Normal costing

practical capacity is the maximum amount of work that can be performed by resources supplied for production or service.

Under applied overhead is the difference between actual and applied overhead when actual overhead is greater than the amount applied.

This overhead rate is usually calculated for an entire year to avoid the fluctuations in cost and activity that results from seasonal variations and peaks in demand. The rate is also predetermined because it is estimated in advance based on estimated rather than actual values.

There are also some debates as to the measure which should be used as denominator when computing the predetermined overhead rate. Three alternatives are more specifically considered: the planned activity, the average activity and the practical capacity. The first one makes no economic sense as it implies the fluctuation in predetermined overhead rates as well, fluctuation which does not translate an actual fluctuation of capacity costs. The average level of activity on the other hand makes sense as it is the level of activity which probably justified the acquisition of the capacity. The problem with this approach is that it conceals the cost of idle capacity. Moreover, it inflates artificially the long-term cost of the product and may therefore give a wrong signal about its sustainability.

The normal cost system is a cost system in which direct materials and direct labor are recorded at actual amounts, why manufacturing overhead is applied to products or services using one normal predetermined overhead rates.

The normal costing system is a cost system in which the cost of the manufactured product is composed of actual direct material, actual direct labor, and normal applied overhead.

Excess capacity, or idle capacity, procures when a company has more than enough resources to satisfy the demand.

Under applied overhead is a difference between actual and applied overhead when applied overhead is lower than actual.

Predetermined overhead rate is a rate estimated before the accounting period begins and use throughout the period of two assignment overhead costs to products or services based on an allocation base or cost driver.

Over applied overhead is the difference between actual and applied overhead when applied overhead is greater than actual.

Normal costing is a costing method that traces actual direct cost to a cost object but allocate indirect costs using a pre-determined or standard overhead rate

Cost application is the allocation of total departmental cost to the revenue producing products or services.

over-applied, over-allocated, or over-absorbed costs are the amount of overhead cost allocated in a period to the product in excess of the actual overhead cost incurred during that period.

Proration is the spreading of overallocated or under-allocated overhead costs among closing inventory and cost of goods sold.

This approach ask users to the system costs in proportion of their use of the facility when it is operating at capacity.

Proration consists in assigning under applied overhead all over applied overhead to cost of goods sold, work in process inventory, and finished goods inventory in proportion to the ending balances of each account.

The key difference between actual normal costing is that actual costing uses the actual allocation rates to allocate indirect costs while normal costing uses the budgeted or standard allocation rate (also called predetermined overhead rate) to apply indirect costs to cost objects. Note that I used the term apply rather than allocate to market even further is a distinction between actual and normal costing.

Predetermined overhead rates have the advantage of being more timely than actual indirect cost rates. With budgeted rates, indirect costs can be assigned to individual cost objects on an ongoing basis, rather than waiting for the end of the accounting period when actual costs would be known.

Since predetermined overhead rate are likely to differ from actual allocation rates, overhead application is unlikely to MT properly is a cost pools into the cost objects. Indeed, either less costs will be applied than would have been allocated, or more cost would be applied than would have been allocated. In the first case will observe and are applied overhead costs remaining within the cost pool; in the second case will take more from the cost pool than was initially accumulated in it, leading to over applied overhead costs. Therefore management accountants will have to pass some adjustment entries to properly entity the cost pools.

Under applied overhead costs occur when the allocated amount of indirect costs in an accounting period is less than the actual (incurred) amount in that period. Over applied overhead costs occur when the allocated amount of indirect costs in an accounting period exceeds the actual (incurred) amount in that period.

There are two ways to adjust for this discrepancy. First the management accountants can adjust allocation rates and restate all entries in the general ledger by using actual cost rates rather than budgeted cost rates. Before the widespread use of computerized systems, this approach was extremely expensive. Alternatively, instead of using adjusted allocation rate approach, the management accountant can use proration. Proration refers to spreading under or over applied overhead among closing stocks and cost of goods sold. This spreading could be proportional to the amount of indirect costs initially applied. This approach should yield the same numbers as the adjusted rates, but was way less work. Proration can also be based on total closing balance before proration are based on a end off to the cost of goods sold.

If fixed costs allocated on the basis of estimated long-term use, some managers may be tempted to underestimate their planned usage. In this way, they will bear a lower fraction of the total costs.