The Net Realizable Value (NRV) Method in Cost Accounting
When cost accounting, separable costs are incurred after you pass the splitoff point. In many cases, the product won’t be sellable at splitoff, because the product isn’t finished yet.
Say you make two types of leather purses. Both purses go through the same production process. Each product incurs a portion of the joint costs of production. But the process doesn’t end there. In this case, you’d expect to have costs after splitoff. You need to add straps and metal accessories to complete the product for sale.
Because many products require production after splitoff, it’s important that you review the net realizable value (NRV) method.
The net realizable value method allocates joint costs on the basis of the final sales value less separable costs. Final sales value is simply the price tag — the price paid by the customer. That price is paid after all production costs, whether they are joint costs or separable costs incurred after splitoff.
What you realize on a sale is usually your profit. You see this term used many times in business. But in this case, realizable value means sale price less separable costs. That doesn’t equal profit. You have to subtract joint costs from the subtotal to get profit. It’s not a perfect comparison, but it’s close.
Use the leather-purse example for working through the net realizable value method. Say you sell two types of purses: The Sassy purse line is more expensive than the Everyday model. The separable costs per unit for Sassy purses, as you see, are higher than those of Everyday purses.
The following table calculates the net realizable value for each product.
|Sales value (A)||$1,000,000||$840,000||$1,840,000|
|Separable costs (B)|
|Net realizable value (A – B)||$760,000||$600,000||$1,360,000|
Work your way down the Sassy purse column. The sales value of $1,000,000 is based on the production multiplied by the unit price (20,000 x $50). Then here’s the separable cost calculation:
Separable cost = units produced x cost per unit
Separable cost = 20,000 x $12
Separable cost = $240,000
The net realizable value is the $1,000,000 sales value less $240,000 separable costs = $760,000. Next, you use net realizable value to allocate joint costs. Take a gander at the next table.
|Net realizable value (NRV)||$760,000||$600,000||$1,360,000|
|Percent of NRV total||55.88||44.12|
|Joint cost allocation||$502,941||$397,059||$900,000|
|Cost per unit||$37.15||$26.54|
This table starts with the net realizable value amounts from the first table. The Percent of NRV total is the percentage of the total NRV for each product. The $760,000 of NRV for Sassy purses is 55.88 percent of the total of $1,360,000. Then you multiply $900,000 in total joint costs by the percentage, and that allocates joint costs to each purse. Simple, no? No.
What about separable costs? The second table displays the separable costs from the first table. Add the separable and joint costs to get total costs. It makes sense that Sassy purses have a higher total cost per unit ($37.15).
The Sassy’s per unit separable cost of $12 (from the first table) is higher than that of the Everyday product ($10), so the Everyday unit’s cost is $26.54. The $502,941 joint costs allocated to the Sassy in the second table are also higher than the joint costs for Everyday purses.
One issue with the net realizable value (NRV) method is that amounts may change. For starters, your production process after splitoff may change. Hopefully, you’re able to review variance results and improve the process. If you change your production after splitoff, your separable cost totals change.
You may not be able to price your product until after production ends. And in a market with heavy competition, to maintain your sales levels, you have to keep your price competitive (for the Sassy purses, say $50 per unit or lower). If your total costs come in lower than expected, maybe you can price the product lower than $50, and that might increase sales.
If you can’t determine a sales price in advance, you can’t calculate relative sales value.