Study Unit 3
COST Allocation
Techniques
Overhead
Normal Costing
OH and Normal Costing
 All
manufacturing costs that are not DM/DL
 MOH = Factory OH = Indirect Pdt Cost
(Indirect Materials, Indirect Labor, Supplies,
Utilities, Insurance, Taxes, Depreciation)
 Costs outside the product cost (G&A,
Selling) are not inventoriable in COGS = P&L
 DL and DM are purely variable costs
 OH contains both Variable and Fixed costs
What is Normal Costing?
Normal costing is used to derive the cost of a product. It includes the following
components:
Actual cost of materials
Actual cost of labor
A standard overhead rate that is applied using the product's actual usage of
whatever allocation base is being used (such as direct labor hours or machine
time)
If there is a difference between the standard overhead cost and the actual
overhead cost, then you can either charge the difference to the cost of goods
sold (for smaller variances) or prorate the difference between the cost of goods
sold and inventory.
Normal costing is designed to yield product costs that do not contain the sudden
cost spikes that can occur when you use actual overhead costs; instead, it uses a
smoother long-term estimated overhead rate.
It is acceptable under generally accepted accounting principles and
international financial reporting standards to use normal costing to derive the cost
of a product.
Normal costing varies from standard costing, in that standard costing uses entirely
predetermined costs for all aspects of a product, while normal costing uses actual
costs for the materials and labor components.
Other Definition
Normal costing uses a predetermined annual overhead rate to
assign manufacturing overhead to products. In other words, the
overhead rate under normal costing is based on the expected
overhead costs for the entire accounting year and the expected
production volume for the entire year.
Under actual costing each month’s actual costs and each month’s
actual production volume are used to assign overhead costs. Since
most companies will experience month to month fluctuations in
activity, the actual monthly overhead rates will likely vary from
month to month.
Normal costing will result in an overhead rate that is more uniform
and realistic for all of the units manufactured during an accounting
year.
MOH = definition
Manufacturing overhead (also referred to as factory overhead, factory burden, and
manufacturing support costs) refers to indirect factory-related costs that are incurred
when a product is manufactured. Along with costs such as direct material and direct
labor, the cost of manufacturing overhead must be assigned to each unit produced
so that Inventory and Cost of Goods Sold are valued and reported according to
generally accepted accounting principles (GAAP).
Manufacturing overhead includes such things as the electricity used to operate the
factory equipment, depreciation on the factory equipment and building, factory
supplies and factory personnel (other than direct labor). How these costs are
assigned to products has an impact on the measurement of an individual product's
profitability.
Nonmanufacturing costs (sometimes referred to as “administrative overhead”)
represent a manufacturer’s expenses that occur apart from the actual
manufacturing function. In accounting and financial terminology, the
nonmanufacturing costs include Selling, General and Administrative (SG&A)
expenses, and Interest Expense. Since accounting principles do not consider these
expenses as product costs, they are not assigned to inventory or to the cost of goods
sold. Instead, nonmanufacturing costs are simply reported as expenses on the
income statement at the time they are incurred.
On financial statements, each product must include the costs of the
following:
 Direct material
 Direct labor
 Manufacturing (or factory) overhead
According to generally accepted accounting principles (GAAP),
manufacturing overhead must be included in the cost of Work in Process
Inventory and Finished Goods Inventory on a manufacturer’s balance sheet,
as well as in the Cost of Goods Sold on its income statement.
As their names indicate, direct material and direct labor costs are directly
traceable to the products being manufactured. Manufacturing overhead,
however, consists of indirect factory-related costs and as such must be
divided up and allocated to each unit produced. For example, the property
tax on a factory building is part of manufacturing overhead. Although the
property tax covers an entire year and appears as one large amount on just
one tax bill, GAAP requires that a portion of this amount be allocated or
assigned to each product manufactured during that year.
Examples:
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Material handlers (forklift operators who move materials and units).
People who set up the manufacturing equipment to the required
specifications.
People who inspect products as they are being produced.
People who perform maintenance on the equipment.
People who clean the manufacturing area.
People who perform record keeping for the manufacturing processes.
Factory management team.
Electricity, natural gas, water, and sewer for operating the manufacturing
facilities and equipment.
Computer and communication systems for the manufacturing function.
Repair parts for the manufacturing equipment and facilities.
Supplies for operating the manufacturing process.
Depreciation on the manufacturing equipment and facilities.
Insurance and property taxes on the manufacturing equipment and
facilities.
Safety and environmental costs.
Steps for Analysis
 Cost
Driver  allocation base (causeand-effect relationship)
 It can be direct machine or labor hours
 Calculating the application rate
 Recording Actual Overhead Costs
 Allocating OH to WIP
 Over and Under applied Overhead
Over – Under applied:
 If
variance is immaterial: directly
allocated to COGS
 If variance is material: allocated based on
relative values of WIP, Finished goods,
COGS
Activity-Based Costing
 Indirect
costs are attached to activities
rather than simply dumped in one or two
indirect cost pools
 More accuracy and greater detail
regarding OH
 More complex and costly to implement
Examples
 Page
106 – review example
 Page 123 # 24: quick calculation
 Page 123 # 25
Service Department Costs
 Direct
Method
 Step-Down Method
 Reciprocal Method
 Single-rate Vs. Dual-Rate Allocation
Key concepts:
 Service
Depart. = OH = not traced to cost
object = must be allocated to operating
Departs.
 Cause-&-effect relationship and/or
benefits received
 Review
examples
 Page 128 #3.7