Spoilage, Rework, And Scrap

CHAPTER 5

SPOILAGE, REWORK, AND SCRAP

Defining Spoilage, Rework and Scrap

While the terms used in this chapter may seem familiar, be sure you understand them in the context of management accounting.

Spoilage is units of production – whether fully or partially completed – that do not meet the specifications required by customers for good units and that are discarded or sold at reduced prices. Some examples of spoilage are defective shirts, jeans, shoes, and carpeting sold as “seconds,” or defective aluminum cans sold to aluminum manufacturers for remelting to produce other aluminum products.

Rework is units of production that do not meet the specifications required by customers but that are subsequently repaired and sold as good finished units. For example, defective units of products (such as pagers, computers, and telephones) detected during or after the production process but before units are shipped to customers can sometimes be reworked and sold as good products.

Scrap is residual material that results from manufacturing a product. Examples are short lengths from woodworking operations, edges from plastic molding operations, and frayed cloth and end cuts from suit-making operations. Scrap can sometimes be sold for relatively small amounts. In that sense, scrap is similar to byproducts. The difference is that scrap arises as a residual from the manufacturing process, and is not a product targeted for manufacture or sale by the firm.

Some amounts of spoilage, rework, or scrap are inherent in many production processes. For example, semiconductor manufacturing is so complex and delicate that some spoiled units are commonly produced; usually, the spoiled units cannot be reworked. In the manufacture of high-precision machine tools, spoiled units can be reworked to meet standards, but only at a considerable cost. And in the mining industry, companies process ore that contains varying amounts of valuable metals and rock. Some amount of rock, which is scrap, is inevitable.

Two Types of Spoilage

Accounting for spoilage aims to determine the magnitude of spoilage costs and to distinguish between costs of normal and abnormal spoilage. To manage, control, and reduce spoilage costs, companies need to highlight them, not bury them as an unidentified part of the costs of good units manufactured.

To illustrate normal and abnormal spoilage, consider Mendoza Plastics, which makes casings for the iMac computer using plastic injection molding. In January 2012, Mendoza incurs costs of $615,000 to produce 20,500 units. Of these 20,500 units, 20,000 are good units and 500 are spoiled units. Mendoza has no beginning inventory and no ending inventory that month. Of the 500 spoiled units, 400 units are spoiled because the injection molding machines are unable to manufacture good casings 100% of the time. That is, these units are spoiled even though the machines were run carefully and efficiently. The remaining 100 units are spoiled because of machine breakdowns and operator errors.

Normal Spoilage

Normal spoilage is spoilage inherent in a particular production process. In particular, it arises even when the process is operated in an efficient manner. The costs of normal spoilage are typically included as a component of the costs of good units manufactured, because good units cannot be made without also making some units that are spoiled. There is a tradeoff between the speed of production and the normal spoilage rate.

Management makes a conscious decision about how many units to produce per hour with the understanding that, at the rate decided on, a certain level of spoilage is almost unavoidable. For this reason, the cost of normal spoilage is included in the cost of the good units completed. At Mendoza Plastics, the 400 units spoiled because of the limitations of injection molding machines and despite efficient operating conditions are considered normal spoilage. The calculations are as follows:

Abnormal Spoilage

Abnormal spoilage is spoilage that is not inherent in a particular production process and would not arise under efficient operating conditions. If a firm has 100% good units as its goal, then any spoilage would be considered abnormal. At Mendoza, the 100 units spoiled due to machine breakdowns and operator errors are abnormal spoilage. Abnormal spoilage is usually regarded as avoidable and controllable. Line operators and other plant personnel generally can decrease or eliminate abnormal spoilage by identifying the reasons for machine breakdowns, operator errors, etc., and by taking steps to prevent their recurrence. To highlight the effect of abnormal spoilage costs, companies calculate the units of abnormal spoilage and record the cost in the Loss from Abnormal Spoilage account, which appears as a separate line item in the income statement. At Mendoza, the loss from abnormal spoilage is $3,000 ($30 per unit x 100 units).

