Process Costing: Spoilage

Useful Terms• Spoilage: Units that do not meet production standards and are

either sold for their salvage value or discarded.• Defective Units: Units that do not meet production standards but

can be economically reworked to sell as good finished goods. Economically reworked means (1) the unit can be reprocessed to a sufficient quality level to be salable through normal distribution channels and (2) incremental rework cost is less than incremental revenue from the sale of reworked units.

• Scrap: Residual material that can’t be put back into production for the same purpose but may be usable for a different purpose or production process, or sold to outsiders for a nominal amount.

• Waste Material: The part of raw material left over after production that has no further use or resale value.

Accounting for Spoiled Units• Theory of Neglect: Spoiled units are considered as never having been

put into production, regardless of the amount of work done on them. • Implications:• Spoiled units are ignored in the calculation of equivalent units• Cost per equivalent unit increases• Cost allocation to units completed and units still in process in computed

using a higher equivalent unit cost

• Shortcomings:• The cost of spoiled units is not calculated• The total cost of spoilage is automatically spread over all surviving units• No distinction is made between normal and abnormal spoilage.

Accounting for Spoiled Units• Spoilage as separate element of cost: Spoiled units are

considered to be part of production and separate calculation of cost for spoiled units are done.

Particulars

Units to account for:

Opening Inventory

Units started during current period/transferred-in

Units to account for

Units accounted for:

Units completed and transferred out

Normal spoilage

Abnormal spoilage

Ending WIP Inventory

Units accounted for

Spoilage• Normal Spoilage: Spoilage inherent in a particular production process that

arises even when the process is operated in an efficient manner.• Abnormal Spoilage: Spoilage that is not inherent in a particular process and

would not arise under efficient operating conditions.• The classification of normal and abnormal spoilage depends on

management expectation regarding lost units. • Management creates a range of tolerance of spoiled units specified by the

accepted quality level. If a company had set its quality goal as 98 percent of goods produced, the company would have been expecting a normal loss of 2 percent. Any loss in excess of the AQL is an abnormal loss. Thus, the difference between normal and abnormal loss is merely one of degree and is determined by arrangement.

Accounting for Spoilage• Normal Spoilage is considered as a product cost• Abnormal Spoilage is considered as a period cost. This treatment

is justified by the cost principle discussed in financial accounting. The cost principle allows only costs that are necessary to acquire or produce inventory to attach to it. All unnecessary costs are written off in the period in which they are incurred. Because abnormal losses are not necessary to the production of good units and the cost is avoidable in the future, any abnormal loss cost is regarded as a period cost. This cost should be brought to the attention of the production manager who should then investigate the causes of the loss to determine how to prevent future similar occurrences.

Accounting for Normal Spoilage• Normal Spoilage is considered as a product cost• The common approach is to presume that normal spoilage

occurs at the inspection point in the production cycle and to allocate normal spoilage cost over all units that have passed that point during the accounting period.

• Normal spoilage is generally defined as the function of the number of units passing the inspection point or the number of good units passing the inspection point.

Question

• Opening WIP 1500 Units (40% complete)• Started 8500 units • Ending WIP 2000 units (70% complete)• Total spoilage 1000 units• Normal spoilage: 10% of units passing the inspection

point• Inspection 20% / 55% / 80% /100%• Prepare the statement of inputs, outputs and

equivalent units

Calculation of SpoilageInspection Point

20% 55% 80% 100%

Total possible (units to account for) 10000 10000 10000 10000

Less: Beginning WIP (if inspected in last period)

Less: Ending WIP (if not inspected in current period)

Actual units inspected

Less: Spoilage

Good units passing the inspection point

Calculation of SpoilageInspection Point

20% 55% 80% 100%

Total possible (units to account for) 10000 10000 10000 10000

Less: Beginning WIP (if inspected in last period)

Less: Ending WIP (if not inspected in current period)

Actual units inspected

Less: Spoilage

Good units passing the inspection point