Joint cost allocation in the sawmilling industry: four methods for estimating raw material costs.
Abstract
When processing a sawlog, four main product groups are produced: center boards, side boards, chips, and sawdust. In this kind of joint production it is difficult to determine raw material costs for the individual products. In this article we consider methods to allocate joint costs to sawn products in the sawmilling industry. Joint cost accounting can be used to allocate raw material costs and thus provide information that is crucial when evaluating profitability in sawmilling. Four joint cost allocation methods are presented and demonstrated. A base scenario is described resembling a typical Norwegian sawmill, and the four joint costing methods are applied to the data. Then a second scenario is introduced; we assume that the value of by-products increases and production efficiency improves and then estimate raw material costs based on the set of new assumptions. All four costing methods yield different results, and therefore the choice of costing method affects profitability for the various product groups, although the aggregate profit is not affected.
In Norway about eight million [m.sup.3] of roundwood are harvested annually, of which about 50 percent is sawlogs. When processing a sawlog, four product groups will be produced: center boards ([congruent to] 40 percent), side boards (15 percent), chips (35 percent), and sawdust (5 percent). In addition, kiln and drying results in 5 percent reduced production volume. Center boards and side boards are referred to as main products while chips and sawdust are considered low-value products and are referred to as by-products.
By far the greater part of Norwegian sawmills are softwood sawmills using Norway spruce (Picea abies (L.) Karst.) and Scots pine (Pinus svlvestris (L.)) as raw material. Logs are sawn according to the Nordic practice, i.e., the main yield is sawn from the center of the log, containing two or more pieces (Anonymous 1994, Juslin and Hansen 2003, Gjerdrum 2007). The thickness varies normally from 38 mm to 75 ram, and the width from 75 mm to 225 mm. The side yield consists of boards with thickness from 16 mm to 32 mm, and width from 75 mm to 225 mm. Except for a minor portion of high quality pine logs, the side boards are inferior to the center boards.
A typical sawlog small-end diameter distribution has a minimum of 12 cm and a maximum of 40 cm, with an average of 17 to 22 cm. The log length distribution ranges normally from 3.4 to 5.8 m, with an average of 4.5 to 5.0 m.
Most of the production costs in sawmilling are raw material costs. Companies have to consider how they can best ascribe raw material costs (joint costs) generated up to the split-off point to particular products. The split-off point in sawmilling is where the sawlog is divided into center boards, side boards, chips, and sawdust. Joint costs were described by Billera et al. (1981) as "... costs which cannot be readily identified with individual products." They stated that joint costs are usually common in extractive, agricultural, and chemical industries, as well as in industries where different grades of the same product are obtained. If the costing system does not capture the consumption of resources by products, costs will be distorted and there is a risk that managers decide to produce unprofitable products.
The joint cost problem has been known for a long time in sawmilling. In 1992 the term "sawmill paradox" was coined by Gronlund (1992), referring to the fact that when processing a sawlog, a range of products (both main products and byproducts) are produced. This is a typical joint production. Some of the products, such as sawdust, will have a considerably lower sales value than both the raw material price and the sales value of other wood products produced from the core of the sawlog. Furthermore, since the raw material price is higher than the net revenue for chips and low-grade sawnwood (side boards), the sawmill is apparently producing these products at negative net value. A profit-maximizing softwood dimension or structural lumber sawmill should therefore maximize production of center boards and minimize the production of low-grade sawnwood (side boards), chips and sawdust. For these sawmills the side boards are generally narrow and short, and thus of lower value per unit volume than the higher value center boards. Clearly the situation will be different for hardwood sawmills where the highest value lumber recovered is from the outer part of the log. However, what is described here would apply to any type of mill, except that the product mix would vary.
There are indications that sawmill by-product prices will increase substantially. Due to the emphasis on energy production based on renewable resources, to meet the EU's binding target of a 20 percent share of renewable energies in overall EU energy consumption by 2020 (Renewable Energy Technology Roadmap up to 2020 (EREC 2007)), increased demand results in an increased price for intermediate product (chips). In the softwood sawmilling case, the problem is to decide when low-value side boards should be further processed at the sawmill or chipped and sold for bioenergy. A substantial part of the costs in sawmilling are joint costs, and in profit analysis joint costs have to be included. This resembles the situation that faced the U.S. oil refining industry in 1973/74. The prices of intermediate products were raised in order to cut back production of gasoline and to increase production of fuel oil. The industry was requested to provide the government with figures representing the loss associated with a change in production from gasoline to home-heating fuel. To be able to do this, allocation of joint costs was necessary because of the existence of joint production costs.
Previous research has been conducted on several industries--sawmilling, oil and gas--in addition to developing a general theory on the topic of joint cost allocation. Johansson and Rosling (2002) developed an approach to allocating joint costs in sawmilling based on a linear programming model. The purpose of this model was to calculate the marginal cost of center boards. This model was further developed by Johansson (2004) and has been used for joint cost allocation in a Swedish pine mill. In Johansson's model, timber costs (i.e., joint costs) include all costs before sawing the logs, minus revenue from cellulose chips, bark and sawdust. Johansson (2004) suggested that marginal cost estimates are useful only for center products, i.e., for products sold to regular customers at negotiated prices and often further processed. For commercial side boards sold at fixed market prices, marginal cost estimates are of little use since prices are given and the volumes are consequences of the production of center boards.
A survey of accounting practices in the European oil and gas industry was conducted by Coe et al. (1997). They stated that the accelerating pace of change in the energy industry created uncertainty, and information on the accounting aspects of this dynamic environment was needed. As early as 1977, Feller highlighted the need for management accounting systems designed for handling joint costs in the oil refining industry. The oil crisis in 1973 to 1974 had made by-products highly profitable, and other costing systems were needed to allocate joint costs in a more appropriate way.
