ACCOUNTING FOR PRODUCTION LOSSES UNDER JOB ORDER COSTING

Production losses in a job order cost system include the following:

1. Materials Scrap
2. Spoiled Goods (Spoilage)
3. Reworking Defective Goods

For the most part, these losses result from a lack of quality and should be eliminated if possible. One way to call
attention to the need for reducing these types of quality failures is to determine their costs and then report
these costs to top management. Large costs signal an opportunity to improve quality substantially, which
should be interpreted by management as an opportunity to improve profits.

Accounting for Scrap

Scrap includes the following:

1. Filings or trimmings remaining after processing materials;

2. Defective materials that cannot be used or returned to the vendor; and
3. Broken parts resulting from employee or machine failures.

If scrap has a value, it should be collected and placed in storage for sale to scrap dealers. If scrap is the result of
trimmings, filings, or materials residue, it may not be possible to determine its cost. A record of the quantity of
scarp should be kept despite the fact that it cannot be assigned any cost. Although this sort of scrap cannot be
eliminated, it should not be ignored, The quantities of scrap should be tracked over time and should be
analyzed to determine if some of the waste is due to inefficient use of the materials and if the inefficiency can be
eliminated or minimized.

The full amount realized from the sale of scrap and waste can be accounted for in any of the several ways, as
long as the alternative chosen is used consistently each period.

To illustrate the various alternatives, assume that ABC Manufacturing Company accumulates material trimmings
from the production department and sells it periodically to a nearby buyer. Scrap sales this period total P500.
The accounting alternatives are as follows:

1. The amount accumulated in Scrap Sales can be closed directly to Income Summary and shown on the
Statement of Income under Scarp Sales or Other Income. At the time of sale, the following entry is
made in the books of ABC Manufacturing Company:

Cash or Accounts Receivable 500

Scrap Sales (or Other Income) 500

2. The amount accumulated can be credited to Cost of Goods Sold, thereby reducing the total costs
charged against sales revenue for the period. Reducing Cost of Goods Sold results in an increase in
income for the period that is the same as reporting the proceeds as Scrap Sales or Other Income. The
entry at the time of sale is as follows:

Cash or Accounts Receivable 500

Cost of Goods Sold 500

3. The amount accumulated can be credited to Manufacturing Overhead Control, thereby reducing the
cost of factory overhead for the period. If scrap is credited to Manufacturing Overhead Control, and if
predetermined overhead rates are used to charge overhead to jobs, the net realizable value of scrap
expected for the period should be estimated and deducted from total budgeted factory overhead before
the overhead rate is computed. Otherwise, the overhead rate will be overstated, which will result in
more factory overhead being charged to jobs than is actually incurred during the period. The entry to
record the sale of scrap is as follows:

Cash or Accounts Receivable 500

Manufacturing Overhead Control 500
 4. When scarp is directly traceable to an individual job, the amount realized from the sale of scrap can be
treated as a reduction in the materials cost charged to that job. The materials cost on the job cost sheet
is reduced by the value of the scrap, and the entry in the general journal to record the sale of the scrap
is as follows:

Cash or Accounts Receivable 500

Work in Process Inventory 500

The above entry assumes the value of the scrap is not significant. When scrap of significant value is
identified, Work in Process is credited and Scrap Inventory is debited. In this way, the scrap is
inventoried awaiting its sale.

If scrap results from defective materials or broken parts, it should be considered an internal failure cost which
can be reduced or eliminated. The cost of this kind of scrap should be determined and periodically reported to
management. If the amount reported is large, It should get management’s attention it indicates a substantial
opportunity for cost reduction through quality improvement. Management should take steps to identify the
cause and eliminate it.

If poor quality materials are detected before they are issued, the defective materials should be returned to the
vendor. If materials quality is unreliable, inspections may be necessary until a source of better materials is found
or created. If defective materials are issued to the factory, other costly factory resources such as labor time,
machine processing time, and good component parts maybe wasted in an materials and culling the defects
before they are used is less expensive than issuing defective materials and incurring production failures later.
Inspecting materials should be viewed as a cost of quality and targeted for elimination. To eliminate the need
for inspection, management must identify suppliers of defective materials and either find alternative sources of
high quality materials or work with the suppliers to improve the quality of the materials.

Accounting for Spoiled Goods

Spoiled goods (spoilage) differ from scrap in that they are partially or fully completed units that are defective in
some way. Spoiled goods are not correctible either because technically it is not possible to correct them or
because it is not economical to correct them.

Spoilage can be caused by an act of the customer, such as change in specifications after production is begun or
imposition of unusually close production tolerance. Spoilage also can be caused by an internal failure, such as
an employee error or badly worn tool. The accounting treatment for spoiled goods depends on which of these
two types of cause is present.

Spoilage Caused by the Customer

If spoilage occurs because of some action taken by the customer, it should not be regarded as a cost of quality.
The customer should pay for this kind of spoilage. The unrecoverable cost of the spoiled goods should be
charged to the job, that is, the salvage value of the spoiled goods should be removed from the job, but all costs
in excess of the salvage value should remain in the cost of the job.

To illustrate: Assume that XYZ Company manufactures 1,000 custom-designed desks for M University on Job
143. After the first 100 desks are completed, M University changes the design specifications. These 100 desks
are not usable by the customer and not correctible to an acceptable condition. XYZ can sell the 100 unusable
desks as seconds for P100 each, or a total of P10,000. An additional 100 chairs are manufactured to meet the
customer’s order requirement, resulting in a total of 1,100 desks (100 spoiled plus 1,000 acceptable to the
customer). Total costs charged to Job 143 follow:

Materials P220,000

Direct Labor 55,000

Factory Overhead 110,000

Total job cost 385,000

 =======

The entry to record the job’s completion is:

Spoiled Goods Inventory 10,000

Finished Goods Inventory 375,000

Work in Process Inventory 385,000

XYZ Company normally sells at 150% of cost. Therefore, Job 143 is billed to M University for P562,500. The
journal entry to record the sale and cost of sales:

Accounts Receivable (or Cash) 562,500

Sales 562,500

Cost of Goods Sold 375,000

Finished Goods Inventory 375,000

When the spoiled goods are subsequently sold, the entry would be:

Cash (or Accounts Receivable) 10,000

Spoiled Goods Inventory 10,000

Spoilage Caused by an Internal Failure

If spoilage occurs because of an internal failure, such as an employee error or worn-out machinery, the
unrecovered cost of the spoiled goods should be charged to Factory Overhead Control and reported periodically
to management. If the cost of the spoilage is of magnitude large enough to distort reported production costs, it
should be reported separately as a loss on the income statement of Income. All production costs expended on
spoiled goods should be determined and removed from job cost records and from the work in process account
in the general ledger. If the spoiled goods have a salvage value, they should be inventoried at the salvage value,
and the unrecoverable cost of the spoiled goods, that is, the cost incurred to produce the spoiled goods in
excess of the salvage value should be charged to Factory Overhead Control. A factory overhead subsidiary
record of the unrecovered cost of spoilage should be maintained for periodic reporting to management.

To the extent spoilage can be predicted but not eliminated, the predetermined overhead rate should be
adjusted by including spoilage in total overhead cost. Before the predetermined overhead rate is computed, the
unrecoverable cost of the spoiled goods should be estimated and included in the total budgeted factory
overhead for the period. The approach increased the predetermined rate for the period, which in turn increases
the factory overhead charged to each product.
To illustrate the accounting treatment when spoiled goods result from an internal failure. Assume the same
facts of the XYZ Company except that the 100 spoiled desks result from a defect in the mold. In this case, each
chair costs P350 to manufacture (P385,000 total job cost divided by 1,100 total desks); therefore, the total cost
of the spoiled units is P35,000 (P350 per desk times 100 spoiled desks). Because the spoiled desks can be sold
for P10,000 (P100 each times 100 desks), the unrecovered spoilage cost is P25,000 (P350 each – P100 salvage) x
100 desks). The cost of the 1,000 good desks shipped to M University is P350,000 (P350 x 1,000 units), and the
sales price for the job is P525,000 (P350,000 x 150%). Because the spoilage is a result of an internal failure, sales
revenue and profits are less than when the spoilage results from a customer requirement. The entries to record
the completion and shipment of the job are:

