Losses - Classification

Losses are classified based on their nature into two:
• Normal Loss

The loss whose occurrence is inevitable i.e. losses which occur on account of normal reasons are normal losses.
• Abnormal Loss

The loss whose occurrence can be avoided i.e. losses which occur on account of abnormal reasons are abnormal losses.

For output, this can also be interpreted as the magnitude of actual loss incurred that is in excess of the normal loss and is given by the relation

Abnormal Loss Units = Normal Output Units − Actual Output Units

Expressing Losses

Losses may be expressed in absolute terms (like say 50 units) or in proportionate terms (like say 1/10th) or in percentage terms (like say 2%).

In problem solving, on what the calculation of loss should be based is to be decided based on the problem data. Where the loss is expressed as a proportion or percentage and no specific mention is made as to on what the calculation is to be based, it is based on gross input.

Identifying whether a loss is Normal or Abnormal

A loss being normal or abnormal is dependent on the context and the nature of the process in consideration.

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

Eg : Consider a production process where 8,000 lts of a chemical has been input. There is a loss of 80 lts of the chemical by the time the production is complete. To decide whether this loss is normal or abnormal, we need to consider the question - "Will this loss occur if we process another batch of 8,000 lts again under similar conditions?" If the answer is yes, then the loss is Normal. If the answer is no, then the loss is Abnormal.

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

The magnitude of loss is dependent on the production process in consideration and is not the criteria for deciding whether the loss is normal or not.

In problem solving, where we are not given the relevant information and we are required to decide whether the loss is normal or abnormal, we may consider the magnitude of loss as a guide in deciding whether the loss is normal or abnormal. It amounts to making assumptions on account of absence of information.

Eg : Consider the same example of a production process where 8,000 lts of a chemical has been input and there is a loss of 80 lts of the chemical by the time the production is complete. The loss is 80 lts out of 8,000 lts which would be 80/8,000 i.e. 0.01 or 1%. Since the input is a chemical whose processing may result in losses like leakage, evaporation etc., 1% loss is normally possible. Therefore we consider this to be normal loss.

Just because the loss is 1%, we cannot conclude that the loss is normal in all cases.

Physical Form of Loss

Based on their physical appearance/form, losses can be classified into two as
1. Loss without a physical presence

These are losses which result in the reduction in the quantity with the quantity lost not being available in a physical form.

One best example for this sort of loss is reduction in weight on account of evaporation. Where the material used is a liquid and it is heated during processing, some of it might get evaporated during processing.

2. Loss with physical presence

These are losses which are available in a physical form, either in the same form as the input or in the form of output or any other intermediary form which is acquired on account of processing.

illustration

We will try understanding the difference between normal and abnormal losses using the following data relating to a loss incurred.

1000 units of material have been input into a production process at a total cost (material, labour/labor, overheads) of 1,00,000 i.e. @ 100 per unit. 100 units of material has been lost in the production process. These 100 loss units would fetch a price of 1 per unit if sold in the market.

Normal Loss

If the nature of the loss in production process is such that it would occur every time 1,000 units of this kind are input into the production process, then this loss of 100 units can be considered normal.

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

The cost incurred for 900 units is

1. 90,000

900 units × 100/unit

Good units valued at cost per unit arrived at taking the total cost and the total input into consideration.

 Cost per unit = $\frac{\mathrm{Total Cost}}{\mathrm{Total Input}}$ = $\frac{1,00,000}{1,000}$ = 100/unit

If we consider this to be the cost, then, we have to think of what would be done with the cost incurred on the 100 units that have been lost.

2. 1,00,000

cost incurred on the total input

This would result in the unit cost of good units working out to 111.11 ( $\frac{1,00,000}{900}$ )

3. 99,900

1,00,000 − 100

Cost of purchasing the total stock (1,00,000) reduced by the amount realised on selling the loss units (100 units × 1/unit)

This would result in the unit cost working out to 111 ( $\frac{99,900}{900}$ )

This is the most appropriate method for assessing the cost incurred in case of the loss being normal loss.

