Spoilage
Within cost accounting, we have a term called spoilage. Spoilage is when you’re working on units, putting time and materials into them, but then the units get ruined, and you can’t sell them.
Imagine that you’re producing bottles of shampoo and two of the bottles get a hole in them. You can’t sell them. You put these costs into these two bottles, but you’re not going to generate any revenue from them. Therefore, it’s essentially a wasted product.
There are two types of spoilage:
1. Normal spoilage
2. Abnormal spoilage
Normal spoilage occurs in the ordinary course of business. Abnormal spoilage is spoilage that does not occur in the ordinary course of business. The example of having defective shampoo bottles would happen in the ordinary course of business, so it would be considered normal spoilage.
Abnormal spoilage would be if a fire ends up burning down your entire manufacturing plant and ruins all of the bottles of shampoo. This certainly does not occur in the normal course of business, it’d be considered abnormal spoilage.
We account for normal spoilage the same way that we account for product costs. If you remember, all the product costs go into inventory accounts until we sell the items, and once we sell them, they move to the cost of goods sold expense account. We handle it the same way for normal spoilage costs.
With abnormal spoilage, since it’s not part of the ordinary course of business, we don’t want to record it in inventory and then wait until we sell units. instead, we’re going to directly expense it on a separate line item on the income statement.
Study Tip 😀
Normal spoilage occurs in the ordinary course of business. We record normal spoilage to our product costs. Abnormal spoilage is spoilage that does not occur in the ordinary course of business. We directly expense it to general & administrative expenses.
Example Of Spoilage
Let’s throw some numbers into the picture. Let’s say that you’re a famous New York pizza
company. It’s the weekend, and you’re in the process of making 1,000 pizzas for a big catering event.
You put the following cost into the pizzas:
● Direct Materials $2,000
● Direct Labor $1,000
● Overhead $500
● Normal Spoilage $150
● General & Administrative Expenses $400
● Abnormal Spoilage $700
Throughout the process, you accidentally drop some pizzas on the ground and have to throw them out. This happens on a normal basis, this is normal spoilage. Let’s say that this costs us $150.
Next, we end up having a lightning storm that shuts off our refrigerators, and all our fresh ingredients go bad. This is abnormal spoilage. It costs us $700.
Let’s answer the following questions:
1. What is the per unit cost of the pizzas assigned to inventory?
2. What amount does your company record as period costs?
For question one, we’re figuring out the per-unit costs. First, we add up all of our product Costs:
● Direct materials $2,000
● Direct labor $1,000
● Overhead $500
● Normal spoilage $150
Our total cost is $3,650. This is the amount we record to our inventory counts until we sell the pizzas and record them to the cost of goods sold. We divide $3,650 by 1,000 pizzas. Our cost per pizza is $3.65.
For question two, we’re figuring out the total of our period costs. Remember, period costs are the costs that we expense right away, regardless of when we sell the pizzas. Our period costs are 1) the general and administrative expense of $400 and 2) the abnormal spoilage of $700. We expense abnormal spoilage right when it happens; our total period costs are $1,100.
CONCLUSION
That, in essence, is how spoilage costs work. Spoilage is when you have units that you’re working on, but then they get ruined, and you’re not going to be able to sell them. We have normal spoilage, which happens in the ordinary course of business, and abnormal spoilage, which does not happen in the ordinary course of business.
For normal spoilage, we record those costs to inventory accounts until we sell units. Those are product costs. For abnormal spoilage, we directly expense the cost on a separate line item on the income statement. Those are considered period costs.