The first issue with actual costing is that most of the indirect costs are not known until after the end of the period. This means that, to computer costs and actual costing, you have to wait for the costs to be known. Such a delay is undesirable as it does not allow day-to-day management. To improve the timeliness of the cost reports, most companies will therefore use an alternative like normal or standard costing.
Actual costing is a method that assign to costs objects the direct and indirect costs “actually” and “historically” incurred during the period. All costs arre recorded at the actual amount.
Practical capacity is a measure that can be achieved under normal (not ideal) operating conditions.
Full capacity occurs when a company is operating its resources to the limit of its capacity. No additional units can be produced of customers served without increasing capacity or incurring opportunity costs.
Capacity cost rate is the cost of supplying capacity for each group of similar resources. It is calculated by dividing the total cost of supplying the resource by the pratical capacity of this resource.
Theoretical capacity is the denominator level concept that is based on the production of output at full efficiency for all the time. It is theoretical in the sense that it does not allow for any interruption, for instance for maintenance, temporary shutdowns and so on.
Practical capacity is the denominator level concept that reduces theoretical capacity for unavoidable operating interactions such as a scheduled maintenance time, shutdowns for holidays.
Normal utilization of our normal activity is the denominator concept based on the level of capacity utilization that satisfies average customer demand over a period that includes seasonal, cyclical or other trends factors.
Unused capacity is is the difference between the productive capacity available and the productive capacity requied to satisfy the demand in the period. It is also called excess capacity.
The pratical capacity is the maximum amount of work which can be performed with available resources under normal conditions of production. It reduces the theoretical capacity for unavoidable operating interruptions such as scheduled maintenance time, shutdowns for holydays, etc.
in Gantt’s terms: “The indirect expense chargeable to the output of the factory should bear the same ratio the indirect expense necessary to run factory normal capacity as the output in question bears to the normal output of the factory.”
The fluctuation of the overhead rate may result in dysfunctional behaviors as it does not reflect economically real fluctuations in the resources consumed. It sends misleading signals to the managers.
When actual rates are used for cost allocation managers do not know the rates to be used until the end of the accounting period. Therefore, they face some uncertainty.
Seasonal factors affect the actual overhead rate. Such factors are not necessarily related to the effectuation of the demand. For instance, the organization will consume more energy to heat the factory in winter, perhaps more energy to cool down the factory in summer, and will have two consume less energy in spring and autumn.As a result two units identical in every way but the period in which they were produced will be allocated with different amounts of overhead costs. Such fluctuations serve no managerial purpose. Therefore, computing the overhead rate on an annual basis appears preferable as it cancels seasonal variations. However, this will mean waiting for the end of the year to allocate costs. This will as well compromise the usefulness of costing information for management as it will not be timely for decision-making. The best way to avoid this is to allocate costs using predetermined overhead rates. This is when we enter the realm of normal and standard costing.