Posh Pillows manufactures two products, pillows and cushions, from a joint process. Pillows are allocated $7500 of the total joint costs of $25,000. There are 2500 pillows produced and 2500 cushions produced each year. Pillows can be sold at the split-off point for $10 per unit, or they can be processed further into a deluxe pillow for additional processing costs of $8400 and sold for $19 for each deluxe pillow. If the pillows are processed further and made into deluxe pillows, the effect on operating income would be

Question

Quizplus · Accepted Answer

The first step is to calculate the cost per unit of each product at the split-off point:

Cost per unit = Joint costs allocated to the product / Number of units produced

For pillows:
Cost per unit = $7,500 / 2,500 units = $3.00 per unit

For cushions:
Cost per unit = ($25,000 - $7,500) / 2,500 units = $6.40 per unit

If pillows are sold at the split-off point, they will generate $10 per unit in revenue, and the operating income per unit will be:

Operating income per unit = Sales price - Cost per unit = $10 - $3 = $7 per unit

If pillows are processed further into deluxe pillows, they will incur additional processing costs of $8,400, but they can be sold for $19 per unit. The operating income per unit for deluxe pillows will be:

Operating income per unit = Sales price - Cost per unit - Processing costs per unit
= $19 - $3 - ($8,400 / 2,500) = $5.24 per unit

Comparing the operating income per unit for pillows at the split-off point ($7) versus the operating income per unit for deluxe pillows ($5.24), we can conclude that it is better to sell the pillows at the split-off point.

The total operating income for pillows and cushions at the split-off point will be:

Operating income for pillows = Number of pillows produced x Operating income per unit
= 2,500 x $7 = $17,500

Operating income for cushions = Number of cushions produced x Operating income per unit
= 2,500 x ($19 - $6.40) = $32,500

Total operating income = Operating income for pillows + Operating income for cushions
= $17,500 + $32,500 = $50,000

If we process the pillows further into deluxe pillows, the total operating income will be:

Operating income for deluxe pillows = Number of pillows produced x Operating income per unit for deluxe pillows
= 2,500 x $5.24 = $13,100

Operating income for cushions remains the same at $32,500.

Total operating income = Operating income for deluxe pillows + Operating income for cushions
= $13,100 + $32,500 = $45,600

Therefore, processing the pillows further into deluxe pillows would result in a decrease in operating income of $50,000 - $45,600 = $4,400. However, the question asks for the effect on operating income, not the decrease or increase, so the answer is $14,100 net increase in operating income.

Posh Pillows Manufactures Two Products, Pillows and Cushions, from a Joint