Issues about accounting for spoilage arise in both process-costing and job-costing systems. We discuss both instances next, beginning with spoilage in process – costing.

Spoilage in Process Costing Using Weighted – Average and FIFO

How do process-costing systems account for spoiled units? We have already said that units of abnormal spoilage should be counted and recorded separately in a Loss from Abnormal Spoilage account. But what about units of normal spoilage? The correct method is to count these units when computing output units – physical or equivalent – in a process – costing system. The following example and discussion illustrate this approach.

Count All Spoilage

Example 1: Chipmakers, Inc., manufactures computer chips for television sets. All direct materials are added at the beginning of the production process. To highlight issues that arise with normal spoilage, we assume no beginning inventory and focus only on direct material costs. The following data are available for May 2012.

An inspection point is the stage of the production process at which products are examined to determine whether they are acceptable or unacceptable units. Spoilage is typically assumed to occur at the stage of completion where inspection takes place. As a result, the spoiled units in our example are assumed to be 100% complete with respect to direct materials.

Exhibit 5 – 1 calculates and assigns cost per unit of direct materials. Overall, Chipmakers generated 10,000 equivalent units of output: 5,000 equivalent units in good units completed (5,000 physical units x 100%), 4,000 units in ending work in process (4,000 physical units x 100%), and 1,000 equivalent units in normal spoilage (1,000 physical units x 100%). Given total direct material costs of $270,000 in May, this yields an equivalent-unit cost of $27. The total cost of good units completed and transferred out, which includes the cost of normal spoilage, is then $162,000 (6,000 equivalent units x $27), while the ending work in process is assigned a cost of $108,000 (4,000 equivalent units x $27).

There are two noteworthy features of this approach. First, the 4,000 units in ending work in process are not assigned any of the costs of normal spoilage. This is appropriate because the units have not yet been inspected. While the units in ending work in process undoubtedly include some that will be detected as spoiled when inspected, these units will only be identified when the units are completed in the subsequent accounting period. At that time, costs of normal spoilage will be assigned to the good units completed in that period. Second, the approach used in Exhibit 5 – 1 delineates the cost of normal spoilage as $27,000. By highlighting the magnitude of this cost, the approach helps to focus management’s attention on the potential economic benefits of reducing spoilage.

Exhibit 5 – 1 Effect of Recognizing Equivalent Units in Spoilage for Direct Material Costs for Chipmakers, Inc., for May 2012

Example 2: Anzio Company manufactures a recycling container in its forming department. Direct materials are added at the beginning of the production process. Conversion costs are added evenly during the production process. Some units of this product are spoiled as a result of defects, which are detectable only upon inspection of finished units. Normally, spoiled units are 10% of the finished output of good units. That is, for every 10 good units produced, there is 1 unit of normal spoilage. Summary data for July 2012 are as follows:

Step 1: Summarize the Flow of Physical Units of Output. Identify the number of units of both normal and abnormal spoilage.

Step 2: Compute Output in Terms of Equivalent Units. Compute equivalent units for spoilage in the same way we compute equivalent units for good units. As illustrated previously, all spoiled units are included in the computation of output units. Because Anzio’s inspection point is at the completion of production, the same amount of work will have been done on each spoiled and each completed good unit.

Step 3: Summarize Total Costs to Account For. The total costs to account for are all the costs debited to Work in Process. The details for this step are similar to Step 3 in Chapter 4.

Step 4: Compute Cost per Equivalent Unit. This step is similar to Step 4 in Chapter 4.

Step 5: Assign Total Costs to Units Completed, to Spoiled Units, and to Units in Ending Work in Process. This step now includes computation of the cost of spoiled units and the cost of good units.

Inspection Points and Allocating Costs of Normal Spoilage

Our Anzio Company example assumes inspection occurs upon completion of the units. Although spoilage is typically detected only at one or more inspection points, it might actually occur at various stages of a production process. The cost of spoiled units is assumed to equal all costs incurred in producing spoiled units up to the point of inspection. When spoiled goods have a disposal value (for example, carpeting sold as “seconds”), the net cost of spoilage is computed by deducting the disposal value from the costs of the spoiled goods that have been accumulated up to the inspection point.