Billera et al. (1981) presented a unique procedure for allocating common costs from a production process. This approach was suitable for allocating joint costs in a production process yielding different products or services, or different grades of the same product. The procedure enabled calculation of marginal unit costs for products produced and finally a relative cost per unit product produced. This is the procedure implemented by Johansson (2004).
Balachandran and Ramakrishnan (1981) also presented a way of allocating joint costs by combining earlier joint cost allocation models developed by Moriarity (1975) and Louderback (1976). Balachandran and Ramakrishnan (1981) used a combination of both Moriarity (1975) and Louderback (1976) to provide a new approach called "prosperity to contribute." A division's "prosperity to contribute" was calculated as the minimum cost of each division acting independently of the company or together (internally) with the other divisions in the company, minus the internal processing cost of each division. Each division's relative share of the contribution was used as a distribution formula when joint costs (i.e., purchasing raw material, joint production cost, etc.) were allocated. Balachandran and Ramakrishnan (1981) also suggested a Shapley value-based scheme to allocate joint costs. A more thorough discussion of game theoretical concepts and Shapley value-based allocation can be found in Hamlen et al. (1977). The methods presented by Balachandran and Ramakrishnan (1981) allocated joint costs to divisions and not to products.
With semiconductor manufacturing as a setting, Gatti and Grinnell (2000) presented an article in which they evaluated the effect of joint cost allocation in cases of productivity and quality improvements. They presented methods called the physical quantities approach and the market value approach. The conclusion was that joint cost allocation based on market values are most sensitive to changes in productivity, and the most comprehensive method in terms of reflecting the effects of improvements of product quality.
Finally, Jang et al. (2006) proposed a method to allocate joint costs in the natural gas industry. Natural gas is a joint product with crude oil and is usually processed and transported via shared facilities to reduce net costs. The method was called the design benefit method (DBM), and joint costs are allocated based on an ideal product's utilization of real capital. Jang et al. (2006) focused on minimizing the total costs connected to producing a number of products. The joint costs of utilizing specific equipment were allocated to the products using a regression analysis to determine each of the products' utilization of the equipment.
Theory and data
Joint cost allocation is comprehensively discussed in the cost accounting literature, but in the practical accounting literature joint cost accounting has not been given much attention. In Horngren's 12th edition of Cost Accounting, more emphasis is put on joint cost allocation than in the previous editions. In addition to the methods referred to above, Horngren et al. (2006) presented four joint cost allocation methods:
(1) Sales value at split-off point: the relative amount of cost is the same as the relative amount of sales value.
(2) Physical measurement: the relative physical part of one product at split-off point is used as the cost allocation key.
(3) Net realizable value (NRV): final sales value for one product minus separable costs (costs connected directly to that product), relative to total net realizable value, is used as a key to allocate joint costs to each product.
(4) Constant gross margin percentage NRV: the gross margin is deducted from a product's total revenue using the gross margin percentage. The remaining amount is the total production cost for that product. Separable cost is then deducted, and the cost remaining is the joint cost for each product.
These are the basic methods for joint cost allocation and many articles on joint cost allocation originate from them. For example Gatti and Grinnell (2000) used the sales value at split-off point method and the NRV method to measure and calculate product profitability in a case of quality and productivity improvements in a semiconductor manufacturing company producing memory devices.
Using data from the Norwegian sawmilling industry, examples showing how joint costs allocation procedures affect products' contribution margins are provided. In addition, illustrations are presented to demonstrate how quality and productivity improvements influence products' profitability. The joint cost allocation methods presented in this article come from findings in Tunes et al. (2006) and from theoretical examples derived in Horngren (2006) and Gatti and Grinnell (2000). The examples presented do not consider further processing of the lumber in planer mills. Planer shavings are therefore not mentioned as a product since the value of that residue is being captured in the planing mill.
Horngren et al. (2006) stated that the sales value at split-off point method should be used when the sales price of the product is available (even if further processing is done) and presented four reasons for this: firstly, it measures the value of the joint product immediately at the end of the joint process; secondly, there are no anticipations of subsequent management decisions; thirdly, it is meaningful to allocate joint costs based on relative revenues; and fourthly, because of its simplicity compared to the other methods described above.
In the sawmilling industry, sales prices at the split-off point are usually not available because the main products (i.e., center boards and side boards) are often used as inputs in value-added production, for example planed, precut or pressure treated. When the sales prices of products at the split-off point are not available and the physical measurement methods are unsuitable, other methods should be used. These are presented by Horngren et al. (2006) as the NRV method and the constant gross margin percentage NRV method. According to Horngren et al. (2006) the NRV method measures products' income better than the gross margin percentage NRV method. The NRV method is also perceived as better than the physical measurement method. However, there are instances when physical measurement methods are preferred. Market price based methods (i.e., the sales value at split-off point method) are for instance difficult to use in the context of rate and price regulations because exact prices of products do not exist, or can be difficult to obtain. In addition, the concepts of future income and costs are of great importance. The idea is that only expected future revenues and costs are taken into consideration when the decisions are made on whether a joint product or main product should be processed further or sold at the split-off point. Horngren et al. (2006) emphasized that joint costs incurred up to the split-off point are irrelevant, because these costs would have been incurred whether the product is sold at the split-off point or processed further. Joint costs up to the split-off point are frequently not available (these are not only raw material costs and labor costs, but include a range of costs such as depreciations, house rent and administration). This is one of the reasons why Horngren et al. (2006) suggested that further processing should depend on product revenue attainable beyond the split-off point.