The replacement cost method (also known as opportunity cost method) of costing by-products is usually used by companies that use their by-product in their own manufacturing plant or somewhere else within the company. In other words, the production of by-product eliminates the need of buying it from an external manufacturer or supplier. For example, coal gas is a by-product produced during the production of coke which is the main product. The producers of coke do not sell this by-product but use it within the organization for heating purpose.
Another example of the by-product that is used within the organization is the bagasse in the sugar mill. A major portion of bagasse is used for heating, boiling and producing electricity for the consumption of the sugar mill.
Under replacement or opportunity cost method, the purchase or replacement cost of the by-product is used to make the entry. The department which consumes the by-product is debited and the production cost of the main product is credited.