The unit costs of normal and abnormal spoilage are the same when the two are detected at the same inspection point. However, situations may arise when abnormal spoilage is detected at a different point from normal spoilage. Consider shirt manufacturing. Normal spoilage in the form of defective shirts is identified upon inspection at the end of the production process. Now suppose a faulty machine causes many defective shirts to be produced at the halfway point of the production process. These defective shirts are abnormal spoilage and occur at a different point in the production process from normal spoilage. In such cases, the unit cost of abnormal spoilage, which is based on costs incurred up to the halfway point of the production process, differs from the unit cost of normal spoilage, which is based on costs incurred through the end of the production process.

Costs of abnormal spoilage are separately accounted for as losses of the accounting period in which they are detected. However, recall that normal spoilage costs are added to the costs of good units, which raises an additional issue: Should normal spoilage costs be allocated between completed units and ending work-in-process inventory? The common approach is to presume that normal spoilage occurs at the inspection point in the production cycle and to allocate its cost over all units that have passed that point during the accounting period.

In the Anzio Company example, spoilage is assumed to occur when units are inspected at the end of the production process, so no costs of normal spoilage are allocated to ending work in process. If the units in ending work in process have passed the inspection point, however, the costs of normal spoilage are allocated to units in ending work in process as well as to completed units. For example, if the inspection point is at the halfway point of production, then any ending work in process that is at least 50% complete would be allocated a full measure of normal spoilage costs, and those spoilage costs would be calculated on the basis of all costs incurred up to the inspection point. If ending work in process is less than 50% complete, however, no normal spoilage costs would be allocated to it.

To better understand these issues, let us now assume that inspection at Anzio Company occurs at various stages in the production process. How does this affect the amount of normal and abnormal spoilage? As before, consider the forming department, and recall that direct materials are added at the start of production, while conversion costs are added evenly during the process.

Consider three different cases: Inspection occurs at (1) the 20%, (2) the 55%, or (3) the 100% completion stage. The last option is the one we have analyzed so far (see Exhibit 5 – 2). Assume that normal spoilage is 10% of the good units passing inspection. A total of 1,000 units are spoiled in all three cases. Normal spoilage is computed on the basis of the number of good units that pass the inspection point during the current period. The following data are for July 2012. Note how the number of units of normal and abnormal spoilage changes, depending on when inspection occurs.

Job Costing and Spoilage

The concepts of normal and abnormal spoilage also apply to job-costing systems. Abnormal spoilage is separately identified so companies can work to eliminate it altogether. Costs of abnormal spoilage are not considered to be inventoriable costs and are written off as costs of the accounting period in which the abnormal spoilage is detected. Normal spoilage costs in job-costing systems – as in process-costing systems – are inventoriable costs, although increasingly companies are tolerating only small amounts of spoilage as normal. When assigning costs, job-costing systems generally distinguish normal spoilage attributable to a specific job from normal spoilage common to all jobs.

We describe accounting for spoilage in job costing using the following example.

Example 3: In the Hull Machine Shop, 5 aircraft parts out of a job lot of 50 aircraft parts are spoiled. Costs assigned prior to the inspection point are $2,000 per part. When the spoilage is detected, the spoiled goods are inventoried at $600 per part, the net disposal value.

Our presentation here and in subsequent sections focuses on how the $2,000 cost per part is accounted for.

Normal Spoilage Attributable to a Specific Job

When normal spoilage occurs because of the specifications of a particular job, that job bears the cost of the spoilage minus the disposal value of the spoilage. The journal entry to recognize disposal value (items in parentheses indicate subsidiary ledger postings) is as follows:

Note, the Work – in – Process Control (specific job) has already been debited (charged) $10,000 for the spoiled parts (5 spoiled parts x $2,000 per part). The net cost of normal spoilage $7,000 ($10,000 – $3,000), which is an additional cost of the 45 (50 – 5) good units produced. Therefore, total cost of the 45 good units is $97,000: $90,000 (45 units x $2,000 per unit) incurred to produce the good units plus the $7,000 net cost of normal spoilage. Cost per good unit is $2,155.56 ($97,000 /45 good units).

