A normal costing approach uses an annual average overhead rate consistently throughout the year, without accounting for day-to-day and month to month fluctuations. This average overhead rate is applied to the cost of a manufactured product, along with actual direct material and actual direct labor. Because the amount of overhead is computed as an average over the year, a department's applied overhead will rarely, if ever, be equal the actual incurred overhead. A department's applied overhead will rarely equal the actual overhead incurred. Why the reason for the variance? The most common reason is that the department is operating at a different level of volume than the level used in calculating the budgeted overhead rate. This can be the result of an over- or under-estimation of the hours which will be needed to produce goods or unexpected events like plant shutdowns. Still, even with the variances, companies prefer to use an annual budgeted overhead rate, despite the month-to-month variances.
Managers often find themselves in the position of having to analyze the difference between the annual overhead rate budgeted for their companies and the actual overhead rate incurred over the course of the year. These two rates are rarely equal to each other, for several reasons. One of the most important factors in the difference is that companies often operate at a different level during the year than was used to figure out the budget in advance. Other causes include poor forecasting of the year's manufacturing needs, or how much product will be produced; the inefficient or unexpected use overhead items; unanticipated price changed in overhead items; behavior of overhead items (need for repairs, etc.); and variations in the amount of work hours from month to month. Normalizing the cost of goods over a year by using the budgeted annual overhead instead of actual incurred costs accounts for these fluctuations and possible distortions, enabling managers to make better…
