What Is Normal Costing & How Is It Calculated?
Explore normal costing, a strategic accounting approach that provides stable and timely product cost figures by uniquely treating indirect manufacturing expenses.
Normal costing is a method used in cost accounting to determine the cost of products or services. It provides a more stable and timely cost figure compared to approaches that rely solely on actual costs. Its primary purpose is to assign costs to products as they are manufactured, especially concerning manufacturing overhead, which often fluctuates significantly.
Understanding Cost Components in Normal Costing
Normal costing considers three main components when determining product costs: direct materials, direct labor, and manufacturing overhead. Direct materials are the raw goods that become a physical part of the finished product. These costs are directly traced to each product unit.
Direct labor refers to the wages and benefits paid to employees directly involved in production. Like direct materials, actual direct labor costs are traced and assigned to specific products.
Manufacturing overhead represents all indirect costs associated with production that cannot be easily traced to a specific product. These costs include factory rent, utilities, depreciation on factory equipment, indirect labor, and indirect materials. Assigning actual manufacturing overhead costs to individual products is challenging and time-consuming due to their indirect nature and variable occurrence. To address this, normal costing uses a predetermined overhead rate (POHR), an estimated rate calculated before the accounting period. This rate smooths out fluctuations in actual overhead costs, allowing timely product cost determination.
Calculating Product Costs with Normal Costing
Normal costing calculates product costs by integrating actual direct costs with estimated indirect costs. This begins with determining the predetermined overhead rate (POHR) at the start of an accounting period. The POHR is calculated by dividing the estimated total manufacturing overhead costs for the upcoming period by the estimated total amount of an activity base. Common activity bases include direct labor hours, machine hours, or direct labor dollars, as they drive overhead costs. For example, if a company estimates $500,000 in manufacturing overhead and 100,000 direct labor hours for the year, the POHR would be $5 per direct labor hour.
Once the predetermined overhead rate is established, manufacturing overhead can be applied to products as they are manufactured. This involves multiplying the POHR by the actual amount of the activity base consumed by each product or job. For instance, if a product requires 2 direct labor hours and the POHR is $5 per hour, $10 of manufacturing overhead would be applied to that product. This applied overhead is then added to the actual direct material costs and actual direct labor costs incurred for the product, resulting in its total normal cost. This allows for continuous and consistent product costing.
Because the predetermined overhead rate relies on estimates, the amount of overhead applied to products may differ from the actual overhead costs incurred. Overapplied overhead occurs when applied overhead exceeds actual overhead, while underapplied overhead means applied overhead is less than actual overhead. These differences are typically adjusted at the end of the accounting period. For immaterial amounts, the variance is often charged directly to the Cost of Goods Sold account. For more significant variances, the difference may be prorated among the Cost of Goods Sold, Work-in-Process Inventory, and Finished Goods Inventory accounts, to accurately reflect costs in financial statements.
Comparing Normal Costing to Other Approaches
Normal costing differs from other product costing methods, like actual and standard costing, in its treatment of manufacturing overhead. Actual costing uses actual costs for all three components: direct materials, direct labor, and manufacturing overhead. While actual costing provides precise historical cost information, it requires waiting until all actual overhead expenses are known, which can delay product costing and timely decision-making, if overhead costs fluctuate significantly. Normal costing overcomes this by applying estimated overhead, allowing more immediate and stable product cost determination.
In contrast, standard costing employs predetermined (standard) costs for all three cost components—direct materials, direct labor, and manufacturing overhead. Under standard costing, all costs are based on what they should be, rather than actual costs for direct materials and direct labor. Standard costing is used for performance evaluation and variance analysis, highlighting differences between actual and expected costs to signal areas for improvement. Normal costing, however, uses actual costs for direct materials and direct labor, offering a more accurate reflection of these direct inputs while providing timely product costs through estimated overhead application. The choice of costing method depends on a company’s operational characteristics and objectives for cost information, like timeliness, precision, or performance analysis.