Northgate Chemicals: abnormal loss and a disputed normal loss allowance
Northgate Chemicals runs a single continuous process. In March, 10,000 litres of raw material were introduced at a cost of £48,000. Normal loss is set at 10% of input; lost material has a realisable value of £3.00 per litre, credited to the process account. Conversion costs of £25,800 were incurred. Output transferred to finished goods was 8,000 litres. Closing work in progress was 800 litres, complete as to material but only 50% complete as to conversion. There was no opening work in progress. The production manager argues that the 10% normal loss allowance is out of date because the cheaper raw material grade introduced last year contains more inert filler, and that the 200 litres of abnormal loss should be reclassified as normal so that the process report does not show an 'abnormal' line. He adds that his bonus is calculated on process cost per litre of good output, and that reclassification would 'stop the number bouncing around'.
1. Calculate the abnormal loss in litres and value, the value of closing work in progress and the value of output transferred to finished goods, showing equivalent unit workings.
Read the worked answer
Expected and abnormal loss Normal loss = 10% × 10,000 = 1,000 litres (scrap value £3,000). Expected good output = 9,000 litres. Actual output + closing WIP = 8,000 + 800 = 8,800 litres, so abnormal loss = 200 litres.
Equivalent units Material: 8,000 completed + 200 abnormal loss (100%) + 800 WIP (100%) = 9,000 Conversion: 8,000 + 200 + (800 × 50% = 400) = 8,600 Normal loss carries no cost; its scrap value reduces material cost.
Cost per equivalent unit Net material = £48,000 − £3,000 = £45,000 ÷ 9,000 = £5.00 Conversion = £25,800 ÷ 8,600 = £3.00
Values Abnormal loss = 200 × (£5.00 + £3.00) = £1,600 (written off to profit or loss, not carried in inventory) Closing WIP = (800 × £5.00) + (400 × £3.00) = £4,000 + £1,200 = £5,200 Output transferred = 8,000 × £8.00 = £64,000
Check: 64,000 + 5,200 + 1,600 = £70,800 = (£48,000 − £3,000) + £25,800. The process account balances.
2. Evaluate the proposal to reclassify the 200 litres and to raise the normal loss allowance to 12%. Quantify the effect on the cost per litre, and recommend how and when the standard should be changed.
Read the worked answer
Quantified effect of a 12% allowance Normal loss becomes 1,200 litres, scrap £3,600; expected good output 8,800 = output 8,000 + WIP 800, so no abnormal loss arises. Equivalent units are then good output only: material 8,800, conversion 8,400. Net material = £48,000 − £3,600 = £44,400 ÷ 8,800 = £5.045; conversion £25,800 ÷ 8,400 = £3.071. Cost per litre = £8.117 versus £8.000 - a rise of about 1.5%. Output becomes 8,000 × £8.117 = £64,935 and WIP £5,265; total £70,200, agreeing to (44,400 + 25,800).
Evaluation The £1,600 abnormal loss simply moves into product cost and disappears from the report. That is not a correction of an error; it is a change of benchmark, and it lowers the bar permanently: every future excess loss up to 12% becomes invisible and is capitalised into inventory at a higher cost per litre.
The manager proposing the change is the person whose bonus depends on the reported cost per litre, and the change would be made after the loss occurred. That is exactly the conflict of interest standard-setting controls exist to prevent.
Recommendation The 10% standard may genuinely be stale, but it must be tested ex ante: trial the new material grade, measure its yield over several batches, and have the technical and finance functions (not the process manager) approve a prospective revision effective from the next period. Until then, report the £1,600 as abnormal, investigate its cause, and assess the manager on total cost and yield against an independently set standard, not on a ratio he can redefine.