ACCOUNTING FOR LOSSES:Spoiled output, Accounting treatment, Inventory Turnover Ratio

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Cost & Management Accounting (MGT-402)

LESSON # 10

ACCOUNTING FOR LOSSES

There is always a chance of occurrence of losses during the manufacturing process and even in the

finished goods godown. Such losses are classified as normal loss and abnormal loss:

LOSSES

Normal losses

Abnormal losses

Normal loss

Occurrence of this type of loss is always expected. It is unavoidable loss and is inherent in the

manufacturing process or its chances of happening are more likely than not. For example; while

transporting petrol, it is normal that a little quantity will be evaporated.

Abnormal loss

It is an unexpected loss. Measures are always taken to avoid abnormal losses. For example; security

system is installed to secure loss by theft from godown of finished goods. Safety measures are

undertaken during manufacturing process against any loss of breakage of the output. Special care is

taken during transportation of petrol to avoid its leakage.

Normal and abnormal losses are treated differently in the financial accounting and in the cost

accounting as well. Following is the self explanatory chart that will help in understanding the

difference between accounting treatment of the two different types of losses.

Treatment in Financial Accounting

Normal loss

Abnormal loss

1. Ignored (no treatment).

1. Specifically recorded

2. Per unit cost increases.

2. Inventory per unit cost remains same

3. Normal losses are absorbed by the good

units.

Treatment in Cost Accounting

Normal loss

Abnormal loss

1. Charged to FOH account.

1. Charged to specific WIP account.

2. Overall per unit cost increases

3. No impact on individual job cost.

In manufacturing process there are two types of distortions that can be identified as losses:

1. Defective output/work

2. Spoiled output

Defective output/work

At the end of or during the manufacturing process the inspection or quality control department

tells about the defective output/work. This can be made good by adding further cost into it. For

example; in a winding department, 10 of the capacitors were found improperly wound up. A

Cost & Management Accounting (MGT-402)

further cost of material, labor and FOH will be required to re-wind these capacitors. Doing this

will remove the defect. (Output means completed units/work means in process).

Spoiled output

This is cost of the goods that have been destroyed because of any reason. This can not be made

good and therefore are sold as scrap inventory.

LOSSES

Types of

Defective Output/Work

Spoiled Output

losses

Having some

Having no

recoverable value

Cost of loss

Total cost of

Additional cost (Material,

Total cost of

charged as

production (less)

Labor, FOH)

production

expenses

recoverable value

Accounting

Scrap inventory

FOH control A/C

Entries

FOH control A/c

Material

FOH control A/c

Normal

WIP or Job A/c

Payroll

WIP or Job A/c

losses

FOH applied/(items)

Accounting

Scrap inventory

WIP or Job A/C

Entries

WIP or Job A/c

Material

Abnormal

No Entry

Payroll

losses

FOH applied/(items)

Accounting treatment

Normal loss

Normal losses are charged to factory overhead control account and thence become part of

the total production/manufacturing cost.

The additional cost incurred to remove the defect is charged to the factory overhead cost,

as it is explained in the accounting entry shown in the above table.

Whereas, the total cost of spoiled output is taken out of the cost already charged to the

job and is then split into to two; scrap inventory and factory overhead cost. Scrap

inventory shows the amount recoverable from the spoiled output through its disposal and

the balancing amount that is estimated to be irrecoverable is charged to the factory

overhead cost. Where nothing is expected to be recovered from the scrap inventory, total

cost of the spoiled output is taken out of the job and charged to the factory overhead.

Abnormal loss

Abnormal losses are charged to the specific job/work in process account and thence

become part of the cost of the specific job. This treatment causes an increase in the cost of

the job.

The additional cost incurred to remove the defect is charged to the work in process

account, as it is explained in the accounting entry shown in the above table.

Whereas, a part of the cost of spoiled output that is expected to be recoverable (scrap

inventory), is taken out of the cost charged to the job. The estimated irrecoverable cost

(loss portion) remains a part of cost of the job, which means that the loss has been charged

to the job.