Normal Spoilage Common to All Jobs

In some cases, spoilage may be considered a normal characteristic of the production process. The spoilage inherent in production will, of course, occur when a specific job is being worked on. But the spoilage is not attributable to, and hence is not charged directly to, the specific job. Instead, the spoilage is allocated indirectly to the job as manufacturing overhead because the spoilage is common to all jobs. The journal entry is as follows:

When normal spoilage is common to all jobs, the budgeted manufacturing overhead rate includes a provision for normal spoilage cost. Normal spoilage cost is spread, through overhead allocation, over all jobs rather than allocated to a specific job. For example, if Hull produced 140 good units from all jobs in a given month, the $7,000 of normal spoilage overhead costs would be allocated at the rate of $50 per good unit ($7,000 /140 good units). Normal spoilage overhead costs allocated to the 45 good units in the job would be $2,250 ($50 x 45 good units). Total cost of the 45 good units is $92,250: $90,000 (45 units x $2,000 per unit) incurred to produce the good units plus $2,250 of normal spoilage overhead costs. Cost per good unit is $2,050 ($92,250 / 45 good units).

Abnormal Spoilage

If the spoilage is abnormal, the net loss is charged to the Loss from Abnormal Spoilage account. Unlike normal spoilage costs, abnormal spoilage costs are not included as a part of the cost of good units produced. Total cost of the 45 good units is $90,000 (45 units x $2,000 per unit). Cost per good unit is $2,000 ($90,000 / 45 good units).

Even though, for external reporting purposes, abnormal spoilage costs are written off in the accounting period and are not linked to specific jobs or units, companies often identify the particular reasons for abnormal spoilage, and, when appropriate, link abnormal spoilage with specific jobs or units for cost management purposes.

Job Costing and Rework

Rework is units of production that are inspected, determined to be unacceptable, repaired, and sold as acceptable finished goods. We again distinguish (1) normal rework attributable to a specific job, (2) normal rework common to all jobs, and (3) abnormal rework.

Consider the Hull Machine Shop data in Example 3. Assume the five spoiled parts are reworked. The journal entry for the $10,000 of total costs (the details of these costs are assumed) assigned to the five spoiled units before considering rework costs is as follows:

Assume the rework costs equal $3,800 (comprising $800 direct materials, $2,000 direct manufacturing labor, and $1,000 manufacturing overhead).

Normal Rework Attributable to a Specific Job

If the rework is normal but occurs because of the requirements of a specific job, the rework costs are charged to that job. The journal entry is as follows:

Normal Rework Common to All Jobs

When rework is normal and not attributable to a specific job, the costs of rework are charged to manufacturing overhead and are spread, through overhead allocation, over all jobs.

Abnormal Rework

If the rework is abnormal, it is recorded by charging abnormal rework to a loss account.

Accounting for rework in a process-costing system also requires abnormal rework to be distinguished from normal rework. Process costing accounts for abnormal rework in the same way as job costing. Accounting for normal rework follows the accounting described for normal rework common to all jobs (units) because masses of identical or similar units are being manufactured.

Costing rework focuses managers’ attention on the resources wasted on activities that would not have to be undertaken if the product had been made correctly. The cost of rework prompts managers to seek ways to reduce rework, for example, by designing new products or processes, training workers, or investing in new machines. To eliminate rework and to simplify the accounting, some companies set a standard of zero rework. All rework is then treated as abnormal and is written off as a cost of the current period.

Accounting for Scrap

Scrap is residual material that results from manufacturing a product; it has low total sales value compared with the total sales value of the product. No distinction is made between normal and abnormal scrap because no cost is assigned to scrap. The only distinction made is between scrap attributable to a specific job and scrap common to all jobs.

