Question

Lafayette Co. produces three products out of a common process; Product L, Product M, and Product N. The company currently uses the physical measures method to allocate joint costs to these products. The following additional information is available:

Product Line​​Physical Volume​​Unit Selling Price

​Product L​​10,000 units​​​$79.20

​Product M​​12,000 units​​​$36.00

​Product N​​18,000 units​​​$20.00

Joint costs to produce the products are $950,000.

The manager of the Product N product line is particularly disgruntled. He believes that his product line is allocated a disproportionate share of joint costs. In a recent managers' meeting, he argued that the company should consider using sales value at splitoff as the joint cost allocation method. He stated that his product is sold in a highly competitive market and increasing price is not an option.

The manager of the Product L product line disagreed strongly. He stated that all products are sold in a competitive marketplace and that allocating joint costs on physical measures was simple and easily verifiable. The manager of the Product M product line sat quietly through the meeting and she did not seem to favour one method over the other.

As the assistant controller, you were asked by the controller to investigate the concerns of the product line managers.

Required:

a. Provide a quantitative analysis that illustrates the issues identified by the manager of Product N and the manager of Product L.

(continued next page)

b. Explain to the controller the main issue(s) in this situation. Use pertinent data from your quantitative analysis.

c. State your recommendation for a solution to this situation. Explain why you believe this is the best way to solve this situation.

Answer 1

a.) A quantitative depiction of the current situation under two difference can be summarized as follows :-

	Joint Costs	9,50,000
	Physical Measures Method
Product	Volume	Cost at product level
Product L	10000	2,37,500
Product M	12000	2,85,000
Product N	18000	4,27,500
Total	40,000
	Sales Split Off
Product	Sales Value	Cost at product level
Product L	792000	4,75,000
Product M	432000	2,59,091
Product N	360000	2,15,909
Total	15,84,000

As can be seen from the data above, using the Physical measures method Product N incurs significant costs of $427,500 as against the Sales split off method where it is around $215K.

Similary , from the point of view of the manager of the Product L, per the Physical measures method that is currently followed, Product L is incurring expenses of around $237,500 which might significantly change if the method of accounting these costs is changed to Sales Value Split off where it would double up the costs

Because of the huge variances as presented in this cost allocation system, there seems to be a lack of understanding and consensus between the managers of Product N and Product L with both of them hoping to keep their costs to produce to the minimum.

b.) The explanations to the controller can be focussed on the following points :-

i.) When using the Physical measures method , we can see that Product N incurs higher costs of almost double the expenses that it would have costed if at all the Joint costs were allocated using the Sales split off method.

ii.) Similarly when using the sales split off method, we can see that Product L incurs higher costs of almost double the expenses that it would have costed if at all the Joint costs were allocated using the Physical measures method.

iii.) There were no suggestions from the manager of Product M who appeared to be quite happy with his current position as the cost facts did not show a huge variance when using either methods for his product.

iv.) The manager of Product N is particularly unhappy about the method which the company is allocating majority of the costs to his product because of the fact that there are a higher number of units produced. He feels that company should consider using sales value split-off method and stating further that the product operates in a highly competitive market with very literally no scope to increase the product price while this move is strongly disagreed by the manager of Product L.

C.) Recommendation :-

Based on the analysis of the situation and the current cost allocation approach, it can be observed that the price per unit to manufacture a unit of Product N is $23.75 while the selling price of the product is only $20. We see that the selling price of the product cannot be increased since it is a highly competitive market. The unit cost data can be calculated and examined as follows :-

	Joint Costs	9,50,000
	Physical Measures Method
Product	Volume	Cost at product level	Cost per Unit	Selling Price	Gain per unit
Product L	10000	2,37,500	23.75	79.2	55.45
Product M	12000	2,85,000	23.75	36	12.25
Product N	18000	4,27,500	23.75	20.00	(3.75)
Total	40,000
	Sales Split Off
Product	Sales Value	Cost at product level	Volume	Cost per Unit	Selling Price	Gain per unit
Product L	792000	4,75,000	10000	47.50	79.2	31.70
Product M	432000	2,59,091	12000	21.59	36	14.41
Product N	360000	2,15,909	18000	11.99	20.00	8.01
Total	15,84,000

In a normal business scenario, it is ideal for a business to allocate the costs through the physical measures method using a variety of factors like units, space, etc.

However, since using that approach is leading to a loss position for Position N , because of a variety of factors including , operating in a highly competitive market, etc. As such, it is better if the Sales Split off method is used for allocation costs. By using that method, as can be seen from the calculation above, even though the gross profit remains the same at a consolidated level, every department is in a position to display a positive gross profit per unit using this method and would be able to scale up the profits in future based on demand.