Inspection Points and Allocating Costs of Normal Spoilage

Learning Objective 4 Account for spoilage at various stages of completion in process costing

• spoilage costs vary based on the point at which inspection is carried out

Spoilage might occur at various stages of a production process, but it is detected only at one or more inspection points. The cost of spoiled units equals all costs incurred on them up to the point of inspection. When spoiled goods have a disposal value (for example, carpeting sold as “seconds”), the net cost of spoilage is the cost of the spoiled goods minus the disposal value.

The unit costs of normal and abnormal spoilage are the same when the two are detected at the same inspection point as in our Anzio Company example, where inspection occurs only upon completion of the units. However, in some situations abnormal spoilage occurs at a different point than normal spoilage. Consider shirt manufacturing. Normal spoilage in the form of defective shirts is identified upon inspection at the end of the production process. Now suppose a faulty machine produces defective shirts at the halfway point of the production process. These defective shirts are abnormal spoilage that occurs at a different point in the production process than normal spoilage. The per-unit cost of abnormal spoilage is then based on costs incurred up to the halfway point of the production process, while the per-unit cost of normal spoilage is based on costs incurred through the end of the production process.

How should normal spoilage costs be allocated between completed units and ending work-in-process inventory? The general approach is to presume that normal spoilage occurs at the inspection point in the production cycle and to therefore allocate its cost over all units that have passed that point during the accounting period.

Anzio Company inspects units only at the end of the production process. So, units in ending work-in-process inventory have not been inspected and are not assigned any costs of normal spoilage. Suppose Anzio were to inspect units at an earlier stage. Then, if units in ending work in process passed the inspection point, the costs of normal spoilage would be allocated to units in ending work in process as well as to completed units. For example, if the inspection point is at the halfway point of production, any ending work in process that is at least 50% complete are allocated normal spoilage costs based on costs incurred up to the inspection point. However, if ending work-in-process inventory is less than 50% complete, no normal spoilage costs are allocated to it.

Suppose Anzio Company inspects units at various stages in the forming department. Recall that direct materials are added at the start of production, whereas conversion costs are added evenly during the process.

Consider three different cases: Inspection occurs at (1) the 20%, (2) the 55%, or (3) the 100% completion stage. The last option is the one we have analyzed so far. A total of 1,000 units are spoiled in all three cases. Normal spoilage is 10% of the good units that pass the inspection point during the current period. The following data are for July 2020. Note how the number of units of normal and abnormal spoilage changes depending on when inspection occurs.

The following diagram shows the flow of physical units for July and explains normal spoilage calculations in the preceding table. Note that 7,000 good units are completed and transferred out—1,500 from beginning work in process and 5,500 started and completed during the period—while 2,000 units are in ending work in process.

To see the number of units passing each inspection point, consider in the diagram the vertical lines at the 20%, 55%, and 100% inspection points. The vertical line at 20% crosses two horizontal lines—5,500 good units started and completed and 2,000 units in ending work in process—for a total of 7,500 good units. (The 20% vertical line does not cross the line representing work done on the 1,500 good units completed from beginning work in process because these units are already 60% complete at the start of the period and, hence, are not inspected this period.) Normal spoilage equals 10% of $\text{7,500}= 750 \text{units}.$ The vertical line at the 55% point crosses just the second horizontal line so only 5,500 good units pass this point. Normal spoilage equals 10% of $\text{5,500}=550 \text{units}.$ At the 100% point, normal spoilage is 10% of $\text{7,000} (\text{1,500}+\text{5,500}) \text{good units}=700 \text{units}.$ 

Exhibit 19-4 shows how equivalent units are computed under the weighted-average method if units are inspected at the 20% completion stage. The calculations depend on the direct materials and conversion costs incurred to get the units to this inspection point. The spoiled units have 100% of direct materials costs and 20% of conversion costs. Because ending work-in-process inventory has passed the inspection point, these units are assigned normal spoilage costs, just like units that have been completed and transferred out. Conversion costs of units completed and transferred out equal conversion costs for (1) 7,000 good units produced plus (2) $20\%\times (10\%\times \text{5,500})=110$ equivalent units of normal spoilage. We multiply by 20% to obtain the equivalent units of normal spoilage because conversion costs are only 20% complete at the inspection point. Conversion costs of ending work-in-process inventory equal conversion costs of (1) 50% of $\text{2,000}=\text{1,000}$ equivalent good units plus (2) $20\%\times (10\%\times \text{2,000})=40$ equivalent units of normal spoilage. Thus, equivalent units of normal spoilage accounted for equal 110 equivalent units related to units completed and transferred out plus 40 equivalent units related to units in ending work in process, for a total of 150 equivalent units, as Exhibit 19-4 shows.

Early inspections help prevent further costs being wasted on units that are already spoiled. For example, suppose units can be inspected when they are 70% complete rather than 100% complete. If spoilage occurs prior to the 70% point, a company can avoid incurring the final 30% of conversion costs on spoiled units or direct materials added after the 70% stage. The downside to conducting inspections too early is that units spoiled at later stages of the process may go undetected. For these reasons, firms often conduct multiple inspections and also empower workers to identify and resolve defects on a timely basis.