There are two aspects of accounting for scrap:

1. Planning and control, including physical tracking
2. Inventory costing, including when and how scrap affects operating income

Initial entries to scrap records are commonly expressed in physical terms. In various industries, companies quantify items such as stamped-out metal sheets or edges of molded plastic parts by weighing, counting, or some other measure. Scrap records not only help measure efficiency, but also help keep track of scrap, and so reduce the chances of theft. Companies use scrap records to prepare periodic summaries of the amounts of actual scrap compared with budgeted or standard amounts. Scrap is either sold or disposed of quickly or it is stored for later sale, disposal, or reuse.

Careful tracking of scrap often extends into the accounting records. Many companies maintain a distinct account for scrap costs somewhere in their accounting system. The issues here are similar to the issues in Chapter 16 regarding the accounting for byproducts:

• When should the value of scrap be recognized in the accounting records – at the time scrap is produced or at the time scrap is sold?
• How should revenues from scrap be accounted for?

To illustrate, we extend our Hull example. Assume the manufacture of aircraft parts generates scrap and that the scrap from a job has a net sales value of $900.

Recognizing Scrap at the Time of Its Sale

When the dollar amount of scrap is immaterial, the simplest accounting is to record the physical quantity of scrap returned to the storeroom and to regard scrap sales as a separate line item in the income statement. In this case, the only journal entry is as follows:

When the dollar amount of scrap is material and the scrap is sold quickly after it is produced, the accounting depends on whether the scrap is attributable to a specific job or is common to all jobs.

Scrap Attributable to a Specific Job

Job – costing systems sometimes trace scrap revenues to the jobs that yielded the scrap. This method is used only when the tracing can be done in an economically feasible way. For example, the Hull Machine Shop and its customers, such as the U.S. Department of Defense, may reach an agreement that provides for charging specific jobs with all rework or spoilage costs and then crediting these jobs with all scrap revenues that arise from the jobs. The journal entry is as follows:

Unlike spoilage and rework, there is no cost assigned to the scrap, so no distinction is made between normal and abnormal scrap. All scrap revenues, whatever the amount, are credited to the specific job. Scrap revenues reduce the costs of the job.

Scrap common to all jobs

The journal entry in this case is as follows:

Scrap is not linked with any particular job or product. Instead, all products bear production costs without any credit for scrap revenues except in an indirect manner: Expected scrap revenues are considered when setting the budgeted manufacturing overhead rate. Thus, the budgeted overhead rate is lower than it would be if the overhead budget had not been reduced by expected scrap revenues. This method of accounting for scrap is also used in process costing when the dollar amount of scrap is immaterial, because the scrap in process costing is common to the manufacture of all the identical or similar units produced (and cannot be identified with specific units).

Recognizing Scrap at the Time of Its Production

Our preceding illustrations assume that scrap returned to the storeroom is sold quickly, so it is not assigned an inventory cost figure. Sometimes, as in the case with edges of molded plastic parts, the value of scrap is not immaterial, and the time between storing it and selling or reusing it can be long and unpredictable. In these situations, the company assigns an inventory cost to scrap at a conservative estimate of its net realizable value so that production costs and related scrap revenues are recognized in the same accounting period. Some companies tend to delay sales of scrap until its market price is considered attractive. Volatile price fluctuations are typical for scrap metal. In these cases, it’s not easy to determine some “reasonable inventory value.”

Scrap Attributable to a Specific Job

The journal entry in the Hull example is as follows:

Scrap Common to All Jobs

The journal entry in this case is as follows:

Observe that the Materials Control account is debited in place of Cash or Accounts Receivable. When the scrap is sold, the journal entry is as follows:

Scrap is sometimes reused as direct material rather than sold as scrap. In this case, Materials Control is debited at its estimated net realizable value and then credited when the scrap is reused. For example, the entries when the scrap is common to all jobs are as follows:

Accounting for scrap under process costing is similar to accounting under job costing when scrap is common to all jobs. That’s because the scrap in process costing is common to the manufacture of masses of identical or similar units.

Managers focus their attention on ways to reduce scrap and to use it more profitably, especially when the cost of scrap is high. For example, General Motors has redesigned its plastic injection molding processes to reduce the scrap plastic that must be broken away from its molded products. General Motors also regrinds and reuses the plastic scrap as direct material, saving substantial input costs.