What Are By-products?
By-products are secondary outputs that emerge incidentally from a manufacturing process designed primarily to produce a main product. While not the primary focus of production, by-products often possess some market value and can generate additional revenue. Understanding their proper classification and accounting treatment is a critical aspect of cost accounting, allowing businesses to accurately determine the true cost of their main products and improve overall profitability.
History and Origin
The concept of by-products has existed as long as complex manufacturing processes. Early industries, particularly those involving natural resources, invariably generated secondary materials. For instance, lumber mills produced sawdust, and sugar refineries yielded molasses. The formal accounting treatment of these incidental outputs began to evolve with the rise of modern industrialization and the need for more precise financial reporting.
In the early 20th century, cost accountants grappled with how to accurately account for these secondary products. A publication from the National Association of Cost Accountants in August 1920 highlighted the "perplexing problems in cost accounting" that by-products presented, particularly in apportioning costs between main products and by-products up to the point of separation.16 Initially, some by-products were simply treated as miscellaneous income upon sale, with no allocated costs. Over time, more sophisticated methods developed to better reflect their economic contribution and influence on the overall cost of goods sold.
Key Takeaways
- By-products are incidental outputs of a primary production process with relatively lower sales value than the main product.
- Their accounting treatment impacts the reported cost of the main product and a company's overall financial statements.
- Two main accounting methods for by-products are the production method and the sales method.
- Effective by-product management can reduce waste, improve resource efficiency, and contribute to sustainability.
- The distinction between by-products and joint products is crucial for proper cost allocation.
Formula and Calculation
While there isn't a single universal formula for by-products, their valuation often involves the concept of net realizable value (NRV). NRV is the estimated selling price of a by-product in the ordinary course of business, less any estimated costs of completion and disposal.
The two primary methods for accounting for by-products are:
- Production Method: This method recognizes by-products at the time they are produced. The estimated NRV of the by-product is credited to the cost of the main product or work-in-process inventory, thereby reducing the main product's production costs. This method treats the by-product as a form of inventory, reflecting its value as an asset on the balance sheet as soon as it's produced.15,14
- Sales Method: This method recognizes the value of the by-product only when it is sold. No costs are allocated to the by-product, and it is not recognized as inventory. The revenue generated from the sale of by-products is typically treated as "other income" or is deducted from the cost of production for the main product in the period of sale.13,12
The choice of method can significantly affect the timing of profit recognition and the reported gross margin.
Interpreting the By-products
The accounting treatment of by-products directly influences the perceived cost and profitability of the main product. Under the production method, the main product's cost is immediately reduced by the by-product's estimated value, which can lead to a higher reported gross margin on the main product.11 This approach provides a more accurate reflection of the total inventory value on the balance sheet.
Conversely, the sales method delays the recognition of by-product value until sale, initially showing a higher cost of goods sold for the main product.10 This can impact the reported income statement figures. From a managerial accounting perspective, understanding the impact of by-products is crucial for setting appropriate pricing strategies, evaluating production efficiency, and assessing the overall financial health of a manufacturing operation.
Hypothetical Example
Consider "Apex Paper Co.," a company whose primary business is producing high-quality paper. In its manufacturing process, Apex also produces wood pulp residue, which has a marketable value.
- Main Product: Paper
- By-product: Wood pulp residue
Let's assume the costs incurred up to the point of separation (where the wood pulp residue can be identified as a distinct product) are $100,000 for a batch.
Scenario 1: Production Method
Apex estimates the net realizable value of the wood pulp residue from this batch to be $5,000.
Under the production method:
- By-product Inventory is debited by $5,000.
- Work-in-Process or Main Product Cost is credited by $5,000.
The effective cost of producing the paper is reduced to $95,000 ($100,000 - $5,000). When the wood pulp is eventually sold, the actual sale price might differ from the NRV, resulting in a small gain or loss. This method ensures the inventory valuation on the balance sheet reflects the by-product's estimated value.
Scenario 2: Sales Method
Apex does not assign a cost or recognize the wood pulp residue as inventory until it is sold.
Under the sales method:
- The total production cost of the paper remains $100,000 initially.
