There are times when manufacturing businesses become faced with the decision to sell a product at its current state or process it further and sell for a higher price. Ultimately, the management must choose the option that will result in higher profits.
In relevant costing, if the increase in price is higher than the increase in cost, then it is better to process the product further as it will result in higher profits.
If further processing costs exceed the increase in revenues, then there is no point in processing the product further.
ABC Company manufactures three products. In one production batch, the company incurs $25,000 manufacturing costs up to the split off-point (the point in the manufacturing process when the products can be separately identified).
The following summarizes the further processing costs beyond the split-off point and ultimate sales value.
|Further processing costs||Expected
The company can sell the products at split-off point. The expected sales revenues at split-off point are: Product 1 - $24,000, Product 2 - $8,000, Product 3 - $7,000. Which products should be sold at split-off point and which products should be processed further?
|Product 1||Product 2||Product 3|
|Increase in sales||$66,000||$20,000||$5,000|
|Increase in costs||72,000||12,000||2,000|
|Effect to profits||($6,000)||$8,000||$3,000|
Product 1 should be sold at split-off point. The increase in sales revenue amounting to $66,000 (i.e., from $24,000 to $90,000) is less than the costs to process the product further ($72,000). Hence, it is better to sell the product at split-off point than process it further. Product 2 and Product 3 could be processed further since it will result in incremental profits.
The decision to sell now or process further boils down to which choice will result in higher profits.
Split-off point refers to the moment in the manufacturing process when different products become separately identifiable.
If the incremental sales revenue is greater than incremental costs, it makes sense to process further. Otherwise, it is better to sell at the split-off point.