What is the Net Realizable Value Method of Allocating Joint Costs?

The net realizable value (NRV) method, also known as the sales value at split-off method, is a cost allocation method used to allocate joint costs among the joint products based on their relative net realizable values. The net realizable value represents the estimated selling price of a product less any additional costs necessary to make the product ready for sale.

Here’s how the net realizable value method of allocating joint costs works:

  1. Determine the Total Joint Costs: Calculate the total joint costs incurred up to the split-off point in the joint manufacturing process. These costs include expenses such as direct materials, direct labor, and factory overhead that are collectively incurred for all the joint products.
  2. Assess the Net Realizable Values at Split-off: Estimate the net realizable values of each joint product at the split-off point. The net realizable value is calculated by subtracting the estimated additional costs required to make the product ready for sale from its estimated selling price.
  3. Calculate the Total Net Realizable Value: Determine the total net realizable value by summing up the estimated net realizable values of all the joint products at the split-off point.
  4. Calculate the Allocation Ratio: Calculate the allocation ratio for each joint product by dividing its estimated net realizable value by the total net realizable value. The allocation ratio represents the proportionate share of the joint costs that each product should bear based on its net realizable value at split-off.
  5. Allocate Joint Costs: Multiply the total joint costs by the allocation ratio for each joint product to determine the allocated joint costs for each product. The allocated costs represent the portion of the total joint costs assigned to each product based on its net realizable value at split-off.
  6. Cost Assignment: Allocate the allocated joint costs to the respective joint products for proper cost assignment. These allocated costs will be used for inventory valuation, cost determination, pricing decisions, and performance evaluation of the individual products.

The net realizable value method focuses on the estimated selling price of the joint products and considers the costs necessary to prepare the products for sale. It assumes that the net realizable value reflects the relative economic value or market potential of each product. By allocating costs based on net realizable values, this method aims to align the cost allocation with the potential revenue and profitability of the products.

It’s important to note that estimating the net realizable values at split-off requires careful consideration of factors such as market conditions, production costs, and potential post-split-off processing costs. Additionally, the net realizable values may vary over time, so periodic reassessment or adjustments may be necessary.

The net realizable value method provides a market-oriented approach to allocating joint costs, as it considers both selling prices and necessary costs for each product. However, it may not fully capture all the costs incurred in producing each product or account for differences in production complexities or cost structures. Therefore, it’s important to consider the specific circumstances and objectives of cost allocation when selecting an appropriate method.

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Caroline Grimm

Caroline Grimm is an accounting educator and a small business enthusiast. She holds Masters and Bachelor degrees in Business Administration. She is the author of 13 books and the creator of Accounting How To YouTube channel and blog. For more information visit: https://accountinghowto.com/about/

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