What Is Abnormal Spoilage and How Is It Accounted For?
Not all production spoilage is treated the same. Learn the crucial accounting distinction for unexpected losses and their direct impact on the income statement.
Not all production spoilage is treated the same. Learn the crucial accounting distinction for unexpected losses and their direct impact on the income statement.
In many production environments, the creation of finished goods involves processes where some loss of materials or partially completed units is unavoidable. This loss, known as spoilage, refers to units that fail to meet quality or technical specifications and are discarded or sold for minimal value. The existence of spoilage is a normal business reality for many industries. Accounting principles provide a structured framework for managing these costs, requiring a distinction in how different types of spoilage are treated financially to ensure accurate reporting.
The initial step in accounting for spoilage is to distinguish between what is considered normal versus what is abnormal. Normal spoilage is the loss that is anticipated and inherent in a particular production process, even when it operates under efficient conditions. This type of spoilage is predictable, and its costs are considered a regular part of producing good, sellable units. Examples include the minor loss of liquid due to evaporation or the small amount of wood trimmed away when cutting lumber to standard sizes.
Abnormal spoilage, in contrast, is spoilage that exceeds the expected, predictable rate. It is not an inherent part of the production process and is generally considered preventable. Common causes include:
The key difference lies in foreseeability; normal spoilage is planned for, while abnormal spoilage is an unexpected event.
This distinction is a requirement under Generally Accepted Accounting Principles (GAAP) because it directly affects how costs are recorded and reported. Companies establish a normal spoilage rate based on historical data and industry benchmarks. Any spoilage above this established threshold is classified as abnormal. This segregation ensures that the cost of operational inefficiencies is not hidden within the cost of good inventory.
Once units are identified as abnormally spoiled, their cost must be calculated and separated from other production costs. The cost of an abnormally spoiled unit is determined in the same manner as the cost of a good unit up to the point of inspection where the defect was identified.
These costs are comprised of direct materials, direct labor, and an allocated portion of manufacturing overhead. Manufacturing overhead includes indirect factory costs like electricity, factory supervision, and equipment depreciation.
For example, if a company starts 10,000 units with total production costs of $200,000, the cost per unit is $20. If an equipment malfunction causes 100 units to be spoiled, the cost of this abnormal spoilage is $2,000 (100 units x $20). This calculation method is applied in both job-order costing and process costing systems.
The accounting treatment for the calculated cost of abnormal spoilage is different from that of normal spoilage. Under GAAP, the cost of abnormal spoilage is not included in the cost of inventory. Instead, it is recognized immediately as a loss in the accounting period in which it occurs.
To execute this in the accounting records, a specific journal entry is required. The Work-in-Process Inventory account is credited to remove the cost of the spoiled units. Simultaneously, a separate loss account, often titled “Loss from Abnormal Spoilage,” is debited for the same amount. This entry moves the cost from an asset account to an expense account.
This loss account is then reported on the company’s income statement for the period. It appears as a separate line item, often under the “Other Expenses and Losses” section, where it directly reduces the company’s net income. This reporting provides transparency to investors and management, identifying the financial impact of preventable production issues. This contrasts with normal spoilage, whose costs are absorbed by the good units produced, becoming part of the Cost of Goods Sold only when the finished products are sold.