OVERVIEW This is an excellent short case to introduce the managerial accounting issues related to the "joint cost" problem.

Classic microeconomics argues unequivocally that attempts to assign cost to individual products in a "joint" set constitute a complete waste of time--"just maximize the total revenue over the batch." Like the comparable adage to "price so that marginal cost equals marginal revenue," the economists' advice about joint costing is certainly accurate, given the assumptions, but not particularly useful in practice. Most managerial accountants, including this author, believe that there are important managerial issues involved in accounting for joint cost in real companies. This case covers those issues for a real company. Questions 1, 2, and 3 consider the calculation aspects of the issue. Question 5 considers what cost system to use, emphasizing behavioral considerations. Questions 3 and 4 address decision making under joint costing--how to think about cost when trying to maximize profit. Question 6 blends cost analysis and strategic positioning in a "cost plus" contracting situation. TEACHING STRATEGY We teach the case in one (90 minute) class period early in the required managerial accounting course. Questions 1 through 5 will easily fill one class period with useful discussion. We push hard to cover these questions in about 75 minutes so that we can also spend some time on question 6. This last question raises strategic positioning issues while reinforcing the accounting issues from the first five questions. We believe it is important to reinforce with the students the idea that strategic issues are always relevant to the managerial accounting issues, even in the "joint cost" context. The defense contracting setting for question 6 heightens the costing dilemma--the assignment of joint cost to individual products is not supposed to be useful for decision-making, but the government will only accept a "cost-based price," and choosing a bid price is clearly a managerial decision!

This teaching commentary was prepared by Professor John K. Shank of the Amos Tuck School of Business, drawing heavily upon notes prepared by Professor Joseph San Miguel of the Naval Postgraduate School. ANSWERS TO ASSIGNMENT QUESTIONS Question 1 The idea here is to construct a "Produced As/Sold As Matrix" (400,000 400,000). Obviously, the possible combinations are endless, so how does one choose a "best" approach? The "best" solution is to start with demand for the highest value product (405) and work back unsold production to the next lowest value product (404) to fill sales demand, and so forth

until 401 sales demand is filled (see Exhibit A). The idea is to minimize potential revenue loss. In a static sense [$246,000 Revenue], any tableau is as good as any other. But, in a dynamic sense, future revenue is always unknown. In that sense, the firm minimizes potential loss by only trading down one level. Since some substitution is necessary anyway, there is no reason to try to avoid it. Half the 405's produced will be sold as 404's, and two thirds of the 404's produced will be sold as 403's, and so on down the line. Thus, in economic terms, only the "sold as" numbers have meaning. Producing this grid and seeing the idea of necessary substitutions should make it easier for students to see the logic in later questions. We emphasize for the instructor that this is a very necessary starting point for the class. Question 2 There are two basic accounting methods for allocating joint cost to the five joint products: the "physical units" or "average cost" method, and the "relative sales value" (RSV) or "net realizable value" (NRV) method. Question 1 says the period began with zero inventories. The objective is to assign the joint cost to the 400,000 units produced and for which we have sales demand information. The physical units method is straightforward: joint cost of $200,000 divided by 400,000 total units produced = $0.50 per unit. All rectifiers are assigned identical unit costs. Since sales prices increase with increasing technical attributes across the five categories, gross margins will also increase from the low to high end products (negative 25% for 401 to 50% for 405). The case says that no production costs are assigned to the by-product. This is one alternative for dealing with by-products. We also assume here that any revenue from by-product sales is credited to miscellaneous income, rather than being offset against the $200,000 manufacturing cost. Otherwise, given the uncertainly about by-product revenues in the case, even the average cost calculation becomes very complex. If the "by-product" units (400s) are considered a joint product, the average cost is $.40 per unit ($200,000 ÷ 500,000 units). The RSV method has a number of twists that can result in many different unit costs for the five products. For inventory costing purposes, any systematic cost allocation system will do. The basic idea of the relative sales value scheme is that all sales should show gross margin percent equal to the average gross margin percent across the full joint product set. This average is 19% [(246 - 200) ÷ 246)]. This does imply 5 different costs for the 5 different products, based on the 5 different selling prices. As long as no product switching occurs, the basic idea is easily preserved. Note here that the relevant designation for a product is the sales designation. Anything sold as a 401 will carry 401 cost. Here are the resulting unit cost numbers: Unit Costs 401402403404405 Physical units method$0.50$0.50$0.50$0.50$0.50 Relative sales value method [Sales price x (1-.19) $0.40 x .81.32 $0.60 x .81.49 $0.70 x .81.57 $0.80 x .81.65 $1.00 x .81.81 Question 3 Costing Method Relative Physical Unit Revenue ($.40/unit x 6,000 units)$2,400$2,400 Costs: ($.50/unit x 6,000 units)3,000Method A: 3000 x .32 3000 x .492,430 Method B: 2400 x .811,944 Sales Value