- When the wood pulp residue is sold for, say, $4,800, that amount is recorded as "Other Income" on the profit and loss account, or it's directly subtracted from the total manufacturing expenses for the period.
This example illustrates how the chosen accounting method affects the immediate financial representation of the main product's cost and the recognition of by-product value.
Practical Applications
By-products are ubiquitous across various industries, often transforming what might otherwise be considered waste into valuable resources. In the agri-food industry, for instance, the processing of fruits for juice often yields pulp, seeds, and skins, which can be used in cosmetics or animal feed.9 Similarly, the dairy industry generates whey during cheese production, which is a valuable by-product used in protein supplements.
The meat, poultry, and fish processing industries also produce significant by-products, such as bones, fats, and organs. Efficient utilization of these by-products is crucial for the profitability of these sectors, contributing substantially to their gross income. For example, by-products can account for over 10% of gross income in beef processing.8 Beyond traditional uses like animal feed and fertilizers, advanced applications are emerging, particularly in the context of the circular economy. This includes converting agricultural and industrial residues into high-value products like biofuels, bioplastics, and bioactive compounds through biotechnological advancements.7 This not only creates new revenue streams but also addresses environmental concerns by reducing waste.
Limitations and Criticisms
Despite their potential value, by-products present several accounting and operational challenges. A primary limitation lies in the difficulty of accurately allocating joint costs incurred before the split-off point—the stage where by-products become separately identifiable from the main product. S6ince by-products are incidental and often of relatively minor value, precise cost apportionment can be impractical or disproportionately complex for their economic significance.
5Critics argue that if by-product costs are simply buried within the main product's costs, it can obscure the true financial performance of each output. A4dditionally, fluctuations in the market value or demand for by-products can introduce volatility into the main product's reported costs if the production method is used. Businesses also face challenges in determining a reliable market value for by-products, especially if they require further processing before sale or if their demand is inconsistent. Compliance with accounting standards further necessitates careful consideration of how by-products are valued and reported.
3## By-products vs. Joint Products
The distinction between by-products and joint products is fundamental in cost accounting. Both result from a common production process, but their economic significance differs.
| Feature | By-products | Joint Products |
|---|---|---|
| Economic Value | Secondary products, lower sales value, incidental to the main product. | Two or more main products with relatively significant and often equal sales value. |
| Production Intent | Not the primary purpose of the production process; inevitably generated. | Intended results of the production process; all are desired outcomes. |
| Cost Allocation | Often receive minimal or no allocation of joint costs; value typically offsets main product cost or treated as other income. | Receive significant allocation of joint costs based on various methods (e.g., sales value at split-off, physical units). |
| Inventory Treatment | May or may not be recognized as inventory, depending on the accounting method (production vs. sales). | Typically recognized as inventory and assigned a portion of joint costs. |
Confusion often arises because both are produced simultaneously. However, the intent behind their production and their relative economic contribution dictate their classification and the subsequent application of cost allocation methodologies. By-products are essentially "leftovers" with some value, whereas joint products are co-equals in terms of production goals and economic contribution.
FAQs
What is the primary purpose of accounting for by-products?
The primary purpose is to accurately determine the true cost of the main product and to ensure that the economic value generated by secondary outputs is properly reflected in the financial records. This helps in better decision-making and resource utilization.
How does a by-product differ from waste or scrap?
By-products have some market value and are typically sold or used further, generating revenue or reducing costs. W2aste and scrap, on the other hand, usually have little to no market value and may even incur disposal costs. While all are residual outputs, by-products are economically more significant.
Can a by-product become a main product over time?
Yes, this can happen. As markets evolve or new technologies emerge, a substance once considered a low-value by-product might gain significant economic importance and become a joint product or even a main product. Historically, gasoline was once a by-product of kerosene refining before becoming the dominant fuel.
Which accounting method for by-products is generally preferred?
Neither method is universally "preferred" as it depends on the specific industry, the relative value of the by-product, and management's reporting objectives. The production method provides a more complete picture of inventory value and the main product's true cost at the time of production, while the sales method is simpler and often used when by-product values are immaterial. E1ach has implications for income recognition and financial statement presentation.