Think about which method you want to use when cost accounting for normal spoilage. You go through the effort of cost accounting to identify areas where you can make improvement. Ideally, you prefer a system where a problem generates a red flag — it gets your attention so you can fix it.
Those spoiled units need to get your attention. Because most companies inspect goods periodically during production, you eventually identify the spoiled units. If you identify spoiled units sooner instead of later, however, you can evaluate your production method and make changes faster.
Normal spoilage is considered unavoidable. Normal spoilage occurs because even the best machines can break down and even the best employees can make some mistakes.
Improvement includes changing production to reduce any spoilage, including normal spoilage. Because you need to evaluate production constantly, you need an accounting system that identifies spoilage cost every month, quarter, or year.
The better method, according to the matching principle, to use for normal costing is to include spoiled units in the equivalent unit calculation. Look at the inspection process:
The inspection process occurs when units are 100 percent complete. (That’s not always the case. Many companies inspect goods more frequently than just at the end of production.)
If you include spoiled units in the equivalent unit calculation, spoiled units are considered completed (and transferred out).
Excluding the costs of spoiled units for the equivalent unit calculation “pushes” costs into ending work in process (WIP). When the costs are pushed into WIP, they are not yet expensed. Because WIP is an inventory account, moving costs into WIP delays the recognition of cost of goods sold.
Including spoiled units in the equivalent unit calculation is the better choice. It allows you to identify spoiled units sooner. The spoiled units act as a much-desired red flag, too. Hopefully, you analyze the spoiled units and find ways to improve your production process.
The good news is that you can sometimes rework a defective product to make it right. The bad news is that you incur a cost to rework it. For example, if the lining in a felt hat needs to be resewn, you incur labor and material costs to make it right.
Here’s where rework differs from spoilage and scrap: Rework revenue is generated from producing the primary product (felt hats). You didn’t intend to generate rework costs. Your intention is that all hats are made to meet your standards.
Obviously, if you do have defects, the rework cost reduces your profit on each reworked felt hat you sell, but that’s better than not having the hat to sell.