Spoiled Goods Inventory 10,000

Factory Overhead Control 25,000

Finished Goods Inventory 350,000

Work in Process Inventory 385,000

Cost of Goods Sold 350,000

Finished Goods Inventory 350,000

Accounts Receivable 525,000

Sales 525,000

Accounting for Rework

Rework is the process of correcting defective goods. As with spoilage, rework can result from either an act of
the customer or an internal failure. As with spoilage, the accounting treatment of rework cost depends on the
cause of the rework.

Rework Caused by the Customer

If the rework is caused by the customer, the cost of rework is charged to the job and ideally is recovered through
an increased sales price. To illustrate: Assume ABCDE Manufacturing Co. manufactures 200 custom-designed
trailers as Job No. 777 to meet design requirements specified by the customer. Costs charged to Job 777 are:

Materials P100,000

Labor (P10 per hour x 2,000 hours) 20,000

Applied factory overhead (P40 per direct labor hour) 80,000

Total cost charged to Job 777 200,000

======

Before the trailers are shipped, the customers decides the trailers need suspension springs heavier than those
originally specified in its order, because the trailers are expected to haul heavy loads over rough terrain. For
each trailer, the heavier springs cost P40 and take ½ hour to install. As a result, the following rework costs are
added to Job 777:

Materials (P40 each set of springs x 200 trailer) P8,000

Labor (1/2 hour per trailer x 200 trailers x P10 per hour) 1,000

Applied factory overhead (P40 per hour x 100 hours 4,000

Total rework cost added to Job 777 P13,000

======
 The Journal Entry to record Job 777’s rework costs is:

Work in Process Inventory 13,000

Materials 8,000

Payroll 1,000

Applied Factory Overhead 4,000

The total costs of Job 777 are now P213,000, consisting off P200,000 before the rework plus P13,000 of rework.
Assuming ABCDE Manufacturing Co. bills its jobs to customers at a 50 percent markup on cost, Job 777 will sell
for 150% of P213,000, or P319,500. When Job 777 is shipped to the customer, the following journal entries are
recorded:

Cost of Goods Sold 213,000

Work in Process Inventory 213,000

Accounts Receivable 319,500

Sales 319,500

Rework Caused by an Internal Failure

If rework results from an internal failure, rework costs should be charged to Factory Overhead Control and
periodically reported to management. Defective goods should be corrected if the cost of rework is less than the
increase in net realizable value that will result from the rework; otherwise the defective goods should be sold as
spoiled goods. In most cases, the increase in net realizable value used in deciding whether or not to rework the
defective goods is the increase in the expected sales price that will result from the rework. However, for
companies concerned about the quality image of their product, the potential effect of substandard products on
the company’s image may be unacceptable, in which case the decision may be to correct the defects or destroy
them. To the extent that rework can be predicted but not eliminated, the estimated cost of the rework should
be built into the predetermined factory overhead rate in the same way as is done for scrap and spoilage.

Assume the facts and figures of the ABCDE Manufacturing Co., except the reason for the rework is because a
manufacturing employee requisitioned wrong springs when the trailers were initially assembled. Assuming the
rework costs are the same as those in the preceding example, the journal entry to record the rework is as
follows:

Factory Overhead Control 13,000

Materials 8,000

Payroll 1,000

Applied Factory Overhead 4,000

Because the cost of rework was charged to factory overhead, the P200,000 total cost of Job 777 does not
increase, and the sales price is 150% of P200,000 or P300,000. When the job is shipped to the customer, the
following entries are made:

Cost of Goods Sold 200,000

Work in Process 200,000

Accounts Receivable 300,000

Sales 300,000

To the extent that rework due to internal failure can be predicted but not eliminated, the predetermined factory
overhead rate should be increased to include this rework cost. This is done by estimating the period’s total
rework costs from internal failure, and including it in the overhead budget before calculating predetermined
overhead rates. This approach results in charging all products with an estimated allowance for rework.
 QUESTIONS

