CHAPTER 9: Normal Costing

MANAGEMENT ACCOUNTING CONCEPTS AND TECHNIQUES

By Dennis Caplan, Oregon State University

CHAPTER 9: Normal Costing

Chapter Contents:

- Introduction

- Normal Costing

- Advantages of using budgeted overhead rates

- Misapplied overhead

- ZFN Apparel Company, Normal Costing example

- Exercises and problems

Introduction:

Recall the discussion from the previous chapter on overhead rates. The overhead rate is the ratio of cost pool overhead dollars in the numerator, and the total quantity of the allocation base in the denominator:

Overhead rate		Overhead costs in the cost pool
	=
		Total quantity of the allocation base

The result represents dollars of overhead per unit of the allocation base. For example, if an apparel factory allocates overhead based on direct labor hours, the overhead rate represents dollars of overhead per direct labor hour.

Normal costing:

Many companies calculate and apply this overhead rate using, not actual overhead costs and the actual quantity of the allocation base, but rather budgeted overhead costs and the budgeted quantity of the allocation base. When a company uses budgeted overhead rates in its costing system, but all other information in the costing system is based on actual costs, the company is using what is called a normal costing system.

It is important to remember that although there are no rules in management accounting, companies always, as a matter of practice, use either budgeted numbers in both the numerator and the denominator of the overhead rate, or actual numbers in both the numerator and the denominator of the overhead rate. Companies never use budgeted overhead divided by the actual quantity of the allocation base, or actual overhead divided by the budgeted quantity of the allocation base.

It is also important to remember that in a normal costing system, the budgeted overhead rate is multiplied by the actual quantity of the allocation base incurred. In Chapter 10, we will discuss another type of accounting system, called a standard costing system, that multiplies the budgeted overhead rate by a flexible budget quantity for the allocation base: the amount of the allocation base that should have been used for the amount of output achieved. However, in a normal costing system, the only budgeted number is the overhead rate; direct costs are recorded at their actual cost, and the overhead rate is multiplied by the actual quantity of the allocation base used during the period.

Advantages of Using Budgeted Overhead Rates:

There are three principal reasons that many companies in all sectors of the economy use budgeted overhead rates, either as part of a normal costing system or as part of a standard costing system.

Actual overhead rates are not known in a timely manner: Factory managers often use production cost information in their monitoring of the manufacturing process. Control of manufacturing activities is a daily or weekly process, not a monthly or quarterly process. The challenge of collecting and reporting actual direct costs—the cost of materials and labor used in production—within one or two days of actual production is difficult, but increasingly possible. For example, all materials used in production have already been purchased, and the cost of those materials can be ascertained. Also, sophisticated data collection systems, often called real-time systems, can track the movement of inventory, and track labor resources incurred at various work stations, as production occurs. Even the quantity of the overhead cost allocation base used in production can probably be ascertained, because the allocation base is usually a measure of a direct input. However, many of the components that make up overhead are not paid daily or even weekly. Utilities and property taxes are often paid monthly or quarterly. The factory manager who wants to know the cost of production on January 3 for the purpose of controlling operations on the factory floor will not want to wait until the books are closed on January 31 for that information. Usually, budgeted overhead rates are sufficiently close to actual overhead rates so that normal costing systems provide reasonably accurate cost information for management control purposes, and normal costing can provide this information in a timely manner.

Overhead rates are subject to short-run fluctuations: For an apparel factory in El Paso, electric costs are significantly higher in July than in January due to the cost of air conditioning. Should overhead rates be calculated and applied separately for each month, or should overhead rates be averaged over the entire year? The answer to this question is not clear, because it depends on the types of decisions for which management will use factory cost information as an input. For example, if the factory has excess capacity and management is considering suspending factory operations for two weeks, monthly cost data will assist in scheduling the down-time to maximize cost savings (i.e., close the factory for two weeks in July, not January). On the other hand, if several product managers are scheduling production for the coming year, it would seem counterproductive to provide these managers incentives to compete with each other for January factory time, for the sake of obtaining the lower per-unit production cost, if some of them will have to schedule production in July in any case. Using an overhead rate that averages over the entire year might be more reasonable for production costing purposes like this one. In fact, many companies prefer to average overhead rates over a quarter or an entire year, and these companies usually prefer using budgeted overhead rates instead of waiting until actual overhead is known at the end of the period.

