Source: Cost Accounting Textbook, Ch. 4 (Sections 4.3–4.4)
Tags: actual costing, normal costing, budgeted indirect cost rate, predetermined overhead rate, job cost record, job cost sheet, seven-step job costing, source document, manufacturing overhead, WIP, work in process, finished goods, cost of goods sold
Difficulty: Intermediate Prerequisites: Part 1 of these notes (cost objects, direct vs indirect costs, cost pools, cost-allocation bases). You need the vocabulary from 4.1–4.2 before this will make sense.
Once you understand direct costs, indirect costs, and allocation bases (Part 1), the next question is practical: how do you actually compute the cost of a job while work is still in progress? Waiting until year-end for exact figures is too slow for pricing, bidding, and monthly financial statements.
This section introduces two costing systems, actual costing and normal costing, and walks through the seven-step approach that structures the work. The key difference between the two systems is a single swap: actual costing uses the real indirect-cost rate (known only after the period ends), while normal costing plugs in a budgeted rate available from day one. Most real companies use normal costing, so give it the lion's share of your attention.
Actual costing waits for year-end numbers, making it accurate but slow. Normal costing uses a budgeted (predetermined) overhead rate so managers can cost jobs throughout the year. Both systems follow the same seven steps; the only difference is whether the indirect-cost rate comes from actual or budgeted figures.
Actual costing
A system that traces direct costs at actual rates and allocates indirect costs using an actual indirect-cost rate, computed after the period ends.
In simple terms, every number in the calculation is a real, after-the-fact figure. Accurate, but you cannot get the answer until the year is over.
Actual indirect-cost rate
Actual indirect-cost rate = Actual annual indirect cost / Actual annual quantity of the cost-allocation base
Normal costing
A system that traces direct costs at actual rates (same as actual costing) but allocates indirect costs using a budgeted (predetermined) indirect-cost rate.
Think of it as: "actual where you can, budgeted where you must." Direct costs are known in real time; indirect rates are estimated at the start of the year so you can cost jobs immediately.
Budgeted (predetermined) indirect-cost rate
Budgeted indirect-cost rate = Budgeted annual indirect cost / Budgeted annual quantity of the cost-allocation base
This rate is set at the beginning of the fiscal year and applied to jobs throughout the year as work occurs.
Budgeted manufacturing overhead rate
The specific version of the budgeted indirect-cost rate used for manufacturing overhead.
Budgeted manufacturing overhead rate = Budgeted manufacturing overhead cost / Budgeted total quantity of the cost-allocation base
Source document
An original record that supports journal entries and tracks costs as they occur. Examples include materials requisition forms and labour time cards.
In simple terms, it is the paper trail (or digital equivalent) that proves a cost happened and ties it to a specific job.
Job cost record (job cost sheet)
A document used to record and accumulate all costs assigned to a specific job, starting when work begins. It is the running total for that job.
Think of it as: the job's personal expense report. Every direct material charge, every labour hour, and every overhead allocation goes here.
Inventoriable costs
Manufacturing costs (direct materials, direct manufacturing labour, manufacturing overhead) that attach to the product and sit on the balance sheet as inventory until the product is sold, at which point they become cost of goods sold.
Period costs
Costs expensed in the income statement in the period they are incurred, not attached to inventory. Marketing and customer-service expenses are common examples.
The textbook illustrates job costing through Robinson Company, which bids on a custom paper-making machine for Western Pulp and Paper (WPP). The five decision steps are:
Step 1 – Identify the problem and uncertainties. What will the job cost? What will competitors bid?
Step 2 – Obtain information. Study the engineering specifications, compare to past similar jobs, and research competitor pricing.
Step 3 – Make predictions. Estimate direct materials, direct labour, and overhead. Factor in risk and potential biases.
Step 4 – Make the decision. Robinson bids $15,000 against an estimated manufacturing cost of $9,800, targeting a markup above 50%.
Step 5 – Implement, evaluate, and learn. After the job, compare predicted costs to actual costs to improve future estimates.
This framework shows why timely cost information matters: Robinson needs a cost estimate before work begins, not after.
Direct costs are traced at actual rates times actual quantities of inputs used.
Indirect costs are allocated at the actual indirect-cost rate times actual quantities of the allocation base consumed.
The catch: the actual indirect-cost rate requires year-end totals for both the numerator (total indirect costs) and the denominator (total allocation base quantity). You cannot compute it mid-year with full accuracy.
Two problems make actual rates unreliable on a monthly or quarterly basis:
The numerator reason (cost pool fluctuations). Monthly indirect costs swing because of seasonal patterns: heating costs spike in winter, maintenance shutdowns cluster in summer. A rate computed in January would look very different from one computed in July.
The denominator reason (allocation base fluctuations). Monthly output and machine usage vary. Fixed indirect costs spread over a low-output month produce a high rate; the same costs spread over a high-output month produce a low rate. Neither rate reflects the true annual picture.
Using a longer period (typically a full year) smooths out both effects. This is why most companies budget annual figures and use normal costing.
Direct costs: traced at actual rates, exactly as in actual costing.
Indirect costs: allocated at the budgeted indirect-cost rate times the actual quantity of the allocation base used by the job.
The budgeted rate is calculated once at the start of the year and stays fixed. This gives managers immediate, consistent cost information for every job throughout the year.
Step 1: Identify the job that is the chosen cost object.
Open a job cost record (job cost sheet) for it. Assign a job number.
Source documents (materials requisitions, labour time cards) feed costs into this record.
Step 2: Identify the direct costs of the job.
Typically direct materials and direct manufacturing labour.
These are traced to the job using source documents.
Step 3: Select the cost-allocation base(s) for allocating indirect costs to the job.
Common choices: direct manufacturing labour hours, machine hours, direct labour cost.
The base should reflect a cause-and-effect relationship with overhead consumption.
Step 4: Identify the indirect costs associated with each cost-allocation base.
Group all manufacturing overhead costs into the relevant cost pool(s).
Indirect manufacturing costs are those necessary to do the job but not traceable to a specific job (e.g. factory rent, equipment depreciation, supervisor salaries).
Step 5: Compute the indirect-cost rate for each cost-allocation base.
Under normal costing: Budgeted manufacturing overhead rate = Budgeted overhead cost / Budgeted total quantity of the allocation base.
Under actual costing: same formula but with actual figures for both numerator and denominator.
Step 6: Compute the indirect costs allocated to the job.
Multiply the rate from Step 5 by the actual quantity of the allocation base the job consumed.
Step 7: Compute the total cost of the job.
Total job cost = Direct materials + Direct manufacturing labour + Allocated indirect costs.
Steps 1 and 2 are identical under both actual and normal costing. The systems diverge at Step 5 (which rate to use).
Understanding the path costs take through the accounting system is essential:
Purchases of direct materials and direct manufacturing labour are traced to Work-in-Process (WIP) Inventory on the balance sheet.
Manufacturing overhead (indirect materials, indirect labour, other indirect costs) is allocated to WIP Inventory.
When a job is complete, its accumulated costs move from WIP to Finished Goods Inventory (still on the balance sheet).
When the finished product is sold, costs move from Finished Goods to Cost of Goods Sold on the income statement.
Period costs (marketing expense, customer-service expense) bypass inventory entirely and go straight to the income statement in the period incurred.
Variable indirect costs change with output volume: supplies, power, indirect support labour.
Fixed indirect costs remain constant in the short run regardless of output: depreciation, general administrative support.
Both types are pooled together when computing the indirect-cost rate, but recognising which costs are variable and which are fixed helps explain why monthly rates fluctuate (the denominator reason above).
Actual indirect-cost rate
Actual indirect-cost rate = Actual annual indirect cost / Actual annual quantity of the cost-allocation base
Budgeted (predetermined) indirect-cost rate
Budgeted indirect-cost rate = Budgeted annual indirect cost / Budgeted annual quantity of the cost-allocation base
Budgeted manufacturing overhead rate
Budgeted MFG overhead rate = Budgeted manufacturing overhead cost / Budgeted total quantity of cost-allocation base
Total job cost (normal costing)
Total job cost = Actual direct materials + Actual direct manufacturing labour + (Budgeted indirect-cost rate x Actual quantity of allocation base used)
Cost flow summary
Direct materials + Direct labour → (traced to) → WIP Inventory → Finished Goods Inventory → Cost of Goods Sold
Manufacturing overhead → (allocated to) → WIP Inventory → Finished Goods Inventory → Cost of Goods Sold
Period costs (marketing, customer service) → Income Statement (expensed immediately)
Every time a construction firm gives you a quote for a kitchen renovation, it is running a version of the seven-step job-costing process: estimating materials and labour (direct costs), layering on overhead for equipment, insurance, and office costs (indirect costs), and adding a margin. Normal costing is what lets the firm quote you a price in January without waiting until December to know what its full-year overhead turned out to be.
Students often think normal costing is less accurate than actual costing. Over a full year, the total overhead allocated under normal costing is usually close to actual overhead. The advantage of normal costing is timeliness, and any difference is adjusted at year-end.
Confusing the budgeted rate with a guess. The budgeted rate is based on careful estimates of costs and volume, not a rough approximation. It is "predetermined," not "made up."
Forgetting that direct costs are treated identically under both systems. The only difference between actual and normal costing is how indirect costs are handled.
Mixing up inventoriable costs and period costs. Manufacturing overhead is inventoriable (it attaches to the product in WIP and Finished Goods). Marketing and customer-service costs are period costs, expensed immediately.
⚠️ You will very likely be asked to compare actual costing and normal costing. The answer centres on one point: normal costing uses a budgeted indirect-cost rate; actual costing uses the actual rate. Direct cost treatment is the same.
⚠️ Expect a problem that walks you through all seven steps for a specific job, ending with "compute the total job cost." Practise the arithmetic.
⚠️ The numerator reason and denominator reason for using annual (not monthly) rates is a common short-answer or multiple-choice item. Know both.
⚠️ Be prepared to trace a cost through the accounts: materials purchase → WIP → Finished Goods → COGS. This flow appears in journal entry problems.
⚠️ The distinction between inventoriable costs and period costs is frequently tested, often with a list of costs where you classify each one.
True or false: Normal costing uses budgeted rates for both direct and indirect costs. False. Normal costing uses actual rates for direct costs and budgeted rates for indirect costs only.
Fill in the blank: The budgeted indirect-cost rate is calculated by dividing __________ by __________. Budgeted annual indirect cost by the budgeted annual quantity of the cost-allocation base.
True or false: Period costs are included in Work-in-Process Inventory. False. Period costs (e.g. marketing, customer service) are expensed immediately on the income statement. Only inventoriable (manufacturing) costs flow through WIP.
Fill in the blank: A __________ is the document used to record and accumulate all costs assigned to a specific job. Job cost record (or job cost sheet).
True or false: One reason companies use annual rather than monthly indirect-cost rates is to avoid the effect of seasonal cost fluctuations. True. This is the numerator reason.
Q: What is the key difference between actual costing and normal costing?
A: Both systems trace direct costs to jobs at actual rates. The difference is in indirect costs: actual costing allocates indirect costs using the actual indirect-cost rate (computed after the period ends), while normal costing uses a budgeted (predetermined) indirect-cost rate set at the start of the year.
Q: A company budgets $1,200,000 in manufacturing overhead and 40,000 direct labour hours for the year. Job 501 uses 150 direct labour hours. Under normal costing, how much overhead is allocated to Job 501?
A: Budgeted overhead rate = $1,200,000 / 40,000 = $30 per direct labour hour. Job 501 overhead = $30 x 150 = $4,500.
Q: Explain the "numerator reason" and the "denominator reason" for computing indirect-cost rates over annual rather than monthly periods.
A: The numerator reason: monthly indirect costs fluctuate due to seasonal patterns (e.g. heating costs in winter), so a monthly rate would spike or drop depending on the time of year. The denominator reason: monthly output and usage of the allocation base also fluctuate, causing fixed indirect costs to be spread over varying volumes, producing erratic rates. Using annual figures smooths both effects.
Q: List the seven steps of job costing under normal costing.
A: (1) Identify the job as the cost object. (2) Identify the direct costs of the job. (3) Select the cost-allocation base(s). (4) Identify indirect costs for each allocation base. (5) Compute the budgeted indirect-cost rate. (6) Compute indirect costs allocated to the job. (7) Compute total job cost by summing direct and indirect costs.
Q: A company incurs $8,000 in marketing costs and $45,000 in manufacturing overhead during the month. Which of these is an inventoriable cost and which is a period cost?
A: Manufacturing overhead ($45,000) is an inventoriable cost; it attaches to products in Work-in-Process Inventory and eventually becomes Cost of Goods Sold. Marketing ($8,000) is a period cost, expensed on the income statement in the month incurred.
The budgeted vs actual rate distinction is the foundation for overhead variance analysis (typically covered in a later chapter on flexible budgets and overhead variances). When budgeted overhead allocated differs from actual overhead incurred, the result is over- or under-applied overhead, a concept that builds directly on this material.
Normal costing also connects to activity-based costing (ABC). ABC refines Step 3 by using multiple allocation bases, each tied to a specific activity, rather than a single plant-wide rate.
The cost flow through WIP → Finished Goods → COGS reappears whenever you study process costing (Chapter 5+), where the same accounts are used but costs are averaged across equivalent units rather than tracked by individual job.
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