What is Normal Volume?
In cost accounting, “Normal Volume” is the standard measure of activity (e.g., production units, labor hours, or machine hours) expected over a specific period that is used to calculate the overhead absorption rate in an absorption costing system. The overhead absorption rate is used to allocate overhead costs to individual units of output.
Detailed Explanation
The overhead absorption rate is determined by dividing the estimated total overheads for a period by the normal volume for the same period:
\[ \text{Overhead Absorption Rate} = \frac{\text{Estimated Total Overheads}}{\text{Normal Volume}} \]
This rate is then applied to the actual activity incurred to assign overhead costs to products or services. Using the budgeted volume helps smooth variances that could arise from fluctuating production levels.
By opting for a “normal” volume, businesses seek to:
- Avoid over- or under-absorbing overheads that can distort product cost and, consequently, profitability analysis.
- Allow for more stable and predictable cost allocation.
Examples of Normal Volume
Example 1: Manufacturing Plant
For a manufacturing plant, if the budgeted production volume for the year is set at 50,000 units, the normal volume used in calculating the overhead absorption rate would be 50,000 units.
Example 2: Service Industry
In a service industry, normal volume might be represented by labor hours. If 200,000 labor hours are budgeted for the next 6 months in a consultancy firm, then 200,000 hours would serve as the normal volume.
Frequently Asked Questions about Normal Volume
1. What is the purpose of using Normal Volume in absorption costing?
The primary purpose is to stabilize the overhead absorption rate, ensuring that overhead costs are fairly allocated across produced units, minimizing distortions due to fluctuating production levels.
2. Is Normal Volume the same as Practical Capacity?
No, while Normal Volume refers to the expected volume of production used for budgeting purposes, Practical Capacity is the maximum output that could theoretically be achieved if the plant were in continuous operation, with allowances for regular stoppages and maintenance.
3. How is Normal Volume determined?
Normal Volume is usually determined from historic production data, adjusted for expected changes. It is often derived in collaboration between financial and production managers during the budgeting process.
4. What happens if actual production deviates from the Normal Volume?
Deviations can lead to over-absorption (too much overhead cost allocated) or under-absorption (too little overhead cost allocated), which subsequently may have to be adjusted in the financial statements.
5. Can Normal Volume change throughout the year?
It can be revised during periodic reviews of the budget or in response to material changes in production expectations, but frequent changes are discouraged to maintain stability in the overhead absorption rate.
Related Terms with Definitions
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Overhead Absorption Rate: This is the rate at which overhead costs are allocated to products or services.
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Absorption Costing: A costing method that includes all manufacturing costs—direct materials, direct labor, and overhead—in the cost of a product.
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Budgeted Volume: The level of activity, such as production units or labor hours, that a company expects to achieve during a specific period, often derived from past performance and future expectations.
Online References
- Investopedia - Absorption Costing
- The Balance - Introduction to Absorption Costing
- AccountingTools - Overhead Absorption
Suggested Books for Further Studies
- “Cost Accounting: A Managerial Emphasis” by Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan.
- “Principles of Cost Accounting” by Edward J. Vanderbeck and Maria R. Mitchell.
- “Management and Cost Accounting” by Alnoor Bhimani, Charles T. Horngren, Srikant M. Datar, and George Foster.
Accounting Basics: “Normal Volume” Fundamentals Quiz
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