When actual overhead rates are used, production volume of each product affects the reported costs of all other products: This issue arises because the production volume of each product affects the total quantity of the allocation base in the denominator of the overhead rate, whereas an important component of the numerator—fixed overhead—is invariant to changes in production volume. Hence, as production volume of one product decreases below budget, the overhead rate (which is common across all products) increases, and when that overhead rate is applied to other products, those products absorb more overhead (and so have higher reported costs) than was budgeted. The important point here is that the direct costs and production activity related to those other products could be exactly as planned, but the reported costs of those products will be higher than planned, due entirely to the production activities of another product. In a factory that makes jeans and chinos, one might imagine the reaction of the jeans product manager when a decline in chinos production increases the reported cost of each pair of jeans.

Misapplied Overhead:

When budgeted overhead rates are used, it is very likely that the amount of overhead applied to production (the debits to work-in-process) will differ from the actual overhead incurred (credits to cash, accounts payable, and various other accounts) during the period. This difference, which will occur whenever the budgeted overhead rate differs from the actual overhead rate, is called misapplied overhead. If less overhead is applied to inventory than is actually incurred, then the difference is called underapplied overhead (it is also called underallocated overhead or underabsorbed overhead). If more overhead is applied to inventory than is actually incurred, then the difference is called overapplied overhead (it is also called overallocated overhead or overabsorbed overhead).

Mechanically, misapplied overhead is accumulated in one or more temporary accounts that are closed out at the end of the period (month, quarter or year). These accounts collect the misapplied overhead because when overhead is debited to inventory, the corresponding credits are posted to these temporary accounts, and when overhead is paid (or accrued), the corresponding debits are also posted to these temporary accounts. The net difference between these debits and credits represents misapplied overhead. If two temporary accounts are used, they are called something like “overhead applied” and “overhead incurred.”

The nature of the closing entry to zero-out these accounts depends on the materiality of the misapplied overhead. If the amount is small, management might take the expedient approach of closing out all misapplied overhead to a line-item on the income statement for the period. The misapplied overhead might be posted to cost-of-goods-sold, or might be treated as a period expense, but in either case, the effect is to increase or decrease income by the total amount of misapplied overhead.

If the amount of misapplied overhead is material, management should consider whether the entry to close out misapplied overhead should be made in such a way as to approximate the balances in the balance sheet and income statement inventory accounts that would have occurred had an actual costing system been used. If so, then the entry to close out misapplied overhead should include the inventory balance sheet accounts of work-in-process and finished goods inventory, as well as cost-of-goods-sold on the income statement. One technique that approximates this objective is to pro-rate misapplied overhead based on the ending balances in work-in-process, finished goods inventory, and cost-of-goods-sold. A more accurate technique is to pro-rate misapplied overhead based on the amount of overhead in each of these three accounts.

If overhead is underapplied, some managers close out the entire amount to the income statement (thereby decreasing income) even if the amount is material. Conservatism is often the justification for this approach.

ZFN Apparel Company, Normal Costing Example:

The ZFN apparel company in Albuquerque, New Mexico makes jeans and premium chinos. Each product line has its own assembly line on the factory floor. Overhead costs for the factory for 2005 were budgeted for $3,600,000, but came in below budget at $3,300,000. Budgeted production for the year was 500,000 jeans and 500,000 chinos. Actual production was 500,000 jeans and 400,000 chinos. The reduction in chinos output relative to plan was due to unexpected slack in the demand for casual slacks. The budgeted direct labor hours per jean is 0.5, and per chino is 0.7. In fact, 500,000 direct labor hours were used: 200,000 for jeans, and 300,000 for chinos. The average direct labor wage rate was the same on both assembly lines, and was $14 per hour. Denim fabric is used to make jeans, and chinos are made from a cotton twill fabric. Overhead is allocated using direct labor hours.

The following journal entries and T-accounts illustrate how a normal costing system records the manufacturing activities of the factory in order to derive product cost information for jeans and chinos.

The first five entries are identical to the ZFN example in the previous chapter. The first entry that differs as the result of using normal costing instead of actual costing is (6). This entry to debit overhead to work-in-process is based on an overhead rate calculated as:

Budgeted Production

Budgeted hours per unit

Budgeted labor hours

Jeans

Chinos

Total

500,000 units x

0.5 hours per unit =

0.7 hours per unit =

250,000

350,000

600,000

The budgeted overhead rate =

$3,600,000 ÷ 600,000 direct labor hours = $6.00 per direct labor hour.

