By-product costing refers to the allocation of costs to by-products, which are minor products generated incidentally during the production of primary products or joint products. These by-products usually have minimal revenue generation compared to the main products but cannot be ignored in financial and cost accounting practices.
Definition
By-product costing is the accounting process used to allocate costs to secondary products (by-products) that are inadvertently produced in a manufacturing process where the main goal is the production of primary or joint products.
A by-product is defined as:
- A secondary product obtained during the production of a main product.
- Typically sold for minimal revenue relative to the primary or joint products.
Types of Cost Allocation Methods
1. Net Realizable Value (NRV) Method
This method allocates costs based on the estimated selling price of the by-product minus any additional processing and selling expenses. It is particularly useful when the by-product can easily be identified in terms of market value.
2. Physical Units Method
Under this method, the costs are allocated based on the physical quantity (weight, volume, or units) of the by-product relative to the primary products. This is often simpler but may not reflect economic value differences.
3. Constant Gross Margin Method
Costs are allocated in such a way that both the primary product and the by-product have the same gross margin percentage. This method ensures consistent profit margins across all products.
Special Considerations
Marginal Revenue Impact
By-products typically generate less revenue, so their impact on pricing and profitability should be considered minimal. However, accurate costing is essential for financial reporting and informed decision-making.
Inventory Valuation
By-products must be included in inventory valuations to provide a true and fair view of an organization’s financial position.
Regulatory Compliance
Proper by-product costing ensures compliance with applicable accounting standards such as GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).
Examples
- Dairy Industry: By-products such as whey are obtained during the production of cheese. Whey may have multiple uses, including in food processing, but generates less revenue compared to cheese.
- Petroleum Industry: During the refining of crude oil, several by-products like asphalt and petroleum coke are produced alongside primary products like gasoline and diesel.
Historical Context
By-product costing methodologies evolved with the industrial age, where complex manufacturing processes necessitated more detailed accounting practices to manage costs and profitability accurately. The development of joint costing and by-product costing principles has been integral to modern cost accounting.
Applicability
By-product costing is essential in industries where multiple outputs are common and helps in:
- Product pricing strategies
- Profitability analysis
- Financial statement accuracy
- Cost control and efficiency improvements
Related Terms
- Joint Product Costing: The financial accounting practice that deals with the allocation of costs to primary products that are produced from the same process.
- Cost Allocation: The process of identifying, aggregating, and assigning costs to various cost objects such as departments, products, or branches.
- Absorption Costing: A method of costing that includes all direct costs and fixed as well as variable overhead costs as part of the cost of a product.
- Process Costing: A costing method used when products are indistinguishable from each other and are produced continuously. Costs are averaged over units produced.
FAQs
Why is by-product costing important?
How is by-product costing different from joint product costing?
Can by-products be disregarded in cost accounting?
References
- Horngren, C. T., Datar, S. M., & Rajan, M. V. (2012). Cost Accounting: A Managerial Emphasis. Prentice Hall.
- Drury, C. (2015). Management and Cost Accounting. Cengage Learning EMEA.
Summary
By-product costing plays a critical role in modern accounting by ensuring that all products, regardless of their revenue impact, are accounted for. This practice aids in accurate financial reporting, efficient pricing strategies, and regulatory compliance, providing a comprehensive view of an organization’s cost structure and profitability.
