Process costing

1. Process Costing: Spoilage

2. 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.

3. 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.

4. 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

5. 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.

6. 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.

7. 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.

8. 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

9. Calculation of Spoilage
Inspection 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

10. Calculation of Spoilage
Inspection 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