Valuation of Normal/Abnormal Losses

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Losses

Losses are classified based on their nature into two types: (a) Normal and (b) Abnormal.
  • Normal Loss

    Those losses whose occurence is inevitable i.e. which occur on account of normal reasons are normal losses.
  • Abnormal Loss

    Those losses whose occurence can be avoided i.e. which occur on account of abnormal reasons are abnormal losses.

Identifying whether a loss is Normal or Abnormal

A loss being normal or abnormal is dependent on the particular context and the goods in consideration.

To test whether a loss is Normal or Abnormal, the question we need to consider is "If we take up this activity again, will we come across this loss for sure?". If the answer is in the affirmative (i.e. yes), then the loss is a normal loss otherwise it is an abnormal loss.

A loss that occurs every time an act is carried on is a normal loss.

A loss that does not occur every time the same act is carried on but only has a chance of occurence is an abnormal loss.

  • Doesn't Magnitude of Loss indicate whether it is Normal or Abnormal !!!

    Deciding the nature of the loss based on the magnitude of loss is a wrong practice. However, in some situations where the nature of the activity is not known, we may be required to make a guess/assumption in which case we use the magnitude of loss as a guide to decide whether the loss is normal or abnormal.
    Eg: Consider a vehicle transporting 10 Metric Tons of oil. There is a loss of 100 kg of Oil. To decide whether this loss is normal or abnormal, we need to consider the question "Will this loss occur if we transport the 10 MT of oil again in the same vehicle in the same route?" If the answer is yes, then the loss is "Normal". If the answer is no, then the loss is "Abnormal".

    In problem solving, where we are not given the relevant information, we consider the magnitude of loss to decide whether the loss is normal or abnormal. Here it is 100 kg out of 10 MT (= 10,000 kg) which would be 100/10,000 i.e. 0.01 or 1%. Since the product is oil whose transportation would result in leakage etc., 1% loss is normally possible. Therefore we consider this to be normal loss. One should note that "just because this loss is 1%" we cannot conclude it to be normal loss in all situations.

    We resort to such assumptions where it is required of us to consider the loss as either normal or abnormal.

Valuation of Normal and Abnormal Loss

Let us try to understand the difference between normal and abnormal losses using the following data (illustration)

1000 units of a product have been purchased at Bombay @ Rs. 100 per unit (including freight and delivery) at a total value of Rs. 1,00,000. These have been transported to Bangalore, the place where they have to be used for production purposes. 100 units of these have been damaged in transit. These 100 damaged units would fetch a price of Rs. 1 per unit if sold in the market.

  • Considering the loss as normal

    If the nature of the loss in transportation is such that it would occur every time 1,000 units of this kind are transported from Bombay to Bangalore, then this loss of 100 units can be considered normal.

    If we are to ascertain the cost of the 900 units left (after keeping aside the 100 units lost), we are to choose between the following propositions.

    The cost incurred by the organisation

    1. For 900 units is Rs. 90,000 (900 units × Rs. 100/unit)
    2. For 900 units is Rs. 1,00,000 being the cost of purchasing the total stock.
      This would result in the unit cost working out to Rs. 111.11 (1,00,000 ÷ 900)
    3. For 900 units is Rs. 99,900 (Rs. 1,00,000 − Rs. 100), being the cost of purchasing the total stock (Rs. 1,00,000) reduced by the amount realised on selling the loss units (100 units × Rs. 1/unit).
      [This would result in the unit cost working out to Rs. 111 (99,900 ÷ 900)]

    Normal Cost

    Normal cost for stock/goods is the cost that would have to be incurred if we try to acquire the same quantity and quality of stock/goods in another instance at or about the same time.

    The idea relating to cost should also be created based on what happens if we consider a similar transaction immediately. Suppose we need another lot of 900 units of this product, how many units have we to buy? Surely, 1,000 units as 100 units will be lost in transit for sure (since the loss is being termed normal).

