Lilac Flour Mills

Managerial Control and Accounting – IISession-12

Submitted By :

Instructor : Prof. Keyur Thaker

Date of Submission :

Concepts to be known for analysis of the Case:

Joint Cost Basics:

Joint Costs: Joint costs are the costs of a production process that yields multiple products simulatenously. If we consider the distillation of coal, it yields coke, natural gas, and other products. The costs of this distillation are joint costs.

Splitoff Point: Splitoff point is the juncture in a joint production process when two or more products become separately identifiable.

Separable Costs: Separable costs are all costs –manufacturing, marketing, distribution and so on- incurred beyond the splitoff point that are assignable to each of the specific products identified at the splitoff point.

Main Products: The term product here refers to any output that has a positive total sales value. Main product, in a joint distribution process, is the product that has high total sales value compared with the total sales value of other products of the process.

Joint Products: When a joint production process yields two or more products with high total sales value compared with the total sales values of othe products, if any, those products are called joint products.

Byproducts: The products of a joint production process that have low total sales value compared with the total sales value of the main product or of joint products are called byproducts.

Why allocate Joints Costs?

To determine inventory costs i.e. costs of goods sold and value of finished goods.

To determine costs for reimbursement and rate regulation (utilities) purposes.

Customer and product profitability analysis.

Approaches to Allocating Joint Costs:

There are two approaches to allocate joint costs:

Approach A: In this method of allocation joint costs are allocated using market-based data such as revenues.

A1. Sales Value at Splitoff Method: This method allocates joint costs ot joint products on the basis of relative total sales value at the splitoff point.

A2. Net Realizable Value Method:

The Net Realizable Value method allocates joint costs to joint products on the basis of relative NRV- final sales value minus separable costs. This method is typically used in preference to the sales value mehtod only when selling prices for one or more products at splitoff do not exist.

A3. Constant Gross-Margin Percentage NRV method:

This method allocates joint costs to joint products in such a way that each individual products achieves an identical gross-margin percentage. This method works backward in that the overall gross margin is computed first. Then, for each product, this gross-margin percentage and any separable costs are deducted from the final sales value of production in order to back into the joint cost allocation for that product.

There are 3 steps involved in allocating costs using the above moethod.

Compute overall gross margin percentage.

Compute total production costs for each product

Compute allocated joint costs.

Approach B: In this method of allocation, joint costs are allocated using physical measures such as the weight, quantity or volume.

B1. Physical Measure Method:

Physical-measure method allocates joint costs to joint products on the basis of a comparable physical measure such as relative weight, quantity, or volume at the splitoff point.

About Lilac Flour Mills:

Lilac Flour Mills processes wheat to produce white flour, suji, wholemeal flour, and bran. In term of physical proportions, the average yield from a ton of wheat is 60 percent for white flour, 10 percent for suji, 10 percent for whole meal flour and 20 percent for bran.

The production process: Plant consisted of several floors and is divided into two parts: i) cleaning section and ii) milling section. Wheat is fed through a bin in the ground floor, which is passed through dust and chaff removal buckets and then through a triour equipment to remove corn, round seeds,maize and stones from wheat. It is then washed, dried and stored in a clean bin.

Cleaned wheat is then passed through an aspiration-cleaning meachine where it is brushed and then it reaches double roller mill. Wheat corn is then passed through roller mills and plantsifters successively until all flour was won. The bran that remained is collected by

means of bran separator. The end products wer passed thorough wooden channels to the ground floor where they were collected and packed.

Inventory Accumulation: Lilac processed about 36 tons of wheat perday. Every ton of wheat yielded about 0.2 tons of bran which comes to about 7.2 tons per day. Wheat bran was primarily used as cattle feed by livestock breeding centers where as flour, suji, and wholemeal flour were used by direct household consumers and industrial units.

Existing Joint Cost Allocation Method: An average unit cost for each product was arrived at by dividing the total joint costs by the combined output of the four products. The reason behind this was that in as much as all the four products were obtained by the same process. The cost of packing, selling and distribution incurred after the sieving stage was identified with individual products and treated as separable costs.

Selling prices Cost Prices Separable Costs

Whiteflour Rs 2100 Rs 1850 Rs 78

Suji Rs 2480 Rs 1850 Rs 84

Wholemeal flour Rs 2000 Rs 1850 Rs 34

Bran :Rs. 1140. Rs 1850 Rs 16

Problems identified from the case:

1. As on December 31, 1973, Lilac Flour Mills was carrying an inventory of 2000 tons of bran, which was valued at Rs.37,32,000

2. This is because the purchase offers ranged from Rs.1000 to Rs.1350, which was far lower than the total cost that was calculated by the followed accounting procedure.

3. In the current procedure, the Joint costs in the process are allocated based on the physical quantities proportion of the output. Because of this, we are getting a total cost of Rs.1866 per ton for bran.

4. Hence if they are selling bran at the market price at the purchase prices available in the market, they will incur a loss of around Rs. 760 which is why they are not able to sell it. Hence a lot of bran is still left as inventory.

