Cost Accounting — Spoilage and Shrinkage: Allocating Normal Spoilage and Abnormal Spoilage

Production always yields some defects. Should the cost of defective units be loaded onto good products, or seen separately as a loss? That is the question of this chapter. The test is whether the defect is unavoidable even under efficient production. This chapter adds spoilage to the process costing of chapter 4.

1. Spoilage, shrinkage and scrap

• Spoiled units: defective units that fail quality standards and cannot be sold normally. The units remain.
• Shrinkage: a reduction in input quantity through evaporation, contraction and the like. No physical form remains.
• Scrap: leftovers from processing (such as wood offcuts). If they can be sold, their value is deducted from cost.
• Rework: defective units that become good units once extra cost is spent fixing them.

2. Normal and abnormal spoilage

The allowance for normal spoilage is usually set as a percentage of the good units that pass the inspection point. Because spoilage is detected at inspection, where the inspection point lies determines both the cost put into spoiled units and which good units bear the normal spoilage cost.

3. Worked example

Company UU adds materials at the start of the process and inspects at the 50% stage of completion. Normal spoilage is 6% of good units that pass inspection. There is no opening work in process.

Closing work in process is 30% complete and has not yet reached the inspection point (50%). So the only good units that passed inspection this period are the 750 completed units. Normal spoilage is $750 \times 6\% = 45$ units and abnormal spoilage $50 - 45 = 5$ units.

A. Equivalent units and unit costs

Current materials cost is ₩50 million and conversion cost ₩16.7 million.

• Materials equivalent units: $750 + 50 + 200 = 1{,}000$ → unit cost 5 (₩50,000)
• Conversion equivalent units: $750 + 50 \times 50\% + 200 \times 30\% = 835$ → unit cost 2 (₩20,000)

B. Cost allocation

Because closing work in process has not passed the inspection point, the ₩2.7 million of normal spoilage cost is allocated entirely to completed units. Had closing work in process already passed inspection, normal spoilage cost would be split between completed units and closing work in process in proportion to their good units. The total of 6,670 equals total costs of $5{,}000 + 1{,}670$.

4. Shrinkage and the disposal value of spoiled units

Shrinkage reduces output relative to input, so normal shrinkage is absorbed naturally by raising the unit cost of the remaining output. If spoiled units can be sold cheaply, their net realizable value is deducted from spoilage cost, and only the remainder is treated as normal or abnormal.

Check your understanding

Company VV adds materials at the start of the process and inspects at the 40% stage. Normal spoilage is 5% of good units. 2,000 units were started, 1,500 completed, 120 spoiled, and closing work in process is 380 units (60% complete). There is no opening work in process. How many units are normal and abnormal spoilage, and who bears the normal spoilage cost?

Closing work in process is 60% complete, past the 40% inspection point, so it counts as good units. Good units are $1{,}500 + 380 = 1{,}880$, normal spoilage is $1{,}880 \times 5\% = 94$ units and abnormal spoilage $120 - 94 = 26$ units. Normal spoilage cost is shared between completed units and closing work in process in proportion to their good units (1,500 : 380). The cost of the 26 abnormally spoiled units is a period loss.

References

• Charles Horngren, Srikant Datar and Madhav Rajan, Cost Accounting: A Managerial Emphasis, ch. 18
• Korea Accounting Standards Board, K-IFRS 1002 Inventories (abnormal amounts of wasted materials)
• Ray Garrison, Eric Noreen and Peter Brewer, Managerial Accounting, ch. 4