An actual cost system uses actual costs for direct materials, direct labor, and overhead to determine unit cost. In practice, strict actual cost systems are rarely used because they cannot provide accurate unit cost information on a timely basis. Per-unit computation of the direct materials and direct labor costs is not the source of the difficulty. Direct materials and direct labor can be traced to units produced. The main problem with using actual costs for calculation of unit cost is with manufacturing overhead. There are three reasons why this is so. First, a traditional system applies overhead using unit-level drivers. However, many overhead items cannot be traced to units of production. Depreciation on plant and equipment, purchasing, and receiving are costs that are not associated with unit-level drivers. Activity-based costing is a way of overcoming this difficulty by using multiple drivers both unit-level and non-unit-level.
Second, many overhead costs are not incurred uniformly throughout the year. Thus, they can differ significantly from one period to the next. For example, a factory located in the Northeast may incur higher utilities costs in the winter as it heats the factory. Even if the factory always produced 10,000 units a month, the per-unit overhead cost in December would be higher than the per-unit overhead cost in June. As a result, one unit of product costs more in one month than another, even though the units are identical, and the production process is the same. The difference in the per-unit overhead cost is due to overhead costs that were incurred nonuniformly. The third reason is that per-unit overhead costs fluctuate dramatically because of nonuniform production levels. For example, suppose a factory has seasonal production. Perhaps it produces 10,000 units in March, but 30,000 units in September as it gears up for the Christmas buying season. Then, if all other costs remain the same, month to month, the per-unit overhead of the product would be approximately three times as high in March as in September. Again, the units are identical; the production process is the same.
The problem of fluctuating per-unit overhead costs can be avoided if the firm waits until the end of the year to assign the overhead costs. Unfortunately, waiting until the end of the year to compute an overhead rate is unacceptable. A company needs unit cost information throughout the year. This information is needed on a timely basis both for interim financial statements and to help managers make decisions such as pricing. Most decisions requiring unit cost information simply cannot wait until the end of the year. Managers must react to day-to-day conditions in the marketplace in order to maintain a sound competitive position.
Normal costing solves these problems associated with actual costing. A cost system that measures overhead costs on a predetermined basis and uses actual costs for direct materials and direct labor is called a normal costing system. Predetermined overhead or activity rates are calculated at the beginning of the year and are used to apply overhead to production as the year goes on. Any difference between actual and applied overhead is handled as an overhead variance. Chapter 4 explained the treatment of overhead variances.
Virtually all firms assign overhead to production on a predetermined basis. This fact seems to suggest that most firms successfully approximate the end-of-the-year overhead rate. Thus, the measurement problems associated with the use of actual overhead costs are solved by the use of estimated overhead costs. A job-order costing system that uses actual costs for direct materials and direct labor and estimated costs for overhead is called a normal job-order costing system.
Second, many overhead costs are not incurred uniformly throughout the year. Thus, they can differ significantly from one period to the next. For example, a factory located in the Northeast may incur higher utilities costs in the winter as it heats the factory. Even if the factory always produced 10,000 units a month, the per-unit overhead cost in December would be higher than the per-unit overhead cost in June. As a result, one unit of product costs more in one month than another, even though the units are identical, and the production process is the same. The difference in the per-unit overhead cost is due to overhead costs that were incurred nonuniformly. The third reason is that per-unit overhead costs fluctuate dramatically because of nonuniform production levels. For example, suppose a factory has seasonal production. Perhaps it produces 10,000 units in March, but 30,000 units in September as it gears up for the Christmas buying season. Then, if all other costs remain the same, month to month, the per-unit overhead of the product would be approximately three times as high in March as in September. Again, the units are identical; the production process is the same.
The problem of fluctuating per-unit overhead costs can be avoided if the firm waits until the end of the year to assign the overhead costs. Unfortunately, waiting until the end of the year to compute an overhead rate is unacceptable. A company needs unit cost information throughout the year. This information is needed on a timely basis both for interim financial statements and to help managers make decisions such as pricing. Most decisions requiring unit cost information simply cannot wait until the end of the year. Managers must react to day-to-day conditions in the marketplace in order to maintain a sound competitive position.
Normal costing solves these problems associated with actual costing. A cost system that measures overhead costs on a predetermined basis and uses actual costs for direct materials and direct labor is called a normal costing system. Predetermined overhead or activity rates are calculated at the beginning of the year and are used to apply overhead to production as the year goes on. Any difference between actual and applied overhead is handled as an overhead variance. Chapter 4 explained the treatment of overhead variances.
Virtually all firms assign overhead to production on a predetermined basis. This fact seems to suggest that most firms successfully approximate the end-of-the-year overhead rate. Thus, the measurement problems associated with the use of actual overhead costs are solved by the use of estimated overhead costs. A job-order costing system that uses actual costs for direct materials and direct labor and estimated costs for overhead is called a normal job-order costing system.
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