    The amount that we have to spend would also be for purchasing 1,000 units i.e. Rs. 1,00,000. However, since the loss units are capable of being sold for Rs. 1 each every time such loss occurs, the cost incurred can be set off by using this realisation in which case the net cost to be incurred for acquiring the stock of 900 units would be Rs. 99,900.

    Thus, the last idea would be the most appropriate one for deciding the cost per unit of the good stock (net stock) purchased. This presented in the form of a statement

    Particulars Quantity Value Rate
    Gross Stock [Cost of Purchase] 1,000 1,00,000 100.00
    Less: Normal Loss 100 100 1.00
    Net Stock [Net Cost of Purchase] 900 99,900 111.00
           

    Note

    • The data in the rate column should always be obtained as the quotient of Value ÷ Quantity.

    The following conclusions can be derived from the above:

    1. Net Realisable (Market) Value of Normal Loss:

      The normal loss units can be sold at Rs. 1 per unit. This rate of Rs. 1 is also called its net realisable value or net marketable rate or market price.

      [Net Realisable Value = Sale Price − Expenses directly relatable to sales like sale commission etc.]
      Here we do not have the expenses as such we consider sale price as the net realisable value]

    2. Value of Normal Loss:

      We were able to derive the Net cost of purchase i.e. Rs. 99,900 or Rs. 111.00 per unit by deducting Rs. 100 from the cost and 100 units from the units purchased. This implies that we have valued normal loss at Rs. 1 per unit its market price (net realisable value).

      Normal Loss is valued at its market price (net realisable value)
      This is an important valuation principle and is true for valuation of "Normal Loss" anywhere.

    3. Cost of Normal Loss Stock

      All the stock was purchased @ Rs. 100 per unit. Therefore all the units that were lost as normal loss should also be considered to have been purchased at the same rate of Rs. 100 per unit. Thus the cost of the normal loss stock would be Rs. 10,000 (Rs. 100 × 100/unit).

      This cost would never be a part of any calculation (should never be considered) under normal circumstances. We are considering it here only for the purpose of learning.

    4. Net Loss on Normal Loss Stock

      Net loss of Normal Loss Stock = Cost − Net Realisable Value

      Thus, the net loss on account of stock lost in normal loss is Rs. 9,900 (Rs. 10,000 − Rs. 100)

      This would also never be a part of any calculation (should never be considered) under normal circumstances. We are considering it here only for the purpose of learning.

    5. What happens to the Net Loss?

      The net loss on account of normal loss stock is absorbed by the good stock. That is the reason the value of good (net) stock has increased from Rs. 100/unit to Rs. 111/unit. The Rs. 11/unit increase being the net loss on account of normal loss (Rs. 9,900) being absorbed by the good stock (900 units) which would increase the unit value by Rs. 11/unit (Rs. 9,900 ÷ 900 units).
  • Considering the loss as Abnormal

    If the nature of the loss in transportation is such that it would not occur every time 1,000 units of this kind are transported from Bombay to Bangalore, then this loss of 100 units can be considered to be abnormal.

    The cost incurred by the organisation

    1. For 900 units is Rs. 90,000 (900 units × Rs. 100/unit)

    In such a situation, the cost incurred for purchasing the 900 units (1000 − 100) can be calculated based on the cost of purchase. This can be better explained by answering the question, how much are we be required to spend if we are to procure a stock of 900 units again?.

    Since the loss is abnormal in nature, the loss need not have to be borne every time. Therefore, to acquire 900 units, we need to place an order for 900 units only which would require an expenditure of Rs. 90,000 (900 units × Rs. 100/unit).

    Particulars Quantity Value Rate
    Gross Stock [Cost of Purchase] 1,000 1,00,000 100.00
    Less: abnormal Loss 100 10,000 100.00
    Net Stock [Net Cost of Purchase] 900 90,000 100.00
           

    Note

    The data in the rate column should always be obtained as the quotient of Value ÷ Quantity.