1. Saffron Co. accumulates fairly large quantities of metal shavings and trimmings from the products it
manufactures. At least once a month, the scrap metal is old to a local smelter for reprocessing. This
month’s scrap sales on account total P1,650
Required: Give the general journal entry to record the sale of the scrap for each of the following
alternatives:
(a) The scrap sales are viewed as additional revenue
(b) The scrap sales are viewed as a reduction of the cost of goods sold
(c) The scrap sales are viewed as a reduction of factory overhead
(d) The scrap sales are traceable to individual jobs and are viewed as a reduction in the cost of materials
used on the jobs.

2. Pepper Co. manufactures custom wooden cabinets and furniture. During the current period, 80 table
legs were incorrectly shaped on Job 555 and had to be replaced. Although the defective table legs
cannot be used on the job, they can be sold to a local lumber company for P1.50 each. The cost of the
80 defective table legs is:
Materials (80 legs x P2 each) P160
Labor (2 hours x P12 per hour 24
Factory Overhead (22 hours x P24 per hour) 48
Total cost of spoilage on Job 555 P232
=====

Required: Give the general journal entry to record spoilage cost and the transfer of the spoiled

Goods to a separate inventory account.

3. Garlic Co. manufactures custom sheet metal products ranging from cabinets and storage containers to
portable buildings and custom trailers. During the current period, an order for 500 custom storage
containers was begun as Job 333. After 100 units had been completed, the customer decided to change
the design specifications for the containers. The design change was successfully implemented on the
400 units that were not complete at the date of the change order; however the 100 completed units
could not be reworked to meet the customer’s new design requirements. As a consequence, an
additional 100 units had to be manufactured (bringing the total number to 600), 500 that met the
customer’s specification and 100 that did not. The customer does not want the 100 units that do not
meet its specifications. The spoiled units can be sold in the seconds market for P100 each. Spoiled
goods are kept in an Inventory account that is separate from Finished Goods. Total costs charged to Job
333 are:

Materials P50,000
Labor (1,200 hours x P15 per hour) 18,000
Factory Overhead (P30 per labor hour) 36,000
Total Cost charged to Job 333 104,000
=======

Required: Determine the cost to be transferred to Spoiled Goods Inventory and the cost of the

Job shipped to the customer, and prepare the general journal entry to record both.

4. Paprika Manufacturing Co. manufactures several different designs of outdoor furniture. Production
costs are accounted for using Job Order cost system. During the current period, 100 metal tables were
manufactured on Job 222. Costs charged to the job before inspection are:

Materials P3,300
Labor (150 hours x P10 per hour) 1,500
Factory Overhead (P12 per labor hour) 1,800
Total cost charged to Job 222 6,600
 =====

Inspection revealed that an umbrella ring had not been attached to the tables. To correct the

Oversight, a small part was welded to the table leg brace and the brace was repainted. The small

part costs P0.50 for each table, and the primer and paint cost P1.00 for each table. Each table

required ¼ hour of labor.

Required: Prepare general journal entries to record the rework and the transfer of the completed

Tables to Finished Goods Inventory.

5. Basil Manufacturing Co. manufactures instruments for aircraft. During the current year, an order for
1,000 units of a custom-designed instrument was begun for Job 111. The costs incurred on the job ae as
follows:
Materials P20,000
Labor (1,000 hours x P15 per hour) 15,000
Factory Overhead (P30 per direct labor hour) 30,000

Total cost charged to Job 111 65,000

=======

Before taking delivery of the instruments, engineers of the buyer changed the design specifications for
the instrument. The change required the replacement of a part. The replacement part cost P1 and required 10
minutes for installation in each instrument. The change affected all 1,000 instruments manufactured on the
job.

Required: Prepare general journal entries to record the rework and the shipment of the completed job to the
customer, assuming the company bills its job to customers at 150% of cost,