By Dennis Caplan, University at Albany (State University of New York)



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




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




500,000 units x

500,000 units x

0.5 hours per unit =

0.7 hours per unit =






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






$   500,000












$    90,000














Accrued Sewing

Operator Wages



Factory Overhead
































Work-in-Process: Jeans


Work-in-Process: Chinos




































Finished Goods: Jeans


Finished Goods: Chinos







































Cost of Goods Sold: Jeans


Cost of Goods Sold: Chinos


(9)  $5,200,000   




















Accounts Payable


COGS: misapplied overhead

























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:






Direct labor



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


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




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.




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Management Accounting Concepts and Techniques; copyright 2006; most recent update: November 2010


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