Normal Cost

Normal cost of output is the cost that would have to be incurred if we try to produce the same quantity and quality of output in another instance at or about the same time and under the same operating conditions.

Ascertaining the Normal Cost

Suppose we need another lot of 900 units of this product, how many units have we to introduce into the production process? Surely, 1,000 units as 100 units will be lost in production process for sure (since the loss is being termed normal).

The amount that we have to spend would also be for 1,000 units of input i.e. 1,00,000, since only then we will be able to obtain 900 units of output.

Since the loss units are capable of being sold for 1 each every time such loss occurs, the cost incurred can be set off with this realisation thereby reducing the final cost borne. Therefore, the net cost to be incurred for producing 900 good units would be 99,900.

Particulars Quantity Value Rate
Input
Normal Loss
1,000
100
1,00,000
100
100.00
1.00
Output 900 99,900 111.00

Note

Data in the rate column should always be obtained as the quotient of $\frac{\mathrm{Value}}{\mathrm{Quantity}}$

Valuation - Normal Loss and Normal Cost

The following aspects have to be noted in valuation of normal loss and ascertaining normal cost.

1. Net Realisable Price or Market Price of Normal Loss

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

Net Realisable Price = Sale Price/unit − Expenses directly relatable to sale per unit

Expenses like brokerage or commission for sale, delivery expense etc which are to be incurred on account of the sale are some examples of expenses directly relatable to sale. Since no such expenses are mentioned, we consider the sale price of normal loss units as the net realisable price.

2. Value of Normal Loss

We were able to derive the Net cost of input i.e. 99,900 or 111.00 per unit by deducting 100 from the cost and 100 units from the units input. This implies that we have valued normal loss at 1 per unit its market price (net realisable value).
Normal Loss is valued at its market price (net realisable price)
This is an important valuation principle and is true for valuation of Normal Loss anywhere.
3. Normal Cost

The cost of good output after absorbing the value loss of normal loss units is called the Normal cost. It can be obtained using the following relation.

Normal Cost

 = Total Cost − Normal Loss Realisation = 1,00,000 − 100 = 99,900

This value is the same as the value that is obtained by adding value loss of normal loss units to the cost of good units.

Normal Loss - Cost incurred, Value loss, loss absorption

The calculations shown here are to aid our understanding and for learning purposes. We will not be required to derive these costs and they would not be part of any calculations normally.
1. Cost incurred on Normal Loss Units

Cost per unit of output, ignoring losses is 100. Therefore all the units that were lost as normal loss should also be considered to have been acquired at the same rate of 100 per unit.

Cost incurred on normal loss units

 = Normal Loss units × cost/unit = 100 × 100/unit = 10,000
2. Value loss on Normal Loss Units

Value loss on Normal Loss Units

 = Total Cost incurred − Total Net Realisable Value = 10,000 − 100 = 9,900
3. What happens to the Value Loss?

The value loss of normal loss units is absorbed by the good output units.
Particulars Quantity Value Rate
Output (Valued at Input Cost)
+ Normal Loss
900
90,000
9,900
100.00
11.00
Output (Valued after absorbing normal loss) 900 99,900 111.00

The value of good (net) output has increased from 100/unit to 111/unit. The 11/unit increase being the value loss of normal loss (9,900) being absorbed by the good output (900 units) which would increase the unit value by 11/unit ().

Abnormal Loss

If the nature of the loss in processing is such that it would not occur every time 1,000 units of this kind are input and processed, then this loss of 100 units can be considered to be abnormal.

If we are to ascertain the cost of the 900 good units left (after keeping aside the 100 units lost), there is only one proposition. The cost can be calculated based on the cost of input.

The cost incurred for 900 units is

1. 90,000

900 units × 100/unit

Good units valued at cost per unit arrived at taking the total cost and the total input into consideration.

