Many accountants reject the normal-volume notion and maintain that each year must .stand by itself; that is, each year's overhead must be applied to each year's production, written off as a loss, or both. This attitude arises from (a) the widespread conviction that the year is the key time period, and (b) adherence to the idea that overhead costs for a given year generally must cling or attach to the units produced during that year regardless of the relationship of that year's activity to average long-run activity.
A more convincing reason for using master-budget volume as a denominator is the overwhelming forecasting problem that accompanies the determination of normal volume'. Sales not only fluctuate cyclically but have trends over the long run. In effect, the use ol normal volume implies an unusual talent for accurate long-run forecasting. Many accountants and executives who reject the normal volume as a denorninator ciaim that the nature of their company's business precludes accurate forecasts beyond one year.
Where companies use normal volume, the objective is to choose a period long enough to average out sizable fluctuations in volume and to allow for trends in sales. The uniform rate for applying fixed overhead supposedly provides for "recovery" of fixed costs over the ions run. Companies expect that overapplications in some years will be offset by underapplications in other years.
Conceptually, when normal volume is the denominator, the yearly overapplied or underapplied overhead should be carried forward on the balance sheet. Practically, however, year-end balances are closed directiy to Income Summary, because the accounting profession (and the Internal Revenue Service) generally views the year as being the terminal time span for allocation olunderapplied or overapplied overhead.
Many managements want to keep running at full capacity, which really means practical capacitv. Their "normal volume" for applying fixed costs is "practical capacity"; anything less reduces profits and is undesirable. Where product costs are used as guides lor pricing, some managers say that this policy results in more competitive pricing, which maximizes truth volume and profits in good times and bad. Of course, profits also depend on lactors other than physical volume-for example, the elasticity of demand. The accounting effects of such a policy are lower unit costs for inventory purposes and the almost perpetual appearance of an unfavorable production volurne variance, sometimes described on the income statements as loss from idle capacity.
Using practical capacity as a denominator volume has become increasingly popular with American businesses. As indicated earlier, over 21 percent of the surveved companies prefer to use practical capacity. A major reason is probably the position of the internal Revenue Service, which forbids variable costing but per- mits using practical capacitv as a denominator volume in conjunction rvith absorption costing. As compared with normal volume or master-budget volume, the practical- capacity denominator volume results in the faster write-offs of fixed factory overhead as a tax deduction.
There is no requirement that American companies use the same denominator volumes for internal managernent purposes and for income-tax purposes. Nevertheless, the economies of recordkeeping often lead to the same accountiug for management and tax purposes.
A more convincing reason for using master-budget volume as a denominator is the overwhelming forecasting problem that accompanies the determination of normal volume'. Sales not only fluctuate cyclically but have trends over the long run. In effect, the use ol normal volume implies an unusual talent for accurate long-run forecasting. Many accountants and executives who reject the normal volume as a denorninator ciaim that the nature of their company's business precludes accurate forecasts beyond one year.
Where companies use normal volume, the objective is to choose a period long enough to average out sizable fluctuations in volume and to allow for trends in sales. The uniform rate for applying fixed overhead supposedly provides for "recovery" of fixed costs over the ions run. Companies expect that overapplications in some years will be offset by underapplications in other years.
Conceptually, when normal volume is the denominator, the yearly overapplied or underapplied overhead should be carried forward on the balance sheet. Practically, however, year-end balances are closed directiy to Income Summary, because the accounting profession (and the Internal Revenue Service) generally views the year as being the terminal time span for allocation olunderapplied or overapplied overhead.
Many managements want to keep running at full capacity, which really means practical capacitv. Their "normal volume" for applying fixed costs is "practical capacity"; anything less reduces profits and is undesirable. Where product costs are used as guides lor pricing, some managers say that this policy results in more competitive pricing, which maximizes truth volume and profits in good times and bad. Of course, profits also depend on lactors other than physical volume-for example, the elasticity of demand. The accounting effects of such a policy are lower unit costs for inventory purposes and the almost perpetual appearance of an unfavorable production volurne variance, sometimes described on the income statements as loss from idle capacity.
Using practical capacity as a denominator volume has become increasingly popular with American businesses. As indicated earlier, over 21 percent of the surveved companies prefer to use practical capacity. A major reason is probably the position of the internal Revenue Service, which forbids variable costing but per- mits using practical capacitv as a denominator volume in conjunction rvith absorption costing. As compared with normal volume or master-budget volume, the practical- capacity denominator volume results in the faster write-offs of fixed factory overhead as a tax deduction.
There is no requirement that American companies use the same denominator volumes for internal managernent purposes and for income-tax purposes. Nevertheless, the economies of recordkeeping often lead to the same accountiug for management and tax purposes.
