Spoilage

Spoilage, in cost accounting, refers to units of product that fail to meet quality standards and are either thrown away or sold at a reduced price, because repairing them would cost too much. Examples include bottles that crack in a glass plant, bread that comes out of the oven burned, garments with misprinted fabric and electronic boards that fail final testing. Spoilage is a cost of manufacturing, and how it is treated in the accounts depends on whether it is an expected part of efficient production or the result of something going wrong.

Spoilage is distinguished from three related ideas. Rework is defective units that are repaired and sold as good units. Scrap is leftover material with low value, such as metal shavings or fabric offcuts, that results from normal production rather than from defective units. Inventory shrinkage is the loss of finished goods through theft, damage or recording errors after production.

• Normal spoilage is the level that is unavoidable under efficient operating conditions, given the process and equipment. Because it is a necessary part of producing good units, its cost is treated as a product cost and included in the cost of the good units, becoming part of inventoriable cost.
• Abnormal spoilage is spoilage beyond the normal level, caused by events such as machine breakdowns, poor-quality materials, operator errors or power cuts. It is considered controllable and avoidable, so its cost is not inventoried. It is written off as a loss in the period it occurs, keeping the cost of good units from being inflated by inefficiency.

The normal rate is usually set as a percentage of good units produced or of units that pass an inspection point, based on engineering studies and past experience.

In a process costing system, spoiled units are counted when they are found at an inspection point. Suppose a juice bottler starts 10,000 bottles in a month, all of which are completed and inspected at the end of the process. Good output is 9,300 bottles and 700 are spoiled. Normal spoilage is set at 5 percent of good units, or 465 bottles, so 235 bottles are abnormal spoilage. Total production cost is $25,000, or $2.50 per unit, with no opening or closing work in process.

• Cost of good units: 9,300 times $2.50 is $23,250.
• Normal spoilage: 465 times $2.50 is $1,162.50, added to the cost of the good units, giving $24,412.50 transferred to finished goods inventory, or $2.625 per good bottle.
• Abnormal spoilage: 235 times $2.50 is $587.50, debited to a loss from abnormal spoilage account and reported on the income statement.

If spoiled bottles can be sold for recycling, their disposal value is deducted from the related cost. When there is partly completed inventory, spoiled units are measured in equivalent units of production, and the cost of normal spoilage is assigned only to units that have passed the inspection point.

In job order costing, normal spoilage that is common to all jobs is built into the predetermined overhead rate and spread across all production through manufacturing overhead. Normal spoilage caused by the special requirements of a particular job, such as unusually tight tolerances requested by one customer, is charged to that job, net of any disposal value. Abnormal spoilage is again written off as a loss.

Under US GAAP, ASC 330 states that abnormal amounts of spoilage are recognized as current period charges rather than inventory costs, and IFRS has an equivalent rule in IAS 2. Separating normal from abnormal spoilage therefore affects both inventory values and reported profit. For managers, spoilage reports are an important quality and efficiency measure. A rising spoilage rate can point to problems with suppliers, equipment maintenance or training, and practices such as total quality management and lean manufacturing aim to reduce even the normal level over time. Treating all spoilage as normal would hide these costs in cost of goods sold, so a clear policy and regular review of the normal rate are needed.