Scrap inventory shows the amount recoverable from the spoiled output through its

disposal. Where nothing is expected to be recovered from the scrap inventory, no

accounting entry in this case is required to be passes, as total cost of the spoiled output is

irrecoverable and should remain in the cost of the job.

Cost & Management Accounting (MGT-402)

Practice Question

Q. 1

A & Co manufactured 500 ceiling fans to fill an order by incurring:

Direct material

Rs.

150,000

Direct labor cost

100,000

F.O.H (60% of labor cost)

60,000

Total production cost

310,000

Some of the work was found defective, to make good such loss, following cost was incurred:

Rework cost on defective work

Material

Rs. 10,000

Labor

30,000

F.O.H (60% of Labor cost)

18,000

Required:

Pass accounting entries to record the cost incurred along with the adjusting entry

for re-work cost, treating the loss as:

Normal

Abnormal

Solution

a) Normal loss

Work in process A/C

310,000

Material

150,000

Payroll

100,000

F.O.H applied

60,000

FOH Control A/C

58,000

Material

10,000

Payroll

30,000

F.O.H applied

18,000

Finished goods A/C

310,000

Work in process A/C

310,000

Cost per unit =

310,000/500 =

Rs. 620 per unit

b) Abnormal loss

Work in process A/C

310,000

Material

150,000

Payroll

100,000

F.O.H applied

60,000

Work in process A/C

58,000

Material

10,000

Payroll

30,000

F.O.H applied

18,000

Finished goods A/C

368,000

Work in process A/C

368,000

Cost per unit =

368,000/500 =

Rs. 736 per unit

Cost & Management Accounting (MGT-402)

Q. 2

Using the data in Q. 1, now suppose the spoiled output is 50 fans, which can be sold as scrap for

Rs. 200 each.

Cost of spoiled output

= Rs. 310,000 x 50

Rs. 31,000

Estimated recoverable amount = Rs. 200 x 50

Rs. 10,000

Cost of loss

Rs. 21,000

Solution

a) Normal loss

Work in process A/C

310,000

Material

150,000

Payroll

100,000

F.O.H applied

60,000

Scrap inventory

10,000

FOH Control A/C

21,000

Work in process A/C

31,000

Finished goods A/C

279,000

Work in process A/C

279,000

Cost per unit =

279,000/500 =

Rs. 558 per unit

b) Abnormal loss

Work in process A/C

310,000

Material

150,000

Payroll

100,000

F.O.H applied

60,000

Scrap inventory

10,000

Work in process A/C

10,000

Finished goods A/C

300,000

Work in process A/C

300,000

Cost per unit =

300,000/500 =

Rs. 600 per unit

Different documents are used in the process of requisition, purchasing, production and for

procurement of material. These are used in sequence presented in the following diagram:

Cost & Management Accounting (MGT-402)

Material / Store requisition

Purchase requisition

Purchase order

Delivery note

Purchase invoice

Goods received

note

Bin card

Store ledger card

Cost & Management Accounting (MGT-402)

Material/Store Requisition

It is a document through which work station incharge requires/receives material from the store. It

is sent to the store incharge duly approved by the production manager, stating the number of units

required for consumption based on which the store incharge issues the required material to the

work shop.

Purchase Requisition

It is forwarded by the store department to the purchase department, indicating the maximum and

minimum stock levels, it also states the reorder level along with the economic order quantity. It is

used to require further purchase to be made by the purchase department. It also indicates the

current position of the material in the store.

Purchase Order

It is used to place order to the supplier for purchase of further material. This document contains

information regarding the quantity, specification, rate, discount, settlement term, time of delivery,

and dealing person. Based on the purchase order the supplier manages to deliver material to the

ordering entity.

Delivery Note

It is issued by the supplier/seller to the purchaser, mentioning the quantity and specification of the

material dispatched. On receipt of the material the recipient acknowledges by the signing the

delivery note and returns it back to the supplier

Purchase Invoice

It is the document that evidences the transaction of purchase of material. It is issued by the seller

stating quantity, rate, discount, and amount of the purchased material. Settlement terms are also

stated at bottom of the invoice. Receiving an invoice means that money is payable to the supplier.

