Example 4:

Question

A company is engaged in processing meat from slaughter house. One of its department cuts
lump shoulder and generates two products
 Shoulder meat (The main product)……………..sold for Br 60 per pack
 Hock meat (The byproduct)……………………….sold for Br 4 per pack
Both products are sold at the split off point without further processing. Data for this
department in July 2004 is as follows
Products
Beg. inventory
production
sales
End. inventory
Shoulder meat (in pack) 0
5000
4000
1000
Hock meat (in pack)
0
1000
300
700
The total manufacturing cost of the products were Br 250,000
Requirements:
1. Show the process using diagram
2. what is the gross profit under the two methods
3. what is the inventory amount to be reported in the balance sheet under each method
4. Which method do you recommend

Answer 1

Let's break down the requirements step by step.

1. Process Diagram

The process can be visually represented as follows:

                             +--------------------+
                             |   Slaughter House   |
                             +--------------------+
                                     |
                                     | Processing
                                     v
                   +-------------------------------------+
                   |            Cutting Department       |
                   +-------------------------------------+
                                  /           \
                               /                 \
                 Shoulder Meat                  Hock Meat
                      (Main Product)            (Byproduct)
                         

2. Gross Profit Under Two Methods

To calculate gross profit, we need to find the total revenue from each product and subtract the total manufacturing costs.

Sales Revenue

• Shoulder Meat:

  • Sales = Number of packs sold × Price per pack
  • Sales = 4,000 packs × Br 60 = Br 240,000

• Hock Meat:

  • Sales = 300 packs × Br 4 = Br 1,200

Thus, total sales revenue = Br 240,000 + Br 1,200 = Br 241,200.

Gross Profit Calculation

Total Manufacturing Cost = Br 250,000

• Gross Profit = Total Revenue - Total Manufacturing Cost
• Gross Profit = Br 241,200 - Br 250,000 = Br -8,800 (Loss)

3. Inventory Amount to be Reported in the Balance Sheet Under Each Method

To calculate inventory, we need to determine ending inventory costs based on the two methods: allocated costs and net realizable value (NRV).

a) Allocated Costs Method

Total manufacturing costs are allocated based on the relative sales value of each product at the split-off point.

1. Calculate total sales value at split-off:

   • Shoulder Meat: 1,000 packs × Br 60 = Br 60,000
   • Hock Meat: 700 packs × Br 4 = Br 2,800
   • Total Sales Value = Br 60,000 + Br 2,800 = Br 62,800

2. Calculate the cost allocation:

   • Proportion for Shoulder Meat: Br 60,000 / Br 62,800 ≈ 0.955 (95.5%)
   • Proportion for Hock Meat: Br 2,800 / Br 62,800 ≈ 0.045 (4.5%)

3. Allocate total manufacturing costs (Br 250,000):

   • Shoulder Meat Cost: Br 250,000 × 0.955 ≈ Br 238,750
   • Hock Meat Cost: Br 250,000 × 0.045 ≈ Br 11,250

4. End Inventory Calculation:

   • Ending Inventory Shoulder Meat = 1,000 packs × (Br 250,000 × 0.955 / 5,000 packs)
     • = 1,000 × Br 47.75 = Br 47,750
   • Ending Inventory Hock Meat = 700 packs × (Br 250,000 × 0.045 / 1,000 packs)
     • = 700 × Br 11.25 = Br 7,875

Total Ending Inventory under Allocated Costs Method = Br 47,750 (Shoulder Meat) + Br 7,875 (Hock Meat) = Br 55,625.

b) Net Realizable Value (NRV) Method

1. Calculate NRV of each product:
   • NRV for Shoulder Meat = (1,000 packs × Br 60) = Br 60,000
   • NRV for Hock Meat = (700 packs × Br 4) = Br 2,800

Total NRV = Br 60,000 + Br 2,800 = Br 62,800.

2. Calculate the proportion of each based on NRV:

   • Shoulder Meat: Br 60,000 / Br 62,800 ≈ 0.955 (95.5%)
   • Hock Meat: Br 2,800 / Br 62,800 ≈ 0.045 (4.5%)

3. Use this proportion to apply to total costs:

   • Shoulder Meat Cost: Br 250,000 × 0.955 ≈ Br 238,750
   • Hock Meat Cost: Br 250,000 × 0.045 ≈ Br 11,250

4. The ending inventory values would be the same as those from the allocated costs calculation since they are both derived using the mentioned proportions.

Summary of Inventory Amounts

• Allocated Costs Method: Br 55,625
• NRV Method: Br 55,625

4. Recommendation

When deciding between the two methods, generally, the NRV method is often preferred as it is based on the values that can be realized from the products, reflecting true market conditions. If the manufacturing costs constitute a significant factor, the allocated costs method might have some advantages in a stable pricing environment.

Considering that the company is operating at a loss and the NRV reflects a more realistic inventory valuation based on impending sales, I would recommend the Net Realizable Value method for reporting inventory on the balance sheet. This scenario helps avoid overstatement of assets when the costs exceed the realizable income, which is crucial for financial health reporting.