LECTURE:

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 P200,000
======
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.

Multiple Choice Questions

Part I: Theory of Accounts

1. A company produces stereo speakers for automobile manufacturers. The automobile manufacturers
emphasize total quality control (TQC) in their production processes and reject approximately 3% of the
stereo speakers received as being unacceptable quality. The company inspects the rejected speakers to
determine which ones should be reworked and which ones should be discarded. The discarded speakers
are classified as:
a. Waste b. Scrap c. Spoilage d. Rework costs
2. Scrap materials consists of:

a. Defective units that may be used or sold.

b. Raw materials remaining from the production cycle but usable for purposes other than the original
purpose.
c. Raw materials remaining from the production cycle but not usable for any purpose.
d. Finished goods that do not meet quality control standards and cannot be reworked.

3. The sale of scrap from a manufacturing process is recorded as a (n):

a. Decrease in manufacturing overhead control
b. Increase in manufacturing overhead control
c. Decrease in finished goods control
d. Increase in finished goods control

4. Assuming the value of scrap sales is material, when is it not necessary to record the value of scrap in
inventory as it is produced?

a. When it is sold regularly, e.g., daily, weekly, etc.

b. When the unit value fluctuates.
c. When it is recognized as miscellaneous revenue.
d. When it is recognized as an offset to overhead.

5. Waste materials consists of

a. Raw materials remaining from the production cycle but not usable for any purpose
b. Finished goods that do not meet quality control standards and cannot be reworked.
c. Defective units that may be used or sold.
d Raw materials remaining from the production cycle but usable for purposes other than the original
purpose.

6. A product that does not meet quality control standards and needs to be reworked to be salable as
either an irregular or a good product is classified as:

a. Spoiled goods b. Defective units c. Scrap materials d. Waste material

7. A manufacturing process normally results in defective units equal to 1% of production. Defective units
are subsequently reworked and sold. The cost of reworking these defective units should be charged to:
a. Manufacturing overhead b. Work-in-process c. Finished goods d. Cost of goods sold

8. In a job-order costing system, the net cost of spoilage that is common to all jobs should be charged to:
a. Materials b. Work in process c. Manufacturing overhead d. Applied manufacturing
overhead

Part II: Problems

1. Some units of output failed to pass final inspection at the end of the manufacturing process. The
production and inspection supervisors determined that the incremental revenue from the
 reworking the unites exceeded the cost of rework. The rework of the defective units was
authorized, and the following costs were incurred in the reworking the units:

Materials requisitioned from stores:

Direct Materials P 5,000
Miscellaneous supplies 300
Direct Labor P 14,000

The manufacturing overhead budget includes an allowance for rework. The predetermined
manufacturing overhead rate is 150% of direct labor cost. The account(s) to be charged and the
appropriate charges for the reword cost would be:
a. WIP inventory control for P 19,000
b. WIP inventory control for P 5,000 and Factory Overhead control for P 35,300
c. FOH control for P 19,300
d. FOH control for P 40,300

2. ABC Corporation’s Job 205 for the manufacture of 6,600 coats was completed during August 20x8
at the following unit costs:
Direct Materials P1,500
Direct Labor 1,000
Factory Overhead (include an allowance of P 50 for spoiled work) 500
P3,000
Final Inspection of Job 205 disclosed 600 spoiled coats which were sold to a jobber for P 600,000.
Assume that spoilage loss is charged to all production during August 20x8. What would be the unit cost of
the good coats produced on the Job 205?
a. P 2,900 b. 2,950 c. 3,000 d. 3,145

3. Using the same information in No. 2, assuming the spoilage loss is attributable to exacting
specifications or chargeable to a particular job, what would be the unit cost of the good coats
produced on Job 205?
a. P 2,900 b. P 2,950 c. P 3,000 d. P 3,145

4. Under Hellen Company’s job order cost system, estimated costs of defective work ( considered
normal in the manufacturing process) are included in the predetermined factory overhead rate.
During March, job 210 for 2,000 hand saws was completed at the following cost per unit:
Direct materials P5
Direct labor 4
Factory overhead(applied at 150% of Direct Labor costs) 6
P 15
Final Inspection disclosed 100 defective saws, which were reworked at a cost of P2 per unit for
direct labor, plus overhead at the predetermined rate. The defective units fall within the normal
range. What is the total rework cost and to what account should it be charged?
a. P 200 to WIP
b. P 200 to FOH control
c. P 500 to WIP
d. P 500 to FOH control

END