How do you choose an appropriate cost driver for joint cost allocation?

1 What is a joint cost?

A joint cost is a cost that is incurred for a single production process or resource that generates two or more outputs. For example, a dairy farm incurs joint costs for feeding and milking the cows, which produce both milk and cream. A joint cost cannot be directly traced to a specific output, so it needs to be allocated using some basis or factor that reflects the relative benefits or consumption of the outputs.

2 Why is joint cost allocation important?

Joint cost allocation is important for several reasons. First, it affects the profitability and pricing of the products or services that share the joint cost. If the joint cost is allocated unfairly or inaccurately, some products or services may appear more or less profitable than they really are, leading to suboptimal decisions. Second, it affects the performance evaluation and incentives of the managers and employees who are responsible for the products or services that share the joint cost. If the joint cost is allocated based on factors that are beyond their control or influence, they may be rewarded or penalized unfairly. Third, it affects the external reporting and taxation of the business. If the joint cost is allocated inconsistently or arbitrarily, it may distort the financial statements and the tax liability of the business.

3 What are the criteria for choosing a cost driver?

A cost driver is a factor that causes or influences the joint cost or the outputs that share the joint cost. For example, the number of gallons of milk and cream produced by the dairy farm could be used to allocate the joint cost of feeding and milking the cows. Choosing a cost driver should consider relevance, measurability, consistency, and simplicity. It should be related to the joint cost or outputs in a logical way, easy to measure and record, consistent with management's strategy and performance evaluation system, and not too complex to apply and communicate.

4 What are the methods for choosing a cost driver?

When choosing a cost driver for joint cost allocation, there are several methods to consider, depending on the availability and quality of data and the nature and characteristics of the outputs. Physical measures, such as weight, volume, quantity, or time, are simple and objective but may not capture differences in quality or value. Market-based measures, such as sales value, market price, or market share, are relevant and consistent but may be affected by external factors. Cost-based measures, such as variable cost, direct cost, or standard cost, are measurable and consistent but may not reflect the benefits or consumption of the outputs. For example, a dairy farm could use the number of gallons of milk and cream as the cost driver for the joint cost of feeding and milking the cows.

5 How do you apply a cost driver?

Once you have chosen a cost driver for joint cost allocation, you need to apply it to allocate the joint cost to the outputs. To do this, first identify the total amount of the joint cost for a given period and then identify the total amount of the cost driver for each output in that same period. Next, calculate the allocation rate by dividing the total joint cost by the total cost driver. Finally, allocate the joint cost to each output by multiplying the allocation rate by the cost driver for each output. For example, if a dairy farm has a total joint cost of $10,000 for feeding and milking cows in a month and produces 8,000 gallons of milk and 2,000 gallons of cream in that same month, using number of gallons as the cost driver, then the allocation rate would be $10,000 / (8,000 + 2,000) = $1 per gallon; $1 x 8,000 = $8,000 would be allocated to milk; and $1 x 2,000 = $2,000 would be allocated to cream.