Accounting records need to be updated after every event and transaction. Robust updating systems make it easy for accountants to look at the current position of a business, and it also eases the accessibility of business documents. Likewise, it is necessary to identify and maintain an updated record of scrap inventory.
Materials may scrap due to various reasons such as wastage, fire, or spoilage, etc. Accountants must pass necessary journal entries to record these circumstances. In this article, we will discuss scrap inventory and the accounting treatment of scrap in accounting.
What is scrap inventory?
It is a leftover or excess material that becomes unusable to produce any final product. The scrap inventory is sold, and the sale proceeds are used to lower the production cost of any specific job or processing cost of a finished product. Scrap inventory is a loss that can be minimized by a careful attitude while setting up production equipment. Further, good quality raw material and proper training of employees, and other measures can be useful to minimize the scrap level. It’s equally important to note that scrap is the leftover material and not a defective product.
Scrap is accounted for in the same way as that of inventory. It involves a similar process, i.e., physical tracking and scrap inventory count. What you need to do is track all the scrap physically and look for the presence of safety measures to avoid theft. Scrap inventory can be sold in the market, and the sales value obtained should be recorded in accounts.
Difference between scrap and by-product
Here you need to understand that if any useless inventory is renewed to make some other products, it will be known as a by-product. When a company sells the leftover material without further work, it is called scrap inventory. However, if the scrap requires further processing to make it saleable in the market, it is classified as a by-product.
Reasons why an inventory becomes scrap
It is very difficult for any manufacturing concern to achieve a 100% efficiency level. Some material is always left that cannot be further utilized in the production process. Some of the other reasons behind scrap inventory are:
- When a company uses low-quality input material, it will generate a huge amount of scrap inventory. Low-quality material doesn’t meet the standard quality, and as a result, there are production losses.
- Another reason behind scrap inventory is the machine breakdown. When a machine suddenly stops working, the material stuck in the machine is damaged and hence cannot meet the standard quality to be utilized further in the production process.
- When there is inadequate planning, and the production process is designed poorly. Consequently, higher amounts of scrap are created, resulting in an excess loss.
Accounting for scrap inventory
Manufacturing concerns need to account for scrap inventory properly in the books of accounts. Here are three ways to do so.
Credit other income in the profit and loss account
The following journal entry is entered in books of accounts to record the sale of scrap.
The debit impact of the transaction is the receipt of cash for the sale of scrap. On the other hand, credit impact reflects income from the sale of the scrap, which is recorded in the income statement as other income. However, the problem with this accounting treatment is that business does not have significant controls over the scrap process. So, this accounting treatment can be a suitable option in case of lower scrap value.
Deduction from the cost of material/factory overheads
Following journal entry is posted to record scrap under this method.
|Factory overheads/cost of material||xxx|
The debit impact of the transaction is receipt of cash. At the same time, credit impact leads to a reduction in the material cost that ultimately reduces value for the work in progress and the cost of sales. The reduced cost of sales leads to higher profitability, the same as in the above case. However, there is an impact on gross profit in contrast to the above.
For production-related control purposes, the given entry is routed as follows,
The journal entry is recorded by debiting the scrap material account when scrap inventory is identified. At the same time, work in progress account is credited that reduces the cost of transferred-out units as follows,
|Scrap inventory account||xxx|
|Work in process account||xxx|
The debit impact of the transaction is the recording of scrap as it has been identified during the production process. On the other hand, credit impact reduces the work in process as this account is debited (increased) when raw material is transferred from the warehouse to production. So, a credit reduces the cost of production when value is transferred to the finished goods account with the following journal entry.
|Work in process account||xxx|
This accounting treatment is suitable when the production facility operates with multiple products, and the scrap of one product cannot be differentiated from other products. So, this method is considered to be suitable in case of significant inventory scrap. However, this approach does not consider specific job-related controls and processes.
Scrap proceeds are recorded in the specific job
The accounting treatment for this method of recording is the same as the second accounting treatment given above. However, this accounting treatment is advisable when the business has a job costing the environment. So, scraps in the production can be separately identified for different products. Further, a scrap of a specific job is allocated to the same job, this helps to enhance profit measurement.
Overall, scrap value is either recorded as income or deducted from cost and leads to higher profits. However, the question arises, is scrap good for the business? The answer is no because scrap arises due to normal/abnormal loss, and the business needs to control it.
Example for understanding scrap inventory concept
Let’s look at an example of a company dealing with Aluminum products. To produce aluminum products, it is required to melt the aluminum first. All the input materials are not transferred to finished goods during the production process and loss is expected. After all, it’s very tough to attain a 100% efficiency level.
When aluminum is melted, there might be some impurities. The company needs to separate aluminum from impurities to produce the finished products. Small amounts of aluminum are also removed that cannot be further used in production. This impure aluminum is then sold in the market at a low cost. A manufacturer’s value by selling impure aluminum is known as scrap value.
Scrap inventory is produced at the time of production. Generally, it’s a result of normal/abnormal loss. The proceeds obtained via the sale of scrap is either recorded as a profit or deducted from the cost of production. In both cases, it leads to a reduction in the cost and increase of profit. However, the proportion of the loss is higher than the value of scrap at the process level. So, the business needs to control the productions losses and related scrap.
Frequently asked questions
Is there any difference between salvage and scrap value?
Salvage is the estimated cost of the asset once it’s fully depreciated. It helps determine the value of the depreciation expense and net book value. On the other hand, scrap is realized during production losses.
Is a higher value of scrap associated with quality of output?
If there is an abnormally higher scrap quantity, production quality needs to be analyzed thoroughly. The reason is that the quality of the process is susceptible and might lead to faulty production.
Is obsolete inventory the same as scrap?
Obsolete inventory is different from scrap. An obsolete inventory is when inventory has not been used/sold in production. As a result, it’s charged as an expense in the financial record. On the other hand, scrap is produced at the time of production.