Normal Overhead Rate

When accounting for inventory, product costs are divided into direct costs and indirect costs also known as overhead. Direct costs are those that relate directly to the formation of the product. Indirect costs are associated with other costs indirectly related to the product like the depreciation of a factory building.

Indirect costs are always semi-variable or fixed. This means the amount of indirect cost incurred per unit of product varies with the level of production. To solve this constant fluctuation depending on production levels when calculating, most manufacturers use a normal overhead rate.

Normal overhead rate is calculated by taking a normal volume of production and what the total indirect costs would be at that volume and then computing the normal indirect cost per unit from there. This amount is the normal overhead rate. The value of production is then consistently accessed by combining the direct material, labor costs and normal overhead. The result is a consistent amount per unit.

Using a normal overhead rate allows the gross margin per unit of sales to remain constant even if when the level of production varies. Although a level of consistency can assist in accounting, too great of a discrepancy is a violation of the conventional accounting practices.

When the difference in amounts are small, they are typically overlooked. However, if they are significant, the accountant should adjust the inventory value and the cost of sales to reflect the actual cost of units produced. Reverting away from the normal overhead rate in this case and returning to the use of the actual overhead costs is judicious.