In practice, the factory would track costs by batch, or perhaps weekly, but to simplify our example, we record only one journal entry for each type of transaction. We also make the unrealistic assumption that there is no work-in-process at the end of the period. To focus the presentation on inventory-related accounts, T-accounts for some non-inventory accounts are omitted. Many companies would use two separate accounts instead of one account to track factory overhead; one account for factory overhead incurred, and the other account for factory overhead allocated.

(1) Raw Materials: denim fabric $3,000,000

Raw Materials: cotton twill 2,250,000

Accounts Payable $5,250,000

(To record the purchase of 600,000 yards of denim fabric at $5.00 per yard, and 500,000 yards of cotton twill fabric at $4.50 per yard.)

(2) Work-in-process: Jeans $2,500,000

Raw Materials: denim fabric $2,500,000

(To record materials requisitions for 500,000 yards, for the movement of denim from the receiving department to the cutting room.)

(3) Work-in-process: Chinos $2,160,000

Raw Materials: cotton twill $2,160,000

(To record materials requisitions for 480,000 yards, for the movement of cotton twill from the receiving department to the cutting room.)

(4) Work-in-process: Jeans $2,800,000

Work-in-process: Chinos 4,200,000

Accrued Sewing Operator Wages $7,000,000

(To record sewing operator wages for the year: 200,000 hours for jeans, and 300,000 hours for chinos, at $14 per hour.)

(5) Factory Overhead $3,300,000

Accounts Payable $1,800,000

Accrued Wages for Indirect Labor 900,000

Accumulated Depreciation 600,000

(To record overhead costs incurred during the year.)

(6) Work-in-process: Jeans $1,200,000

Work-in-process: Chinos 1,800,000

Factory Overhead $3,000,000

(To allocate overhead to production, using a budgeted overhead rate of $6 per direct labor hour, multiplied by actual hours used in production.)

(7) Finished Goods: Jeans $6,500,000

Work-in-process: Jeans $6,500,000

(To record the completion of all 500,000 jeans, at $13.00 per pair.)

(8) Finished Goods: Chinos $8,160,000

Work-in-process: Chinos $8,160,000

(To record the completion of all 400,000 chinos, at $20.40 per pair.)

(9) Cost of Goods Sold: Jeans $5,200,000

Cost of Goods Sold: Chinos $7,140,000

Finished Goods: Jeans $5,200,000

Finished Goods: Chinos $7,140,000

(To record the sale of 400,000 jeans and 350,000 chinos.)

(10) Cost of Goods Sold: misapplied overhead $300,000

Factory Overhead $300,000

(To close out underapplied overhead to COGS. The total amount is taken to COGS because the result is not materially different from allocating misapplied overhead to COGS and finished goods inventory)

Raw Materials: Denim Fabric				Raw Materials: Cotton Twill
(1)	$3,000,000 $ 500,000	$2,500,000	(2)	(1)	$2,250,000 $ 90,000	$2,160,000	(3)

Accrued Sewing Operator Wages			Factory Overhead
	$7,000,000	(4)	(5)	$3,300,000 $0	$3,000,000 300,000	(6) (10)

Work-in-Process: Jeans				Work-in-Process: Chinos
(2) (4) (6)	$2,500,000 2,800,000 1,200,000 $0	$6,500,000	(7)	(3) (4) (6)	$2,160,000 4,200,000 1,800,000 $0	$8,160,000	(8)

Finished Goods: Jeans				Finished Goods: Chinos
(7)	$6,500,000 $1,300,000	$5,200,000	(9)	(8)	$8,160,000 $1,020,500	$7,140,000	(9)


Cost of Goods Sold: Jeans				Cost of Goods Sold: Chinos
(9) $5,200,000				(9)	$7,140,000

Accounts Payable			COGS: misapplied overhead
	$5,250,000 1,800,000	(1) (5)	(10)	$300,000

The per-unit cost of finished goods inventory is calculated as follows:

Jeans: $6,500,000 ÷ 500,000 pairs = $13.00 per pair

Chinos: $8,160,000 ÷ 400,000 pairs = $20.40 per pair

These amounts can be detailed as follows:

Input

Jeans

Chinos

Fabric

Direct labor

Overhead

Total

1 yard/jean x $5/yard = $5.00

0.4 hrs/jean x $14/hr = $5.60

0.4 hrs/jean x $6.00/hr = $2.40

$13.00

1.2 yards/chino x $4.50/yard = $5.40

0.75 hrs/chino x $14/hr = $10.50

0.75 hrs/chino x $6.00/hr = $4.50

$20.40

Overhead is applied using the budgeted overhead rate of $6.00 per hour. However, this budgeted overhead rate is multiplied by the actual direct labor hours used by each product. Therefore, the only reason that more overhead or less overhead is allocated to each unit of product than budgeted is because each product used more of the allocation base or less of the allocation base (in this case, direct labor hours) than planned. Jeans used less overhead per unit than planned (0.4 versus 0.5), so less overhead is allocated to each pair of jeans than planned. Chinos used more overhead than planned (0.75 versus 0.7), so more overhead is allocated to each pair of chinos than planned.