Gross Margin$(600)Method A:$(30) Method B:$456 A problem arises under RSV costing when there is product switching (402's sold as 401's). Now, there is a choice: 1.Stay with the 5 different costing numbers, which means the 402's sold as 401's still carry 402 costs. The result, however, is consistent application of the rule and violation of the basic idea. For sales of $2400 (6000 401's) the basic idea is clear-reported gross margin should be 19% or $456, since 19% is the average gross margin percent, and this is a normal sale. 2.In order to achieve the desired result (gross margin of $456), it is necessary to consider all 6000 of the items shipped to be 401's. This means violating the costing rule. Use a 401 cost, not a 402 cost, for the 402's shipped as 401's.

This question in the case is a set-up to see if students will be more concerned about consistent application of rules or consistent application of the basic idea underlying the rules. Our experience is that most students see the rules as more important than the concept! They will use method (A) here far more often than method (B). We believe only method (B) is proper, but we have had CPAs argue otherwise in class! Since some 402's will be sold as 401's during the year anyway, the issue really is one of manufacturing scheduling! Is it time to produce another batch, or not? What level of inventory triggers the production decision? Since we average one new batch every 2 1/2 weeks anyway, we are never more than several days away from the next run. If it is not yet time for another production run, they should ship 3,000 402's as 401's. In Unitron, the "working rule" for sales persons was easy: always accept the order if you can fill it without going up more than one product level. Let production worry about when to run the next batch. Question 4 The toy company may be forcing Unitron to change its long-term view on joint products and by-products. The "seconds" are already large to be considered a by-product (sales of at least 35,000 units a year). They are only exceeded by the 402 product line in number of units produced annually. At a selling price of $0.25 per unit, the "seconds" have a relatively low sales value per unit. And even this low selling price doesn't have many takers. Only 35% of the units produced were sold, so far. The key is what is the customer value associated with these "seconds"? The mid-1970s were the start of the electronic toy market. There may be more future demand from toy makers for "seconds" at the lower price. Even Texas Instruments got into the toy business about this time with "Speak and Spell." At the even lower selling price of $.15 per unit, the Toy Company's 48,000 "seconds" will generate $7,200 incremental revenue and gross profit. Based on RSV, 401's generate only $7,480 gross profit annually. Even the high tech 404's and 405's combined generate only $9,724 ($5,984 + $3,740) gross profit. What does a product have to do to be called a joint product? However, giving "seconds" the status of a joint product does not significantly change the overall picture. Assume 83,000 units sold at $.15/unit, sales value=$12,450(35,000+48,000) Total joint products sales revenue=$246,000+12,450=$258,450 Total joint production costs=200,000 Gross profit=$ 58,450 Gross profit percent of sales value 23% (versus 19% now) But, whether 400's are considered joint products or by-products doesn't really change the economics of the toy company offer. The "Relevant Cost" for the "seconds," for purposes of evaluating this offer is Opportunity Cost. If I sell them now for $.15, will I lose an opportunity to sell them later for enough more than $.15 to make up for the time value of the foregone cash inflow? Annual output is 100,000 units and inventory on hand is 65,000. This is 13 batches, or 32+ weeks supply. That is, we have not sold any for 160 days at the $.25 price. I would grab the order quickly!! It is also probably true that once the toy company becomes a regular customer for 50,000 or so units a year, the 400 will be reclassified a joint product. This really doesn't affect management decisions. Question 5 There is no simple answer to the "proper" allocation method. The impact may be purely behavioral. Equal unit costs will

