Although, most modern firms make several products, Economic Theory has been developed on the premise that each firm produces only one product. The reasons for such inadequate premises are found partly in the historical origins of theory and partly in the simplicity of theoretical analysis when it is confined to production of just one single product. In many manufacturing enterprises two or more different products emerge from common production process and common raw-material used. Production of multiple product has almost become the rule.
When two or more different products emerge from a single common production process and a single raw material, they get identified as separate products only at the end of common processing which is called the ‘Split of Point’. The costs that that have been incurred up-to the split of point are common costs. The common costs cannot be traced to the separate products. Some common costs are unaffected, such as cost of factory building. Thus common costs that are fixed need not be allocated, they will remain constant. Only those common costs which vary with the decision should be allocated to individual products. The problem of product costing arises in identifying parts of common costs with particular products. In fact, short-run variable costs are most important and warrant special attention.
For multiple product costing it is desirable to distinguish the two broad categories of common products: viz; 1) The Joint Products and 2) The Alternative Products.
When an increase in the production of one product causes an increase in the output of another product, then the products and their costs are traditionally defined as joint. Whereas, an increase in the output of a product is accompanied by a reduction in the output of other products, it is case of what is called the alternative products. When one product is much less important than other, it may be regarded as a by-product, a gratuitous use of waste material. However there is no real distinction between joint- products and by-products. Where the pace of technology is rapid, as in some sciences, by-products soon become joint products and may even surpass the main product.
The cost of an alternative product can always be computed in terms of the foregone profits from the other product, whereas the cost of joint product is not quite determinate.
For joint products the cost problems relate more commonly to the incremental effect of an increase in output rate to meet new demand for one of the joint products. An increase in demand for one of the joint products will imply increase in production of other joint products as well. These joint-products, except the one whose demand has increased, will not fetch enough returns to cover their cost. They will have to be sold out at a much lower price. In that case the price of the joint product-in-demand must be sufficiently high not just to cover the marginal cost of the whole product-package but also to cover any loss of revenue due to the lowered prices of other not-so-in-demand joint products.
It would be possible to estimate the independent effect upon cost by varying the output of one product while holding all other constant; thereby arriving at the cost allocation for that product.