The total misapplied overhead is a function of two factors: (1) the numerator in the budgeted overhead rate differing from actual overhead incurred; and (2), the denominator in the budgeted overhead rate differing from the actual quantity of the allocation base incurred. In the next two paragraphs, we consider each of these two factors.

Less overhead was incurred than planned: $3,300,000 versus $3,600,000. It is probable that one reason actual overhead incurred was less than budgeted is that fewer units were produced than planned. Unless all overhead is fixed, a reduction in output should decrease the total overhead incurred.

The denominator in the budgeted overhead rate can differ from the actual quantity of the allocation base incurred for two reasons. First, the amount of the allocation base used per unit of product (in this case, direct labor hours per unit) can differ from plan. Jeans used less direct labor hours per unit than planned, but chinos used more direct labor hours than plan. Second, the level of production can differ from plan (either total production or product mix). Because fewer units were made than planned (900,000 units versus 1,000,000 units), less overhead was allocated than otherwise would have been the case.

Exercises and Problems:

9-1: A company uses a Normal Costing System, and allocated overhead using direct labor hours. At the beginning of the year, the company estimated that there would be $960,000 in overhead and 40,000 direct labor hours worked. At the end of the year, the company had worked 39,000 hours and incurred $949,000 in overhead. What is the underapplied or overapplied overhead for the year?

(A) There is not enough information to determine this.

(B) $13,000 underapplied

(D) $11,000 underapplied

9-2: DRG Company makes three products: cypress, silius, and sibelius. DRG expects to incur $900,000 in overhead, and expects to use 300 machine hours to make 500 units of cypress, 200 machine hours to make 100 units of silius, and 100 machine hours to make 50 units of sibelius. DRG uses a Normal Costing System, and uses machines hours as the allocation base.

A) If DRG uses 50 machine hours to make 20 units of sibelius, and actually incurs overhead of $1,111,000, how much overhead will be allocated to each unit of sibelius?

B) If DRG uses 200 machine hours to make 400 units of cypress, 400 machine hours to make 150 units of silius, and 50 machine hours to make 20 units of sibelius, what is the amount of overapplied or underapplied overhead?

9-3: The not-for-profit health clinic Shots-Я-Us provides various types of vaccinations and other shots, especially flu shots, to the public for free or for a nominal fee. The clinic is funded by several local governmental agencies as well as by a number of charitable organizations. Since different donors wish to fund different types of shots, the clinic determines the full cost of each type of shot, by adding overhead to the direct costs, and then provides this information to current and prospective donors.

Following are actual and budgeted costs for Shots-Я-Us for 2003:

Actual

Budgeted

Number of patient visits

Number of shots administered

Fixed overhead: salaries, rent for the facility, insurance, depreciation.

Variable overhead: nursing staff hoursly wages, utilities, disposable supplies.

Cost of hypodermics (a direct cost)

Cost of medications (a direct cost)

5,000

6,000

$94,000

$66,000

$1,000

$30,000

4,000

4,500

$110,000

$40,500

$750

$20,000

A) Under normal costing, the variable cost per shot is

(A) $9 per shot

(B) $13.61 per shot

(D) $38.06 per shot

B) Which of the following might help explain the increase in total variable overhead, from budget to actual?

(I) The increase in the number of shots given, from budget to actual.

(II) A misclassification of some fixed costs as variable (i.e., the costs are actually fixed, but are included under variable overhead, in both the budget and the actual columns).

(III) An increase in the average hourly wages for the nursing staff, from budget to actual.

(A) I only

(B) III only

(D) I, II and III

9-4: The Santa Cruz Candy Company expects to incur overhead of $24,000. Also, the company expects to incur 300 direct labor hours (which is paid an average of $10 per hour) and 200 machine hours, in order to produce 2,000 pounds of candy. Using the information provided, calculate three different overhead rates using three different allocation bases. In each case, be sure to identify the allocation base.