    The following conclusions can be derived from the above:

    1. Value of Abnormal Loss:

      We were able to derive the Net cost of purchase i.e. Rs. 90,000 or Rs. 100.00 per unit by deducting Rs. 10,000 from the cost and 100 units from the units purchased. This implies that we have valued abnormal loss at Rs. 100 per unit, the rate at which they were purchased. This rate of Rs. 100 is its purchase price and not selling price or the net marketable rate.

      Abnormal Loss is valued at cost or its full value
      This is an important valuation principle and is true for valuation of "Abnormal Loss" anywhere.

    2. Net Realisation from Abnormal Loss

      Normal Loss is valued at a notional price which is its net realisable price. But abnormal loss is valued at cost.

      The realilsation relating to abnormal loss stock would come into picture only when the abnormal loss stock is sold or relaised. The marketable rate of abnormal loss units would be dependent on the condition of the units lost/destroyed at the time they were treated as having been lost. [The idea relating to the rate at which the damaged goods can be sold is applicable only to Normal Loss Stock. The abnormal loss stock cannot be assumed to be capable of being sold at this price except when it is so specified.]

      Assuming that the abnormal loss stock are sold at Rs. 25/unit, the realisation from abnormal loss stock would be Rs. 2,500 (100 units @ Rs. 25/unit)

    3. Other Realisations from Abnormal Loss Stock

      Stock may be insured to cover losses on account of abnormal reasons. Thus where the abnormal loss stock has been insured, there might be insurance realisation.

      Where the stock has been insured, the insurance company might take away the salvaged stock and consider the total stock as lost for paying the insurance amount. It might also leave the salvaged stock with the customer, value it at a certain price and consider the rest of the value of the total stock as having been lost.

      Thus there may be only insurance realisation or both sale proceeds and insurance realisation with regard to the abnormal loss stock.

      Say the insurance company has agreed to pay Rs. 1,000.

    4. Cost of Abnormal Loss Stock

      All the units in the stock were purchased @ Rs. 100 per unit. Therefore all the units that were lost as abnormal loss should also have been purchased at the same rate of Rs. 100 per unit. Thus the cost of abnormal loss stock would be Rs, 10,000 (100 units × Rs. 100/unit).
    5. Net Loss on Abnormal Loss Stock

      Net loss of Abnormal Loss Stock = Cost − Net Realisation − Insurance Realisation

      Thus, the net loss on abnormal loss stock is Rs. 4,500 (Rs. 10,000 − Rs. 2,500 − Rs. 3,000)

    6. What happens to the Net Loss?

      The net loss on account of stock lost on account of abnormal reasons should not be absorbed by the good stock. It is charged to the "Profit & Loss a/c". This loss being of abnormal nature should not be charged to any account giving the core profit of a particular type of business activity (like "Trading a/c" , "Consignment a/c" , "Branch a/c", etc).

      That is the reason the value of abnormal loss stock is eliminated from these accounts and dealt with separately.

      The value of net stock would be Rs. 100 per unit and is not influenced by the loss on account of abnormal loss.

      Particulars Quantity Value Rate
      Abnormal Loss 100 10,000 100.00
      Less: Sale Realisation 100 2,500 25.00
        100 7,500 75.00
      Less: Insurance Received   1,000 10.00
      Net Loss[Transferred to P & L a/c] 100 6,500 65.00
             

      Note

      1. The data in the rate column should always be obtained as the quotient of Value ÷ Quantity.
      2. Rate of Valuing Abnormal Loss Stock = Rate of Valuing Good Stock

        Notice that the abnormal loss stock is valued at the same rate as the other stock along with it. From this one has to understand that there are basically two valuation rates only. Normal loss is valued at market price and all other stocks are valued at the same rate which includes purchase price and the relevant direct expenses.
      3. Transfer to P & L a/c

        "Trading a/c", "Consignment a/c", "Branch a/c" etc., are accounts which would give us the profit or loss made from transactions relating to a certain stream of business. Each of these will generate a certain amount of profit/loss which is collected in the profit and loss account and all other losses/expenses of indirect nature are set off from this collective profit thereby leaving the "Net Profit" for the organisation.