 Cost per unit = $\frac{\mathrm{Total Cost}}{\mathrm{Total Input}}$ = $\frac{1,00,000}{1,000}$ = 100/unit

On considering this to be the cost, we have to deal with the cost incurred on the 100 units that have been lost.

This can be better explained by answering the question, "How much are we be required to spend if we are to produce an output of 900 units again?".

Since the loss is abnormal in nature, the loss need not have to be borne every time we carry on processing to produce the output. Therefore, to procure 900 units, we need to input 900 units only which would require an expenditure of 90,000 (900 units × 100/unit).

Particulars Quantity Value Rate
Input
Abnormal Loss
1,000
100
1,00,000
10,000
100.00
100.00
Output 900 90,000 100.00

Note

Data in the rate column should always be obtained as the quotient of $\frac{\mathrm{Value}}{\mathrm{Quantity}}$.

Valuation of Abnormal Loss

The following aspects have to be noted in valuation of abnormal loss.

Value of Abnormal Loss

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

Valuing Abnormal Loss units ≡ Valuing Good units

The output 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 units also, the principles for valuation of assets should be followed. This means that except for the fact that the output units are damaged, there is no difference in valuing good output and abnormal loss units.

Abnormal loss units are valued at the same rate as good output units.

There are only two methods of valuation. Normal loss is valued at net realisable price and all other output is valued at cost.

Abnormal Loss - Cost incurred, Value loss, loss absorption

1. Cost incurred on Abnormal Loss units

All the units input cost 100 per unit. Therefore all the units that were lost as abnormal loss should also have been cost at the same rate of 100 per unit.

Cost incurred on abnormal loss units

 = Abnormal Loss units × cost/unit = 100 × 100/unit = 10,000

For abnormal loss units cost and value are synonymous.

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.

We consider realisation from abnormal loss units only on it being sold for a consideration. The marketable rate of abnormal loss units would be dependent on the condition of the units lost/destroyed and is not a figure that can be consistently applied to all units alike.

Valuing the units at an estimated rate at which they can be disposed is done only in case of Normal Loss units.

For the purpose of understanding, assume the abnormal loss units are sold at 25/unit,

Realisation from abnormal loss units

 = 100 units @ 25/unit = 2,500

Net Price

In considering the price at which the abnormal loss units are sold, we will have to consider the net price after deducting all the expenses directly relatable to sale.
3. Other Realisations from Abnormal Loss Units

Insurance Realisation

Where the organisation has taken an insurance policy to cover losses on account of abnormal reasons, there might be insurance realisation.

The insurance company may pay up to compensate the total loss in which case it would take away the salvaged stock. In such a case, the only realisation relating to the abnormal loss units that the organisation gets is insurance realisation.

For the sake of the illustration consider the insurance company to have paid 3,000 only.

Salvage

• Property or goods saved from damage or destruction
• salve

Sale of Salvaged units

The insurance company may also leave the salvaged units with the customer, value it at a certain price and pay up to compensate only the rest of the value of the units as having been lost.

In such a case, the organisation would realise both sale proceeds of salvaged units and insurance realisation with regard to the abnormal loss units.

4. Value loss of Abnormal Loss units

Value loss of Abnormal Loss units

 = Total Cost incurred − Net Sale Realisation − Insurance Realisation = 10,000 − 2,500 − 3,000 = 4,500
5. What happens to the value Loss?

The value loss of units lost on account of abnormal reasons should not be absorbed by the good units. It is charged to the Profit & Loss a/c (integrated accounting) or Costing Profit and Loss a/c (cost ledger accounting).

The final value of good units would be 100 per unit which is not influenced by the abnormal loss.

Particulars Quantity Value Rate
Abnormal Loss
− Sale of Salvaged units
100
10,000
2,500
100.00
25

− Insurance Recovered
100 7,500
1,000
75.00
10.00
Net Loss (Transferred to P & L a/c) 100 6,500 65.00

Note

Data in the rate column should always be obtained as the quotient of $\frac{\mathrm{Value}}{\mathrm{Quantity}}$.
Author : The Edifier