conglomerate, jointly processes purchased hydrocarbons to
generate three nonsalable intermediate products: ICR8, ING4, and XGE3. These intermediate
products are further processed separately to produce crude oil, natural gas liquids (NGL), and
natural gas (measured in liquid equivalents). An overview of the process and results for
August 2017 are shown here. (Note: The numbers are small to keep the focus on key
concepts.)

A federal law that has recently been passed taxes crude oil at 30% of operating income. No
new tax is to be paid on natural gas liquids or natural gas. Starting August 2017, Sinclair Oil
& Gas must report a separate product-line income statement for crude oil. One challenge
facing Sinclair Oil & Gas is how to allocate the joint cost of producing the three separate
salable outputs. Assume no beginning or ending inventory.

Required:
1. Allocate the August 2017 joint cost among the three products using the following:
a. Physical-measure method
b. NRV method
2. Show the operating income for each product using the methods in requirement 1.
3. Discuss the pros and cons of the two methods to Sinclair Oil & Gas for making decisions
about product emphasis (pricing, sell-or-process-further decisions, and so on).
4. Draft a letter to the taxation authorities on behalf of Sinclair Oil & Gas that justifies the
joint-cost-allocation method you recommend Sinclair use.
SOLUTION

ICR8 Processing Crude Oil

150 bbls × $18 / bbl =
(Non-Saleable) $175 $2700

ING4 Processing NGL

Joint Costs = 50 bbls × $15 / bbl =
$1800 (Non-Saleable) $105 $750

Gas
XGE3 Processing 800 eqvt bbls ×
(Non-Saleable) $210 $1.30 / eqvt bbl =
$1040
Splitoff
Point

1a. Physical Measure Method

Crude Oil NGL Gas Total

1. Physical measure of total prodn. 150 50 800 1,000
2. Weighting (150; 50; 800 ÷ 1,000) 0.15 0.05 0.80 1.00
3. Joint costs allocated (Weights  $1,800) $270 $90 $1,440 $1,800

1b. NRV Method

Crude Oil NGL Gas Total

1. Final sales value of total production $2,700 $750 $1,040 $4,490
2. Deduct separable costs 175 105 210 490
3. NRV at splitoff $2,525 $645 $ 830 $4,000
4. Weighting (2,525; 645; 830 ÷ 4,000) 0.63125 0.16125 0.20750
5. Joint costs allocated (Weights  $1,800) $1,136.25 $290.25 $373.50 $1,800

2. The operating-income amounts for each product using each method is:

(a) Physical Measure Method

Crude Oil NGL Gas Total

Revenues $2,700 $750 $1,040 $4,490
Cost of goods sold
Joint costs 270 90 1,440 1,800
Separable costs 175 105 210 490
Total cost of goods sold 445 195 1,650 2,290
Gross margin $2,255 $555 $ (610) $2,200
(b) NRV Method

Crude Oil NGL Gas Total

Revenues $2,700.00$750.00 $1,040.00 $4,490.00
Cost of goods sold
Joint costs 1,136.25 290.25 373.50 1,800.00
Separable costs 175.00 105.00 210.00 490.00
Total cost of goods sold 1,311.25 395.25 583.50 2,290.00
Gross margin $1,388.75$354.75 $ 456.50 $2,200.00

3. Neither method should be used for product emphasis decisions. It is inappropriate to use
joint-cost-allocated data to make decisions regarding dropping individual products, or
pushing individual products, as they are joint by definition. Product-emphasis decisions
should be made based on relevant revenues and relevant costs. Each method can lead to
product emphasis decisions that do not lead to maximization of operating income.

4. Since crude oil is the only product subject to taxation, it is clearly in Sinclair’s best
interest to use the NRV method since it leads to a lower profit for crude oil and,
consequently, a smaller tax burden. A letter to the taxation authorities could stress the
conceptual superiority of the NRV method. Chapter 16 argues that, using a benefits-received
cost allocation criterion, market-based joint cost allocation methods are preferable to
physical-measure methods. A meaningful common denominator (revenues) is available when
the sales value at splitoff point method or NRV method is used. The physical-measures
method requires nonhomogeneous products (liquids and gases) to be converted to a common
denominator.

E16-27 Joint-cost allocation, sales value, physical measure, NRV methods.

Fancy Foods produces two types of microwavable products: beef-flavored ramen and shrimp-
flavored ramen. The two products share common inputs such as noodle and spices. The
production of ramen results in a waste product referred to as stock, which Fancy dumps at
negligible costs in a local drainage area. In June 2017, the following data were reported for
the production and sales of beef-flavored and shrimp-flavored ramen:

Due to the popularity of its microwavable products, Fancy decides to add a new line of products
that targets dieters. These new products are produced by adding a special ingredient to dilute the
original ramen and are to be sold under the names Special B and Special S, respectively.
Following are the monthly data for all the products:

Required:
1. Calculate Fancy’s gross-margin percentage for Special B and Special S when joint costs
are allocated using the following:
a. Sales value at splitoff method
b. Physical-measure method
c. Net realizable value method
2. Recently, Fancy discovered that the stock it is dumping can be sold to cattle ranchers at
$4 per ton. In a typical month with the production levels shown, 6,000 tons of stock are
produced and can be sold by incurring marketing costs of $12,400. Sandra Dashel, a
management accountant, points out that treating the stock as a joint product and using the
sales value at splitoff method, the stock product would lose about $2,435 each month, so
it should not be sold. How did Dashel arrive at that final number, and what do you think
of her analysis? Should Fancy sell the stock?
P16-33 Alternative methods of joint-cost allocation, product-mix decisions.
The Eastern Oil Company buys crude vegetable oil. Refining this oil results in four products
at the splitoff point: A, B, C, and D. Product C is fully processed by the splitoff point.
Products A, B, and D can individually be further refined into Super A, Super B, and Super
D. In the most recent month (December), the output at the splitoff point was as follows:
■ Product A, 275,000 gallons
■ Product B, 100,000 gallons
■ Product C, 75,000 gallons
■ Product D, 50,000 gallons
The joint costs of purchasing and processing the crude vegetable oil were $105,000. Eastern
had no begin-ning or ending inventories. Sales of product C in December were $45,000.
Products A, B, and D were further refined and then sold. Data related to December are as
follows:

