Normal costing definition
/What is Normal Costing?
Normal costing is used to derive the cost of a product. This approach applies actual direct costs to a product, as well as a standard overhead rate. It includes the actual cost of materials, the actual cost of labor, and a standard overhead rate that is applied using the product's actual usage of whatever allocation base is being used (such as direct labor hours or machine time).
If there is a difference between the standard overhead cost and the actual overhead cost, you can either charge the difference to the cost of goods sold (for smaller variances) or prorate the difference between the cost of goods sold and inventory.
When to Use Normal Costing
Normal costing is designed to yield product costs that do not contain the sudden cost spikes that can occur when actual overhead costs are used; instead, it uses a smoother long-term estimated overhead rate.
It is acceptable under the generally accepted accounting principles and international financial reporting standards accounting frameworks to use normal costing to derive the cost of a product for financial reporting purposes.
Example of Normal Costing
As an example of normal costing, Everly Brothers is a bidet manufacturer that produces a low-slung and high version of its signature product. By using normal costing, Everly can budget for the production cost of these bidets next year, using the per-unit factory overhead costs incurred in the current year.
In the current year, Everly has produced 5,000 low-slung bidets and 2,000 high bidets. The overhead costs per unit are $20 for a low-slung unit and $15 for a high unit. This results in the following total factory overhead costs in the current year:
(5,000 units x $20) + (2,000 units x $15) = $130,000
The material costs for these products are $50 for the low-slung units and $60 for the high units, while the associated labor costs are $10 for the low-slung units and $12 for the high units.
To calculate the total normal costs of these units, Everly’s accountant combines all overhead, materials, and labor costs, which are as follows:
($100,000 overhead + $250,000 materials + $50,000 labor) = $400,000 low-clung bidet cost
($30,000 overhead + $120,000 materials + $24,000 labor) = $174,000 high bidet cost
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Normal Costing vs. Standard Costing
Normal costing varies from standard costing, in that standard costing uses entirely predetermined costs for all aspects of a product, while normal costing uses actual costs for the materials and labor components.
For a more accurate view of the direction in which product costs are headed, it is better to use actual costs, since they match the current amount of actual overhead costs. Standard costs are the least usable from a management perspective, since the costs used may not equate to actual costs. The accuracy level of normal costs is between actual costs and standard costs.