What is Scrap Inventory and How to Account for it?

Scrap inventory is the residue, unfinished, or damaged inventory that cannot be used under normal circumstances.

All production processes produce scrap and waste material inevitably. If the costs are smaller, a company may account for these costs as overhead costs. However, if scrap costs are significant, a company would need to account for them separately.

Let us discuss what is scrap inventory and how to account for it.

Scrap Inventory – Definition

Scrap can be defined as leftover material after the production process. It can be in different forms such as raw material, work in progress, or finished goods.

Scrap inventory is different from a byproduct. A scrap inventory or material does not require any modification or rework. Companies having sophisticated production processes may have unwanted scrap inventory at different stages.

Precisely scrap inventory does not mean finished goods. These are leftover items from raw materials that are damaged or broken and cannot be reused in the manufacturing process.

Scrap inventory may be sold at residual or salvage value if at all. The accounting treatment will also differ for scrap inventory depending upon the fact that it can be sold or not.

Scrap Inventory in Different Stages of Production

When we talk about scrap inventory, we can find scrap at three stages of production. The amount, causes, and value of the scrap inventory would be different at these three stages of production.

Scrap Inventory in Raw Material

 It is in the form of raw material or the first material used in the production process. It is usually wasted material that cannot be redeemed or used in the production process.

first material scrap can also be witnessed if production machinery requires testing each time before starting the batch production.

For new products, scrap inventory in raw material can be due to wrong input components or defective items.

Scrap Inventory in Work in Progress

Scrap inventory may result during the production phase as well. These are bad products that may or may not be reworked. Often scrap inventory in the WIP phase results when the production process does not pass the quality assurance test.

 In some cases, a company can modify or reuse the raw material during the work in progress stage. however, often the WIP phase does not allow the reuse. companies can sell these unfinished or damaged products at salvage value.

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 Scrap Inventory in Finished Goods

 Finished products may not meet the quality assurance requirements as well. Also, defective products or out-of-design products would result in the scrap inventory in the form of finished goods.

In most cases, scrap inventory in the finished goods form can be sold at a discount or a residual value.

What Does Scrap Inventory Consume?

As we discussed above, scrap inventory may result at all three stages of production. Therefore, there are several types of scrap sources that scrap inventory consumes and causes losses to a business.

Material

Scrap inventory consumes raw material. in reality, scrap inventory consumes material at all stages of production. The later the inventory becomes a scrap the higher is the cost of wasted material.

Rework Time

By definition, scrap inventory cannot be repaired. However, companies still need to process scrap inventory. It means a write-off or disposal activity will take rework time that incurs a cost for any business.

Energy Resources

Scrap results from the wasted products during the production. It means they waste energy resources during the production process.

Scrap inventory will consume energy resources to rework or dispose of as well.

Material Handling

Scrap inventory consumes material handling resources during production and disposal processes.

For large product manufacturers, the scrap material handling costs can be significantly higher.

Disposal Costs

Genuinely, scrap inventory cannot be reworked. It should only be disposed of. Therefore, scrap inventory will inevitably result in disposal costs.

Assurance Costs

Quality assurance and inspection costs are linked with the overall production process. However, increased scrap inventory would result in increased inspections and assurance costs for the company.

Human Resources

Handling scrap inventory and disposal will require machine and labor hours. Thus, it will inevitably increase human resource costs for a business.

Calculating the Cost of Scrap

A business first needs to calculate the cost of scrap. It will then assess if the scrap inventory can be resold or disposed of.

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Any income resulting from selling the scrap inventory or costs incurred would then be accounted for in the general ledger of the business.

A business may calculate scrap inventory costs in a number of ways.

Scrap by Activity

The most common way of identifying scrap inventory costs is to identify scrap inventory at each activity stage.

For example, a company can identify scrap material wasted during the initial or testing stages. It can also use the same method to identify scrap inventory during production or bad products produced.

At each stage, the business can assign a scrap material per unit cost. During the initial stages, raw material costs and finished goods the total production costs can be used for accounting purposes.

Scrap by Accounting Period

Scrap inventory can also be accounted for using the accounting period approach. For instance, a business can calculate the total scrap inventory costs incurred during a month or a quarter.

This method is useful for businesses where scrap inventory has a low percentage of scrap in the total manufacturing production system.

Scrap by Percentage of Finished Products

It is inevitable to find damaged or bad products in many ways. Thus, the scrap inventory at the finished goods state can be calculated using the percentage of finished goods as well.

For example, a company may find 1% of its monthly produced products as faulty or damaged that cannot be repaired.

This method is the easiest one to calculate the cost of scrap inventory.

Accounting Entries for Scrap Inventory

Once a company calculates the cost of scrap inventory, it can then enter the accounting entries in its record books.

If both the quantity and cost of the scrap inventory are known, a company should create a new ledger account for scrap inventory.

A business should first record the total scrap costs and then it can record any revenue in its income statement. The company can also reduce the overhead costs or work in progress costs against the sale of scrap inventory.

The general journal entry to record the scrap inventory will be:

AccountDebitCredit
Scrap Inventory$ XXXX 
Scrap Revenue $ XXXX

If the company uses the factory overhead or WIP account then,

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AccountDebitCredit
Scrap Inventory$ XXXX 
Factory Overhead / WIP $ XXXX

Once the scrap is transferred to inventory, it can be reused or sold at a residual value.

When the company sells scrap inventory, the journal entry will be:

AccountDebitCredit
Cash/ Accounts Receivable$ XXXX 
Scrap Inventory $ XXXX

An entity should record the effect of scrap inventory in its work in progress inventory as well. This way, the company will not carry the scrap inventory as an asset.

The journal entry to reflect the impact will be:

AccountDebitCredit
Overhead Cost Pool / Activity$ XXXX 
Work in Progress Account $ XXXX

Reasons for Scrap Inventory

Businesses can have scrap inventory for various reasons and from several activities during or after the production process.

Some common reasons of having scrap inventory include:

  • The low quality raw material will result in waste material and scrap inventory eventually for any business.
  • Inefficiency in production processes due to machine or labor low-time can also result in scrap inventory.
  • Designing flaws and assurance standards may also discard some finished goods that would end up as scrap inventory.

Scrap Inventory Vs Obsolete Inventory

Unlike the common notion, scrap inventory and obsolete inventory are two different things.

Scrap inventory cannot be modified or reused under normal circumstances. It is often sold at a very cheap price as compared to the finished goods or raw material costs.

Obsolete inventory is the inventory that is yet to be sold. This type of inventory is termed obsolete often when it nears its lifecycle completion.

Perishable goods such as food and drinks are good examples of industries having more obsolete inventory.

A key difference between the two is that obsolete inventory can be sold at a normal price before its expiration.

Scrap Inventory Vs Defective Inventory

Defective inventory is similar to scrap inventory but somehow it has some differences.

Defective inventory can be reused or modified during different production stages. Often, defective inventory is seen at the finished goods stage of the production.

Defective products can be packaged or even sold to customers sometimes. These items can be replaced or repaired after a referral.

On the other hand, scrap inventory cannot be sold to retail customers or modified easily so that it can be sold at normal prices.

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