discourage selling low-end products because of their lower margins. Yet, the biggest demand is in the lower end of the product line. Equalizing the gross profit margins across all products would send the message that we must sell as many of all the units as we can and substitutions are ok. But we don't want to trade away high-end products if not necessary. Customers might start to game their orders (timing their orders for low-end products when they really want high-end products, guessing that we will fill their order with high-end products). For example, if they order more than 4,500 units of 401 (greater than a batch's yield) we will not likely have a sufficient quantity on hand and will ship some 402 units. If Unitron's strategy is to push high-end items, with the low end as just fillers, and if the high-end items are harder to sell, then average costing better matches the strategy. If, on the other hand, all items are equally hard to sell and Unitron sees all units as part of the strategy, then relative value costing fits the strategy. This line of reasoning is summarized below: Behavioral Implications? The Average Cost System shows low-end items (401) as losers. It shows higher profit per unit for higher priced units. This tends to encourage trying to sell more high-end products. Substitutions of higher-end items for lower-end orders would be discouraged. The Relative Value System shows each category as equally profitable--each category shows 19% gross margin on sales. This shows each item as equally attractive which tends to push the entire line equally hard. Planned for substitutions are also equally profitable so they are encouraged. The sales view is always sell downward one level if necessary. It is up to production scheduling to replenish the inventory at the right time. Which set of likely behavioral consequences is preferable for Unitron? BOTTOM LINE: THE TOTAL SALES MUST COVER JOINT COST AS WELL AS PROVIDE A GOOD GROSS PROFIT. CHOOSE WHICHEVER COST ALLOCATION RULE SEEMS TO BEST SUPPORT THIS GOAL. Question 6 At the simplest level, selling an additional 100,000 404's involves producing 34 additional batches (3,000 404's per batch)-a highly unlikely scenario. Even if 404's and 405's are combined, the government order requires 20 extra batches (5,000 404's/405's per batch). This is still very unlikely. It involves spending $200,000 extra ($10,000 per batch, full cost) to generate something less than $80,000 of extra revenue while producing 300,000 excess units of 401, 402 and 403. Obviously, the more extra batches we are required to produce for this order, the less attractive it looks. The fewer extra batches, the better it looks. We can use the matrix tableau from question 1 to demonstrate that only twelve extra batches would be needed, given the product substitutions which already occur. Of the 100,000 404's and 405's produced in a year, 40,000 are sold as 403's. Thus we really only need 60,000 extra 404's and 405's, if we can find a way to replace the current 40,000 unit demand for 403's now being met with 404's. Twelve more batches yields the 60,000 extra 404's and 405's, and 54,000 more 403's as well. This is more than enough 403's to replace the 40,000 404's that would now be diverted to the government. So, we have brought the extra production demand down from 34 batches to 20 to 12. Is the order attractive at 12 extra batches? There is still a big gap between the $120,000 extra cost and the $80,000 extra revenue. Even considering only the incremental produc-tion costs of $6,400 per batch, twelve batches still costs us almost $80,000 extra ($6,400 x 12 = $76,800). But, can we get the production requirement down even further? One Approach Extending the time frame to 18 months, (the term of the order) yields the following table:

18 Months (30 Batches)Extra Output SalesDODNeedsProd.ShortfallPerEight moreUnits (All Amounts in Thousands)BatchBatchesExcess #401150--150135(15)4.53621 #402210--210180(30)6.04818

