Normal spoilage refers to the inherent worsening of products during the production or inventory processes of the sales cycle. This is the deterioration of a firm’s product line that is generally considered to be unavoidable and expected. For commodity producers, this is the natural resource that is lost or destroyed during extraction, transportation, or inventory. Companies typically set a normal spoilage rate for lines of products which they produce and assign the costs of such spoilage to cost of goods sold (COGS).
Normal spoilage occurs for companies operating in any sort of manufacturing or production environment. They will inevitably see at least part of their production line wasted or destroyed during extraction, manufacturing, transporting, or while in inventory. Consequently, firms will use historical data along with some forecasting methods to produce a number or rate of normal spoilage to account for such losses. The expenses incurred due to normal spoilage are often included as a portion of the COGS.
The normal spoilage rate is calculated by dividing the units of normal spoilage by the total units produced. For example, assume a firm produces 100 widgets per month. Historically, 2 of those widgets have not been up to standards. The normal spoilage rate is calculated at 2% (2 units of normal spoilage / 100 units produced).
The firm will include this 2% spoilage rate in with its cost of goods sold (COGS), although the widgets were not actually sold. That is because this amount is the normal and expected rate of spoilage in this firm’s typical course of business. The COGS is deducted from net sales revenue to arrive at the gross margin, so normal spoilage is accounted for in a product line’s gross margin.
Abnormal spoilage, which is considered avoidable and controllable, is charged to a separate expense account that will show up on a line item further down the income statement. It, therefore, has no impact on gross margin. It is important for investors and other financial statement users to be able to quickly identify the expenses incurred due to abnormal spoilage, since is not expected as part of a normal course of business.