Normal Loss

Abnormal Loss

Identifying whether a loss is Normal or Abnormal

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 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.

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

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 vehicle transporting 10 Metric Tons of oil where there is a loss of 100 kg of Oil. The loss 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.

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

1000 units of a product have been purchased at Bombay @ 100 per unit (including freight and delivery) at a total value of 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 1 per unit if sold in the market.

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

The cost incurred by the organisation for 900 units is

1. 90,000

   900 units × 100/unit

   Good units valued at purchase price.

   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 of purchasing the total stock

   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

Ascertaining the Normal Cost

The amount that we have to spend would also be for purchasing 1,000 units i.e. 1,00,000, since only then we will be left with 900 units of good stock.

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 acquiring 900 good units would be 99,900.

Note

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 Stock

   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 purchase i.e. 99,900 or 111.00 per unit by deducting 100 from the cost and 100 units from the units purchased. 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 stock after absorbing the loss on account of normal loss stock 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 normal loss value to the cost of good stock.

1. Cost incurred on Normal Loss Stock

   All the stock was purchased @ 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 100 per unit.

   Cost incurred on normal loss stock	=	Normal Loss units × cost/unit
   	=	100 × 100/unit
   	=	10,000

2. Value loss on Normal Loss Stock

   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 stock is absorbed by the good stock.

   Particulars	Quantity	Value	Rate
   Net Stock (Valued at Cost of Purchase) + Normal Loss	900	90,000 9,900	100.00 11.00
   Net Stock (Valued after absorbing normal loss)	900	99,900	111.00

   The value of good (net) stock has increased from 100/unit to 111/unit. The 11/unit increase being the loss of value of normal loss (9,900) being absorbed by the good stock (900 units) which would increase the unit value by 11/unit ($\frac{\mathrm{9,900}}{900\mathrm{units}}$).

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 purchase.

The cost incurred by the organisation for 900 units is

1. 90,000

   900 units × 100/unit

   Good units valued at purchase price.

   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 procure a stock of 900 units again?".

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

Note

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

Value of Abnormal Loss

Valuing Abnormal Loss Stock ≡ Valuing Good Stock

Abnormal loss stock is valued at the same rate as good stock.

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

Cost to be considered

In saying valued at cost, we mean cost that represents value of the stock.

1. Cost incurred on Abnormal Loss Stock

   All the units in the stock were purchased @ 100 per unit. Therefore all the units that were lost as abnormal loss should also have been purchased at the same rate of 100 per unit.

   Cost incurred on abnormal loss stock	=	Abnormal Loss units × cost/unit
   	=	100 × 100/unit
   	=	10,000

   For abnormal loss stock 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 stock 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 stock at an estimated rate at which they can be disposed is done only in case of Normal Loss Stock.

   For the purpose of understanding, assume the abnormal loss stock is sold at 25/unit,

   Realisation from abnormal loss stock	=	100 units @ 25/unit
   	=	2,500

   Net Price

   In considering the price at which the abnormal loss stock is sold, we will have to consider the net price after deducting all the expenses directly relatable to sale.

3. Other Realisations from Abnormal Loss Stock

   Insurance Realisation

   Where stock has been insured 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 stock 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 Stock

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

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

4. Value loss of Abnormal Loss Stock

   Value loss of Abnormal Loss Stock	=	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 stock lost on account of abnormal reasons should not be absorbed by the good stock. It is charged to the Profit & Loss a/c.

   The value of good stock would be 100 per unit and is not influenced by the abnormal loss.

   Particulars	Quantity	Value	Rate
   Abnormal Loss − Sale of Salvaged Stock	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 $\frac{\mathrm{Value}}{\mathrm{Quantity}}$.

   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 that specific stream of business. Each of these will generate a certain amount of profit/loss called the gross profit/loss from that stream. This gross profit/loss from all the streams is transferred to the profit and loss account.

   The profits from all the streams are collected in the P/L a/c 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 is 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 may have to be incurred which arises on account of abnormal reasons should be charged to the Profit and Loss account by transferring it to the Profit & Loss a/c.