#403150--150135(15)4.53621 #404/40590100190150(40)5.040-TOTALS600100700600(100)20.016060 *Eight extra batches means full cost of $80,000, but incremental cost of only $51,200. It is not likely the Defense Department will reimburse costs unless they are "properly allocated" to all commercial and defense contracts. Thus, the allocated fixed manufacturing cost to the Defense order must be somewhat lower than normal to take account of higher overall volume. Given the relatively small percentage of overall operations for this order, it isn't likely the allocated costs percentage will decrease significantly. The allowed profit margin on defense work varies between 8% and 10%. Assuming a $.75 discounted price with a 10% allowed margin, we can estimate what the cost report to the government would have to look like: Total revenue of $75,000 and allowable profit of $7,500 means total cost cannot exceed $67,500: Sales revenue ($.75 /unit x 100,000 units)$75,000(100%) Production costs (at 81% of normal revenue)60,750(81%) Gross profit (normal, at 19%)14,250(19%) Corporate/Division overhead ($14,250 - $7,500)$6,750(9%) Profit$7,500(10%) Assuming a 9% charge for all non-manufacturing costs was "reasonable," this "cost plus" bid proposal would probably survive the government audit review. Since Unitron spends far more than 9% of sales on total nonmanufacturing costs, it would be easy to justify the 9% allocation as reasonable. Unitron would have spent $80,000 extra manufacturing cost (full cost) to generate $75,000 extra revenue and produce 60,000 excess low value units as well. This is less than break even, on a full cost basis, even without considering any assignment of corporate selling or administrative expense. Is this really a good deal? When Unitron generally wants to keep government work to a low percent of total business, this contract seems like a good one to avoid! It only looks good on a marginal cost basis. As noted many times earlier in this book, this author takes the position that "marginal costing leads to marginal managers," particularly on contracts that extend over 18 months. A Closer Look As Exhibit B to this note shows, it is possible to meet the extra demand with only 5 extra batches if we extend the horizon over a 2 1/4 year time frame. This means extra production cost of only $32,000 (on a variable cost basis) and $50,000 (at full cost). At a $75,000 bid, with the DOD cost report as shown above, this is $25,000 extra profit (full cost basis) with no excess production of lower value items. This sounds a lot better! But there is still the strategic positioning question. And, are we comfortable that the DOD cost report above is "legal" if we are really only making five extra batches to supply the order. The report can be "explained," but are we really "cheating" on defense contracting rules to hide much of the real extra profit? How much are you concerned about a potential future headline in the Boston Globe-- "Local Blue Chip High Tech Company Convicted of Defense Contract Fraud." Question 6 is very rich, as this commentary reveals. We like to spend at least 15 minutes of class time here to demonstrate the following: 1.Careful analysis can make the problem look much different (need for 34 extra batches versus only five extra). 2.At five extra batches, the real cost picture (even fully allocated cost) does not jibe with the proposed cost report to the government. Does this matter?

3.In the end, this decision will probably be made on strategic positioning grounds, regardless of the cost analysis. Yet the chance to bid on the order would probably have been summarily dismissed without the insights derived from the more careful analysis. EXHIBIT A Produced As/Sold As Matrix Sold As 401402403404405Total 40190,00090,000 40210,000110,000120,000 40330,00060,00090,000 Produced As 40440,00020,00060,000 40520,00020,00040,000 Total100,000140,000100,00040,00020,000400,000

Work from the highest value products backward to the lowest value products. Note that sales demand and estimated production quantities do not match for individual products. Some 405's must be sold as 404's, some 404's must be sold as 403's, etc. Which substitutions seem to make the most sense? (Should 405's be sold as 401's, for example?) The Concept --Try to maximize flexibility for future switches --Minimize lost potential revenues EXHIBIT B (Thousands of Units) Now-2 1/4 Years (45 Batches)Make 5 Extra Batches Note: Zero Extra 401/402/403's to worry about.

Batches NowRevised Year 12030 Year 22015 Year 3 (First Quarter)55 Total4550 Strategic Fit?