Goods Received Note

It is prepared by the inspection department after verifying the quantity and quality of the material

received. Received material along with the goods received note is sent to the store incharge.

Bin Card

Store incharge after receiving the material as per the goods received note, places the material at its

location and makes an entry in the bin card. Bin card is used to maintain physical record of the

material received in and issued from the store. It updated for balance in the store after each

transaction. It also contains information regarding reorder level, economic order quantity,

maximum and minimum stock levels, maximum and minimum daily consumption, and lead time.

It is placed at the location where the material is stored.

Store Ledger Card

It is maintained by the accounting department, more precisely stating it is maintained by the cost

accounting department that is concerned about the calculation of cost per unit. It is similar to the

bin card as far as receipt and issue of the quantity of material is concerned, but the main purpose

of maintaining the store ledger card is to know the cost of material consumed and material in store

along with the cost per unit of the material. Store ledger card is maintained using the FIFI, LIFO

and W Avg methods.

Inventory Turnover Ratio

Inventory Turnover ratio shows the stock position of the store room. In how many times

inventory is used in a year and for how long the inventory is held in the store.

Cost & Management Accounting (MGT-402)

Inventory Turn over Ratio

Cost of goods sold or Material consumed =

times

Average Inventory

Average Inventory

Opening Inventory +

Closing Inventory = Average inventory

Stock holding period

Number of days in a year =

number of days

Inventory turnover ratio

PRACTICE QUESTION

Opening stock

1,000 units

Material Purchase

7,000 units

Closing Stock

500 units

Material consumed

Rs. 7,500

Solution

Inventory Turn over Ratio

Material consumed

Average Inventory

7500

10 times

(1000+500)/2

Inventory holding period

No of days in a year

Inventory Turn over Ratio

= 36 days

360

MULTIPLE CHOICE QUESTIONS

The following information is to be used for questions 1 and 2

A national chain of tyre fitters stocks a popular tyre for which the following information is

available:

Average usage: 140 tyres per day

Minimum usage: 90 tyres per day

Maximum usage: 175 tyres per day

Lead time:

10 to 16 days

Re-order quantity: 3,000 tyres

1 Based on the data above, at what level of stocks should a replenishment order be issued?

A 2,240

B 2,800

Cost & Management Accounting (MGT-402)

C 3,000

D 5,740

2 Based on the data above, what should be the maximum level of stocks possible?

A 2,800

B 3,000

C 4,900

D 5,800

Moura uses the economic order quantity formula (EOQ) to establish its optimal reorder

quantity for its single raw material. The following data relates to the stock costs:

Purchase price: £15 per item

Carriage costs:

£50 per order

Ordering costs: £5 per order

Storage costs:

10% of purchase price plus £0.20 per unit per annum

Annual demand is 4,000 units.

What is the EOQ to the nearest whole unit?

A 53 units

B 170 units

C 485 units

D 509 units

4 Which of the following statements is correct?

A store ledger account will be updated from goods received note only.

A. A stores requisition will only detail the type of product required by a customer.

B. The term 'lead time' is best used to describe the time between receiving an order and

paying for it.

C. To make an issue from stores authorization should be required.

5 What would be the most appropriate cost unit for a cake manufacturer?

Cost per:

A Cake

B Batch produced

C Kilogram produced

D Production run

The following information relates to questions 6 and 7

Turner Limited has the following stock record:

Date

Number of units

Cost (Rupees)

1 March Opening stock 100 units

at 3.00/unit

3 March Receipt

200 units

at 3.50/unit

8 March Issue

250 units

15 March Receipt

300 units

at 3.20/unit

17 March Receipt

200 units

at 3.30/unit

21 March Issue

500 units

23 March Receipt

450 units

at 3.10/unit

27 March Issue

350 units

6 What is the valuation of closing stock using LIFO at each issue?

A Rs. 460

B Rs. 465

Cost & Management Accounting (MGT-402)

C Rs. 467

D Rs. 469

What is the valuation of issues using the weighted average method of stock valuation at each

issue?

A Rs. 3,248

B Rs. 3,548

C Rs. 3,715

D Rs. 4,015

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