9-5: The Santa Cruz Machine Shop allocates overhead based on machine hours, using a budgeted overhead rate. The budgeted overhead rate is calculated using an estimate of 6,000 machine hours in the denominator, and $60,000 in the numerator. Actual overhead was $500 less than budgeted. Actual machine hours were 1,500 more than budgeted. Calculate the misapplied overhead. Be sure to indicate whether this misapplied overhead is underapplied or overapplied.

9-6: Following is information for Penquo, Inc., which makes crayons in its Billings, MT factory:

Budget

Actual

Production (# of boxes of crayons)

Total Direct Costs (materials & labor)

Total Machine Hours

Overhead (fixed and variable)

1,000

$ 2,000

140

$2,800

800

$ 2,400

100

$3,000

Penquo allocates overhead using a budgeted overhead rate, using machine hours as the allocation base. The overhead rate is then applied to product based on actual machine hours incurred. In other words, the company uses a Normal Costing system.

Required:

A) What is the overhead rate?

B) How much overhead would be applied to each box of crayons?

C) What is the actual direct cost of each box of crayons?

9-7: The Rio Grande Tile Company uses a budgeted overhead rate, and direct labor costs (i.e., direct labor dollars) as the allocation base. Overhead is applied using actual labor costs incurred. Following is information for January 2005. The labor wage rate was budgeted at $6 per hour, but was actually $8 per hour. Overhead was budgeted at $42,000, but was actually $49,000.

Ceramic Tiles

Slate Tiles

Total

Production:

Budgeted

Actual

Total Direct labor hours:

Budgeted

Actual

4,000

3,000

500

400

2,000

4,000

200

300

6,000

7,000

700

A) Calculate the overhead rate. How much overhead would be allocated to all 4,000 slate tiles?

B) Now assume the company uses a budgeted overhead rate, direct labor hours as the allocation base, and applies overhead based on actual direct labor hours incurred. How much overhead would be applied to each ceramic tile?

C) Now assume the company allocates overhead using direct labor hours as in part (B). What is the misapplied overhead? Is overhead overapplied or underapplied?

9-8: The Svendsgaard Organic Cereal Company makes cereal. Following is information for November:

Actual Information

Budgeted Information

Pounds of cereal produced

Total direct materials

Total direct labor

Total machine hours

Total direct labor hours

Total overhead

800 pounds

$3,200

$800

60 hours

45 hours

$30,000

800 pounds

$2,600

$800

50 hours

40 hours

$30,000

A) Calculate the overhead rate using Normal Costing and machine hours as the allocation base.

B) Using Normal Costing, how much overhead will be applied to each pound of cereal?

C) Compute the amount of misapplied overhead.

9-9: Following is information for the James Woods Company, and one of the products made by the company. The factory has the capacity to produce 1.5 million square feet of wood product.

Budget for the Company

Actual for the Company

Budget for Mahogany Laminate

Actual for mahogany Laminate

Production

(in square feet)

Direct Product Costs

Variable Overhead

Fixed Overhead

1,000,000

$2,500,000

$2,000,000

$1,500,000

1,200,000

$2,880,000

$2,400,000

$1,200,000

50,000

$150,000

40,000

$128,000

A) Calculate the amount of overhead allocated to all of the mahogany laminate if the company uses a budgeted overhead rate, square feet of product as the allocation base, and applies the overhead rate based on actual square feet produced.

B) Calculate the amount of overhead allocated to all of the mahogany laminate if the company uses a budgeted overhead rate, direct product cost as the allocation base, and applies the overhead rate based on actual direct product costs incurred.

C) Calculate the amount of overhead allocated to all of the mahogany laminate if the company uses a budgeted overhead rate, square feet of product as the allocation base, and applies the overhead rate based on actual square feet produced. However, the company allocates variable overhead and fixed overhead separately. The denominator for the overhead rate for variable overhead is budgeted square feet, and the denominator for the overhead rate for fixed overhead is factory capacity (in terms of square feet).

9-10: A factory makes jeans and chinos. Overhead was budgeted at $150,000, but was actually $132,000. Budgeted production was 10,000 jeans and 5,000 chinos. Actual production was 10,000 jeans and 2,000 chinos. Overhead is applied using a budgeted overhead rate, and the allocation base is units of output.

A) Calculate the overhead rate.

B) How much overhead would be applied to the chinos production line?

C) What is the misapplied overhead? Is it underapplied or overapplied?