Chapter 4: 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
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, which we studied in Chapter 5. 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 conceal them as an unidentified part of the costs of good units manufactured. To illustrate normal
and abnormal spoilage, consider Mendoza Plastics, which makes coverings 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 coverings 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

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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:

Because normal spoilage is the spoilage related to the good units produced, normal spoilage rates are computed
by dividing units of normal spoilage by total good units completed, not total actual units started in production.
At Mendoza Plastics, the normal spoilage rate is therefore computed as 400/20,000 = 2%.

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*100 units). Issues about accounting for spoilage arise in
both process-costing and job-costing systems.

Spoilage in Process Costing

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.

Example: 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.

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Exhibit-1 calculates and assigns cost per unit of direct materials.

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

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from normal spoilage common to all jobs. We describe accounting for spoilage in job costing using the
following example.

Example: 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 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*$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*$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*45 good
units). Total cost of the 45 good units is $92,250: $90,000 (45 units*$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

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of the 45 good units is $90,000 (45 units*$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 the above
Example. 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.
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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 5 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:
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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 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
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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.