Question

1. What two problems are associated with actual costing?
2. How does normal costing "solve" these two problems?
3. At the end of a month, how is over or under applied overhead reported on the financial statements?
4. At the end of the year, how is over or under applied overhead reported on the financial statements?

Answer 1

Ans 1 Two prblems associated with actual costing are:

1) It unit cost of the product keeps on fluctuating from one period to other, as actual cost of overhead is used which is different in every period. So we do not have a consistent/standard product cost

2) It does not give accurate unit cost information on timely basis because the actual manufacturing overhead is recorded when it is incurred so at a given point of time accurate unit cost cannot be calculated.

ans 2 Normal costing/standard costing can solve this problem as a predetermined overhead rate is calculated based on estimated manufacturing overhead which is divided by estimated activity which can be direct labor hours/cost, machine hours etc.. Than this rate can be applied to actual activity undertaken during the year. So through this an unit product cost can be calculated which will not fluctuate from one period to another and the unit cost can be known on a timely basis

ans 3 and ans 4

Now the predetermined overhead rate will be multiplied by actual activity for example actual direct labor hours/machine hours etc and we get applied overhead

Now if applied overhead is less than actual overhead than it is known as underapplied overhead.

If applied overhead is more than actual overhead than it is known as overapplied overhead.

There are two ways to close this variance

1) Close it to Cost of good sold if the variance amount is immaterial

2) Close it on a prorata basis to Work In process inventory,finished goods inventory and Cost of good sold

So effect of it on financial statements

1) If the overhead is underapplied and is immaterial in amount than Cost of goods sold will increase in Income statement resulting in decrease in net income which in turn decreases the stockholder equity in Balance Sheet

2) If the overhead is overerapplied and is immaterial in amount than Cost of goods sold will decrease in Income statement resulting in increase in net income which in turn increases the stockholder equity in Balance Sheet

Now if the amount is material

1) If the overhead is underapplied Cost of goods sold will increase in Income statement resulting in decrease in net income which in turn decreases the stockholder equity in Balance Sheet. Work in process and Finished goods inventory will increasethereby increasing the current assets in Balance sheet

2) If the overhead is underapplied Cost of goods sold will decrease in Income statement resulting in increase in net income which in turn increases the stockholder equity in Balance Sheet. Work in process and Finished goods inventory will decrease thereby decreasing the current assets in Balance sheet

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