Separable Processing Costs to Make Revenues

Super Products
Super A $240,000 $375,000
Super B 60,000  150,000
Super D   45,000   75,000

Eastern had the option of selling products A, B, and D at the splitoff point. This alternative
would have yielded the following revenues for the December production:
■ Product A, $75,000
■ Product B, $62,500
■ Product D, $67,500

Required:
1. Compute the gross-margin percentage for each product sold in December, using the
following methods for allocating the $105,000 joint costs:
a. Sales value at splitoff
b. Physical measure
c. NRV
2. Could Eastern have increased its December operating income by making different
decisions about the further processing of products A, B, or D? Show the effect on
operating income of any changes you recommend.
SOLUTION

A diagram of the situation is in Solution Exhibit 16-33.

1. Computation of joint-cost allocation proportions:

a. Sales Value of
Total Production Allocation of
$105,000
at Splitoff Weighting Joint Costs
A $ 75,000 75.0 ÷ 250 = 0.30 $ 31,500
B 62,500 62.5 ÷ 250 = 0.25 26,250
C 45,000 45.0 ÷ 250 = 0.18 18,900
D 67,500 67.5 ÷ 250 = 0.27 28,350
$250,000 1.00 $105,000

b.
Physical Measure Allocation of
$105,000
of Total Production Weighting Joint Costs
A 275,000 gallons 275 ÷ 500 = 0.55 $ 57,750
B 100,000 gallons 100 ÷ 500 = 0.20 21,000
C 75,000 gallons 75 ÷ 500 = 0.15 15,750
D 50,000 gallons 50 ÷ 500 = 0.10 10,500
500,000 gallons 1.00 $105,000

c.
Final Sales Net Allocation
Value of Realizable of
Total Separable Value at $105,000
Production Costs Splitoff Weighting Joint Costs
Super A $375,000 $240,000 $135,000135 ÷ 300 = 0.45 $ 47,250
Super B 150,000 60,000 90,000 90 ÷ 300 = 0.30 31,500
C 45,000 – 45,000 45 ÷ 300 = 0.15 15,750
Super D 75,000 45,000 30,000 30 ÷ 300 = 0.10 10,500
$300,000 1.00 $105,000

Computation of gross-margin percentages:

a. Sales value at splitoff method:

Super A Super B C Super D Total
Revenues $375,000 $150,000 $45,000 $75,000 $645,000
Joint costs 31,500 26,250 18,900 28,350 105,000
Separable costs 240,000 60,000 0 45,000 345,000
Total cost of goods sold 271,500 86,250 18,900 73,350 450,000
Gross margin $ 103,500 $ 63,750 $26,100 $ 1,650 $195,000
Gross-margin percentage 27.6% 42.5% 58.0% 2.2% 30.23%
 b. Physical-measure method:
Super A Super B C Super D Total
Revenues $375,000 $150,000 $45,000 $75,000 $645,000
Joint costs 57,750 21,000 15,750 10,500 105,000
Separable costs 240,000 60,000 0 45,000 345,000
Total cost of goods sold 297,750 81,000 15,750 55,500 450,000
Gross margin $ 77,250 $ 69,000 $29,250 $19,500 $195,000
Gross-margin percentage 20.6% 46.0% 65% 26% 30.23%

c. Net realizable value method:

Super A Super B C Super D Total
Revenues $375,000 $150,000 $45,000 $75,000 $645,000
Joint costs 47,250 31,500 15,750 10,500 105,000
Separable costs 240,000 60,000 0 45,000 345,000
Total cost of goods sold 287,250 91,500 15,750 55,500 450,000
Gross margin $ 87,750 $ 58,500 $ 29,250 $19,500 $195,000

Gross-margin percentage 23.4% 39.0% 65.0% 30.23%

26.0%

Summary of gross-margin percentages:

Joint-Cost
Allocation Method Super A Super B C Super D
Sales value at splitoff 27.6% 42.5% 58.0% 2.2%
Physical measure 20.6% 46.0% 65.0% 26.0%
Net realizable value 23.4% 39.0% 65.0% 26.0%

2. Further Processing of A into Super A:

Incremental revenue, $375,000 – $75,000 $300,000
Incremental costs 240,000
Incremental operating income from further processing $ 60,000

Further processing of B into Super B:

Incremental revenue, $150,000 – $62,500 $ 87,500
Incremental costs 60,000
Incremental operating income from further processing $ 27,500

Further Processing of D into Super D:

Incremental revenue, $75,000 – $67,500 $ 7,500
Incremental costs 45,000
Incremental operating loss from further processing $ (37,500)
Operating income can be increased by $37,500 if Product D is sold at its splitoff point rather
than processing it further into Super D.
SOLUTION EXHIBIT 16-33

Revenues at Splitoff
Joint Costs
and Separable Costs

A, 275000 gallons
Processing Super A
Revenue = $75000
$240000 $375000

B, 100000 gallons Processing Super B

Revenue = $62500 $60000 $150000
Processing
$105000
C, 75000 gallons
Revenue = $45000

D, 50000 gallons Processing Super D

Revenue = $67500 $45000 $75000
Splitoff
Point