Question

Cotopaxi makes backpacks. Traditionally, they bought fabric in quantity, and cut out the forms for their backpacks from large pieces, discarding the interstitial material as scrap. Due to the integrated nature of the production facility, the cost of all this fabric was considered a joint cost, allocated by the approximate relative sales value method, and the scraps were considered a waste by-product. Recently however, an enterprising employee had the great idea to use these scraps and make small, unique bags from the heretofore-discarded pieces of fabric. The company agreed to implement this idea on a trial basis, and the accounting department decided to consider these bags a by-product using the net realizable value method. The marketing department set the price for the by-product bags at $50, and in the first year of production, 10,000 of these scrap bags were sold. At the end of the first year, the accounting department determined that each bag incurred an additional processing cost of $40 on average in additional materials (straps, buckles, thread, etc.), labor, and variable overhead (not including the cost of the scrap fabric from whence they came).

If Cotopaxi had instead allocated the joint-cost of fabric using the physical units method, how would this affect their overall profitability for the company as a whole (compared to allocating by the approximate relative sales value method)? (Note: assume all produced products were sold)

Increase profitability

Decrease profitability

No effect on profitability

If Cotopaxi had instead accounted for the new bags as a full product instead of a by-product, how would this affect their overall profitability for the company as a whole (compared to considering the new bags a by-product)? (Note: assume all produced products were sold)

Increase profitability

Decrease profitability

No effect on profitability

In the first year of tests, some of the main-product line bag divisions decided to bundle the by-product bags with their sales. What should the manager of the by-product bags charge as the transfer price assuming the capacity to produce these by-product bags is effectively infinite (far greater than external market demand for the by-product bag)?

$0 per bag

$10 per bag

$40 per bag

$50 per bag

After the first year, Cotopaxi realized that the demand for the by-product bags is so great that they cannot supply enough for both the direct market sales and as bundled products. What is the optimal transfer price that the by-product bag division should charge given this capacity constraint?

$0 per bag

$10 per bag

$40 per bag

$50 per bag

Answer 1

As the joint costs are costs which have already been incurred and also as all the products are sold , the method of allocation of the joint costs does not have any effect on the overall profitability of the company.

As the company accounts for all the costs incurred ,whatever the classification of the products, and also as all the products are sold , the classificaion of the products does not have any effect on the overall profitability of the company.

As the aditional cost of making the by-porduct bags is $40, the manager of the by-product should charge $40 as the transfer price.

In the event of capacity constraint,the by-product manager should charge $50 as the transfer price.