Study Unit 3
COST Allocation
Techniques
Overhead
Normal Costing
3.4 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
SU 3.4 Question 1
Question 1 - CMA1 Study Unit 3: Cost Allocation
Techniques
Nash Glassworks Company
has budgeted fixed
manufacturing overhead of
$100,000 per month. The
company uses absorption
costing for both external and
internal financial reporting
purposes. Budgeted
overhead rates for cost
allocations for the month of
April using alternative unit
output denominator levels
are shown in the next
column.
Budgeted
Budgeted
Denominator
Level
Overhead
Capacity Levels (units of output)
Cost Rate
Theoretical
1,500,000
$0.07
Practical
1,250,000
0.08
Normal
775,000
0.129
Master-budget
800,000
0.125
Actual output for the month of April was 800,000
units of glassware.
SU 3.4 Question 1 (continued)
A.
B.
C.
D.
Normal capacity.
Expected annual activity.
Theoretical capacity.
Master-budget capacity.
SU 3.4 Question 1 Answer
Correct Answer: C
Theoretical (ideal) capacity is the maximum capacity given continuous
operations with no holidays, downtime, etc. It assumes perfect efficiency at
all times. Consequently, it can never be attained and is not a reasonable
estimate of actual volume.
Incorrect Answers:
A: Normal capacity is the long-term average level of activity that will
approximate demand over a period that includes seasonal, cyclical, and
trend variations.
B: Expected annual activity is an approximation of actual volume levels
for a specific year.
D: Master-budget capacity is the expected level of activity used for
budgeting for a given year.
SU 3.4 Question 2
Question 2 - CMA1 Study Unit 3: Cost Allocation Techniques
Annual overhead application rates are used to
A.
Budget overhead.
B.
C.
Smooth seasonal variability of
overhead costs.
Simulate seasonal variability of
activity levels.
D.
Treat overhead as period costs.
SU 3.4 Question 2 Answer
Incorrect Answers:
A: Overhead must be budgeted before a
rate can be calculated.
C: Overhead application rates are used to
smooth seasonal variability of overhead costs.
D: An overhead rate applies overhead to the
product.
SU 3.5 Question 1
Question 1 - CMA1 Study Unit 3: Cost Allocation
Techniques
Pane Company uses a job costing system and
applies overhead to products on the basis of
direct labor cost. Job No. 75, the only job in
process on January 1, had the following costs
assigned as of that date: direct materials,
$40,000; direct labor, $80,000; and factory
overhead, $120,000. The following selected
costs were incurred during the year:
SU 3.5 Question 1 (continued)
Traceable to jobs:
Direct materials
$178,000
Direct labor
345,000
Total
$523,000
Not traceable to jobs:
Factory materials and supplies
$46,000
Indirect labor
235,000
Plant maintenance
73,000
Depreciation on factory equipment
29,000
Other factory costs
76,000
Total
$459,000
SU 3.5 Question 1 (continued)
Pane’s profit plan for the year included budgeted direct labor of $320,000
and overhead of $448,000. Assuming no work-in-process on December 31,
Pane’s overhead for the year was
A.
$11,000 overapplied.
B.
$24,000 overapplied.
C.
$11,000 underapplied.
D.
$24,000 underapplied.
SU 3.5 Question 1 Answer
Correct Answer: B
Pane applies overhead to products on the basis of direct
labor cost. The rate is 1.4 ($448,000 budgeted OH ÷ $320,000
budgeted DL cost). Thus, $483,000 ($345,000 actual DL cost ×
1.4) of overhead was applied, of which $24,000 ($483,000 –
$459,000 actual OH) was overapplied.
Incorrect Answers:
A: The amount of $11,000 equals the difference between
budgeted and actual overhead.
C: The amount of $11,000 equals the difference between
budgeted and actual overhead.
D: The overhead was overapplied.
SU 3.5 Question 2
Question 2 - CMA1 Study Unit 3: Cost Allocation
Techniques
During the current accounting period, a manufacturing
company purchased $70,000 of raw materials, of which
$50,000 of direct materials and $5,000 of indirect materials
were used in production. The company also incurred
$45,000 of total labor costs and $20,000 of other
manufacturing overhead costs. An analysis of the work-inprocess control account revealed $40,000 of direct labor
costs. Based upon the above information, what is the total
amount accumulated in the overhead control account?
A.
B.
C.
D.
$25,000
$30,000
$45,000
$50,000
SU 3.5 Question 2 Answer
Correct Answer: B
Overhead consists of all costs, other than direct
materials and direct labor, that are associated with
the manufacturing process. The overhead control
account should have the following costs:
Indirect materials
Indirect labor ($45,000 – $40,000)
$ 5,000
5,000
Other overhead
20,000
Total overhead
$30,000
SU 3.5 Question 2 Answer
(continue)
Incorrect Answers:
A: The amount of $25,000 excludes the
indirect materials.
C: The amount of $45,000 is the total labor
cost.
D: The amount of $50,000 is the direct
materials cost.
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
SU 3.6 Question 1
Question 1 - CMA1 Study
Unit 3: Cost Allocation
Techniques
In allocating factory
service department costs
to producing
departments, which one
of the following items
would most likely be
used as an activity
base?
A.
B.
C.
Units of product sold.
Salary of service department employees.
Units of electric power consumed.
D.
Direct materials usage.
SU 3.6 Question 1 Answer
Correct Answer: C
Service department costs are considered part of factory overhead and
should be allocated to the production departments that use the services. A
basis reflecting cause and effect should be used to allocate service
department costs. For example, the number of kilowatt hours used by each
producing department is probably the best allocation base for electricity
costs.
Incorrect Answers:
A: Making allocations on the basis of units sold may not meet the causeand-effect criterion.
B: The salary of service department employees is the cost allocated, not
a basis of allocation.
D: Making allocations on the basis of materials usage may not meet the
cause-and-effect criterion.
SU 3.6 Question 2
Question 2 - CMA1 Study Unit 3:
Cost Allocation Techniques
When allocating costs from one
department to another, a dual-rate
cost-allocation method may be
used. The dual-rate cost-allocation
method is most useful when
A.
B.
Two or more cost pools are to be
allocated.
Two or more departments’ costs are
to be allocated.
C.
Two or more products are produced.
D.
Costs are separated into variablecost and fixed-cost subpools.
SU 3.6 Question 2 Answer
Correct Answer: D
The dual-rate method of allocating costs from one
department to another involves classifying the costs to be
allocated into two pools, one variable and one fixed.
Incorrect Answers:
A: The dual-rate method is used with exactly two cost
pools, one for fixed costs and one for variable costs.
B: Use of the dual-rate depends on cost behavior, not
the number of departments.
C: Use of the dual-rate depends on cost behavior, not
the number of products.