        In all these businesses, the same principle relating to normal and abnormal losses should be adopted. All normal losses should be absorbed by the respective business accounts. The profits that are revealed by these accounts should not be influenced by losses of abnormal nature. Therefore, they are eliminated from these accounts. Any loss that has to be borne on account of abnormal loss stock should be charged to the "Profit & Loss a/c"

Cost to be considered for Valuing Abnormal Loss

The stock lost on account of abnormal reasons is also an asset and since we find it destroyed/damaged we are assuming a loss. Therefore, in valuing abnormal loss stock also, the principles for valuation of assets should be followed. This means that except for the fact that the stock is damaged, there is no difference in valuing normal stocks and abnormal loss stocks.

Value of Stock = Cost + Direct Expenses incurred till the point of valuation
≡ Value of Abnormal Loss Stock = Cost + Direct Expenses incurred till the point of loss

Statement for Valuation of Stocks and Losses Hide/Show

Particulars Quantity
(in units)
Rate
(in Rs/unit)
Amount
(in Rs)
Goods Consigned 1,100 50 55,000
Add: Consignor Direct Expenses 10 11,000
1.Freight8,000
2.Loading Charges3,000
 Total11,000
     
  1,100 60 66,000
Less: Abnormal Loss - in - Transit 100 60 6,000
Goods Collected by the Consignee 1,000 60 60,000
Add: Consignee Direct Expenses 5 5,000
1.Octroi4,000
2.Unloading Charges1,000
 Total5,000
     
Value of Stock received by the Consignee 1,000 65.00 65,000
Add: Opening Stock with the Consignee 100 62 6,200
Average Value of total stock 1,100 64.73 71,200
       
Abnormal Loss in Storage 50 65 3,250.00
Value of Unsold Stock 100 65 6,500.00
Cost of Goods Sold 950 (?) 64.68 61,450.00

Losses can arise at different points. Therefore, the various points (specifically in accounting for consignments) at which value of abnormal loss stock is found would be

  1. Value of Stock lost in transit
          = Cost of Stock + Consignors Direct Expenses
  2. Value of Stock where loss is ascertained just before being unloaded at the consignees godown
          = Cost of Goods + Consignors Direct Expenses + Proportionate Consignee Direct Expenses
  3. Value of Stock lost after being placed in the consignees godown
          = Cost of Goods + Consignors Direct Expenses + Proportionate Consignee Direct Expense

This is similar to the idea behind valuation of closing stock. Please read through the pages on valuation of stocks to have a clear idea.

Following is the format of a statement that would be useful in all situations dealing with both normal and abnormal losses.

Statement for Valuation of Stocks and Losses Hide/Show

Particulars Quantity
(in units)
Rate
(in Rs/unit)
Amount
(in Rs)
Goods Consigned 1,100 50 55,000
Add: Consignor Direct Expenses 10 11,000
1.Freight8,000
2.Loading Charges3,000
 Total11,000
     
  1,100 60 66,000
Less: Normal Loss in Transit 10 1 10
  990 60.60 59,990
Less: Abnormal Loss in Transit 40 60.60 2424
  950 60.60 57,566
Add: Consignee Direct Expenses
        (Relevant to all Goods)
2 1900
  950 62.60 59,466
Less: Abnormal Loss in Transit
        (Valuation Rate includes consignee Dir. Exp.)
50 62.60 3,130
  900 62.60 56,336
Add: Consignee Direct Expenses
        (Relevant to only unloaded Goods)


3

2700
        Value of Stock received by the Consignee 900 65.60 59,036
Less: Normal Loss in Storage 10 0 0
  890 66.33 59,036
Add: Opening Stock with the Consignee 100 62 6,200
        Average Value of total stock 990 65.90 65,236
       
Abnormal Loss in Storage 40 66.33 2,653.20
Value of Unsold Stock 150 66.33 9,949.50
Cost of Goods Sold 700 66.33 53,064.00

Just ignore the rows which are not relevant to the situation and work out the statement to obtain all the needed information.

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