From the above points, it is evident that the problem is due to the allocation of the joint costs based on physical distribution.

Range of possible Solutions: When there are two are more products that undergo the same process at the same time in the course of conversion, the joint costs should be allocated to each of the products based on some allocation basis.

The allocation basis can be of different types:

1. Physical Quantity method: This is the method currently followed by Lilac Flour mills. This is not yielding the required results as we end up allocating high cost to bran and so not able to sell it.

The ratio of the products in physical quantity produced per each unit of wheat is 6:1:1:2 in the order of white flour, suji, wholemeal flour and bran respectively.

Table I Allocating the joint costs in the same proportion, we can split the joint costs

among the different products based on this proportion. Adding separable costs to the joint costs will give the total cost per each product.

The selling price is assumed to be the market price for different product as of now in the market. The selling price for bran is assumed to be Rs.1140 per ton.

The profitabilities of different products based on this method are tabulated in table I2. Sales Value Method:

In sales value method, we use the sales value as the basis for allocation.

Table II

We allocate the joint costs based on the proportion of the Sales value of the four products

The following table-II gives the profitability of different products when this method is adopted:

3. Net Realization Value(NRV) method: In NRV method, we use (selling price – separable costs) as the allocation basis

for the different products

Table III

Table III gives the allocation of the joint costs based on this method, and also the profitability of the different products when this method is followed

4. Assuming all the three products other than white flour as by-products: In this case, we assume only white flour as the main product as it constitutes

60% of the total output. The remaining three products namely suji, wholemean flour and bran are treated as by-products.

Table IV

When some of the products are treated as by-products, we presume that the total cost of the by-product is just equal to the selling price of it. Or in other words, profit for these products is zero.

Hence, when we allocate the joint costs to the different products, we see that the allot the joint costs to the by-products such that the total cost of these equal their selling price. The remaining costs are allocated to the main product which is the white flour.

The tabe IV gives the cost allocation and the profitability for the different products when this method is used

5. Assuming only Bran as by-product: Here, we assume only Bran as by-product. The other three products namely

white flour, suji and wholemeal flour are considered as main products Hence, we allocate the joint costs to Bran such that the total cost of Bran

equals its selling price. The remaining joint costs are allocated to the three main products based on

their sales value. Table V gives the cost allocation and profitability calculation for the different

products based on this method:

Table V

6. Constant Gross margin NRV method: In this method, we calculate the total Gross margin on all the products

together, and we assume the same gross margin for different products

Evaluating the solutions:

Table VI gives the summary of all the alternatives discussed above and the gross margins calculated for different methods:

1. Physical Quantity method: From the case, it is clear that this method does not give the results that we expect. We end up allotting a very high cost for Bran. So, this is not the appropriate method

Table VI

2. Sales value method:This method is better than Physical Quantity method as we do not observe any loss on any of the products. But if we adopt this method, we will have gross margin of only 0.7% for the white flour, which is our main product. This might cause a concern especially for the senior management.

3. Net Realization Value(NRV) method:By this method we are getting a good and even profit margin among all the products. Also we are getting a decent 1.2% gross margin (which is very close to our overall margin) on our main product white flour.

4. Assuming all the three products other than white flour as by-products:In this method, as according to our assumption, we can see that we are getting a profit margin of 0% on our main product, white flour. Also, we are observing a gross margin of 1.9% on white flour. We have to be careful when we use this method, because we should note that we are allocating the extra joint costs of by-products to white flour. In case the market prices of the three by-products fall, then it leads to an increase in overall cost of the white flour and hence decreases its margin. Also, there will be a lot of volatility in the cost allocation every time.

5. Treating only Bran as by-product:

From the table we can see that, if we adopt this method we are getting a gross margin of at least 1.1% on the three joint products. Also, the inventory costs of the three products bear some cost corresponding to Bran(as we assume it as by-product).

Best solution:

From the above analysis, we can arrive at two final methods which we can adopt:

1. Net Realization Value method2. Treating only Bran as By-Product

If we have to choose one method from these two, we can go for the Net Realization Value method. The reason being, in the long term, it might happen that the selling price of Bran changes and it leads to a change in the Inventory costs of other products too. So, to avoid volatility in our values, we can go for the former method.

Lessons from the case:

From the case analysis, we can identify the following points as learnings:

a) When multiple products are produced using the same processes simultaneously, the costs involved in the process (Joint costs) should be allocated after choosing an allocation basis to arrive at the right costs for each product.

b) Physical distribution method though easy to implement, it can be used only when the products produced from the process are of comparable value.

c) We should be careful when treating some of the products as by-products. Since we will be allocating part of their joint costs to the main products, this increases the inventory costs of our main product, which reflects on the balance sheet. So, we should make sure that there is no significant impact because of this.

d) Finally, we should keep in mind that the cost allocation of joint costs should not cause any change in the economic decisions of the firm. So, which ever method we adopt should not have any impact on the managerial decisions made. These methods should be viewed only from accounting perspective.