Deducting from Manufacturing Costs or Cost Of Goods Sold via Inter-Account Transfer

When defective materials or spoilage (spoilage after becoming work-in-progress) occur, rather than directly reducing work-in-progress (or manufacturing costs like material costs or processing costs), transferring them indirectly to other accounts through inter-account transfers is the same as with depreciation or allowance for doubtful accounts.

What Is Transfer of Manufacturing Costs?

In manufacturing, the costs incurred to produce products are called manufacturing costs (Cost of Goods Manufactured, COGM). From the beginning product inventory and the current period’s manufacturing costs, the cost of what is sold is termed cost of goods sold (COGS). No new expense accounts are added; it’s just a designation.
For example, when spoilage occurs during the manufacturing process, the factory moves the spoiled items to an NG (non-good) warehouse, isolating them from normal work-in-progress.

The ending WIP inventory is recorded as lower due to the spoiled items isolated in the NG warehouse, meaning the spoilage cost ends up included in the manufacturing costs.
To clarify the amount of spoilage costs within manufacturing costs, separate journal entries are made. This can be done by directly transferring materials to spoilage costs or indirectly via inter-account transfers (Transfer to Other Account).

In this case, the formula for calculating manufacturing costs is adjusted as follows:

Since spoilage costs are part of manufacturing costs, the total manufacturing cost amount doesn’t change; it’s merely a “transfer of expenses within manufacturing costs.”
Next, if a product is dropped and broken in the product warehouse, to clarify that the responsibility lies with the sales department rather than manufacturing, it’s transferred from COGS to selling, general, and administrative expenses (SG&A).

In this case, the formula for calculating COGS becomes:

As a result, the broken product, initially included in COGS, is deducted from COGS and recorded as SG&A.
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Total Average Unit Cost and Manufacturing Costs

The current month’s manufacturing costs for products are:

The total average unit cost of input WIP is:

The current month’s manufacturing costs for WIP are:

The total average unit cost of input materials is:

Thus, for an item at the top level (Level 0), the manufacturing cost is “(Total average unit cost of input items × actual input quantity) + own process costs.” When that item becomes an input for another, its input amount is calculated based on the total average unit cost derived from the prior manufacturing costs and beginning inventory amount.

Cost Element (Portion) Management

Manufacturing costs flow according to the account linkage chart as follows:

When managing this by separating direct material costs and labor costs into portions, the material cost portion flows from materials through WIP to products:

Processing costs flow from WIP to products:

Types of Inter-Account Transfers

Deduction means “subtracting the over-recorded portion of manufacturing costs or COGS.” Using inter-account transfer (WIP) deducts from manufacturing costs, while using inter-account transfer (Products) deducts from COGS.

Record in Manufacturing Costs (Spoilage Costs) and Deduct from COGS

When defective materials or spoilage occur, instead of directly reducing materials, WIP, or products, they are indirectly transferred to another account, spoilage costs (Loss due to Spoiled Work), via inter-account transfer.

Record in Manufacturing Costs (Spoilage Costs) and Deduct from Manufacturing Costs (WIP)

Spoilage is transferred from direct material costs to spoilage costs within manufacturing costs.

Record in SG&A and Deduct from Manufacturing Costs (WIP)

For large customer returns, claims are excluded from manufacturing costs and recorded as SG&A or extraordinary losses.

Record as Assets and Deduct from COGS (Products)

When self-manufactured products are transferred to assets, ending product inventory decreases due to prototypes, increasing COGS. Inter-account transfer (Products) indirectly deducts this from COGS.

Manufacturing Cost Calculation Process Using the Total Average Method

When production management systems record output as “10 good units, 2 defective units,” the WIP or product yield is 12 units, with direct material and processing costs already incurred for the 2 defective units.
Spoilage is confirmed upon disposal by recording disposal output, reducing inventory quantity. Until disposal, if it’s WIP, it’s included in the current month’s manufacturing costs’ direct material portion; if it’s a product, it’s in the WIP portion, automatically flowing into COGS.

How to Display Indirect Deduction of Spoilage Costs on the P/L

ERP systems either continuously adjust inventory accounts and expense issued amounts, or process purchases mid-month in a purchase account, transferring beginning inventory to ending inventory via the purchase account to expense them.
When reflecting spoilage recorded in output data into costs and accounting, the common P/L presentation for both systems uses inter-account transfers to indirectly deduct from costs.

Transferring Direct Material Costs Recorded in Manufacturing Costs to Spoilage Costs

Since it’s just a transfer from direct material costs to spoilage costs within manufacturing costs, neither manufacturing costs nor COGS change, and gross profit remains unaffected.

Or:

Recording Spoilage Costs in Manufacturing Costs and Deducting from COGS

Adding spoilage from disposal to manufacturing costs increases COGS and reduces gross profit. Since spoilage isn’t sales’ responsibility, deducting it from COGS keeps gross profit unchanged.

Or:

Transferring Direct Material Costs Recorded in Manufacturing Costs to Extraordinary Losses

Deducting amounts included in manufacturing costs as direct material costs lowers COGS, increasing gross profit and operating profit. Recording them as extraordinary losses reduces net income, balancing the books.

Or: