Right at the very start of cost accounting we understand that decision making is one of the crucial and an ongoing process in every organization. Managers have to decide about many things all the time and for this they need relevant and reliable information or to be specific complete information. This is where cost accounting helps in many different ways.
Coming straight to the point, in many instances of decision making we need total production cost which implies that we have to collect information about cost incurred towards usual three components of production cost direct material, direct labour and overheads.
Most often the direct costs i.e. direct material cost and direct labour cost can be calculated at any point in time with considerable accuracy and also without putting much effort. As direct costs are traceable and also can be measured on per unit level we can figure out how much cost is incurred on the number of units so far. Also the records towards direct material cost and direct labour cost are mostly maintained on run time or if not than we still can calculate cost easily any time it is required. For example to calculate direct material cost we can check raw material used so far and its value. Same goes for direct labour where we have clock cards from which we can determine how many hours of work has been done so far and thus how much labour cost has been incurred.
But this is not possible for majority of overheads cost. For example, if we want to know the electricity cost during the month than it is not possible and most often we have to wait for electricity bill to arrive by the end of the month. Another problem is that even if get the overheads cost data on time, it is usually on total basis for example electricity bill, rent etc and we have no clue about how much overheads were incurred towards a particular number of units.
In short, either the overheads cost data is not available on time or overheads costs cannot be measured accurately. So does it mean that managers should decide using only direct material and direct labour cost and leave overheads cost? Well, it will not be a good idea as we are incurring those cost and if these are not included in the production cost then almost no decision will be good.
What is the solution then?
The problem is that we can have the actual cost incurred towards direct material, we can have the actual cost incurred towards direct labour but we cannot have actual cost incurred towards overheads.
To solve this problem we can use one powerful technique called estimation.
What we will do is that we will use actual material cost, actual labour cost and applied overheads calculated using estimated data (or budgeted data). This is normal costing.
Under normal costing we calculate applied overheads (also known as absorbed overheads etc) using an overheads absorption rate (OAR) which is then multiplied with the actual data available. Where OAR is calculated on the basis of budgeted data. If it is too hard to grasp then put it this way that applied overheads are calculated by using actual data and estimated/budgeted data together. We use this combo because of unavailability of complete information on time basis.
Budgeted data simply consists of budgeted overheads and the budgeted quantity or amount of absorption “base”. “Base” simply refers to the basis on which overheads are estimated. Companies mostly use such basis regarding which actual data is easily available e.g. units produced, direct material cost, direct labour cost, machine hours and labour hours etc.