Normal Costing System and Product Costs

A normal costing system is used to determine production costs. Production costs consist of both direct costs such as production labor and materials, and indirect costs such as manufacturing overhead allocated to production and absorbed in the total cost of the product.

Normal Costing vs Actual Costing

Both normal costing and actual costing systems use actual prices and quantities to calculate direct costs. The difference between the two systems is that the normal costing system uses standard overhead absorption rates based on the overhead budget, instead of actual overhead rates.

The table below summarizes the differences between the normal costing system and an actual cost system.

Normal Costing vs Standard Costing

As we have seen above the normal costing system uses actual quantities and prices for direct costs and actual quantities and standard rates for overheads. This is in contrast to a standard system which uses standard quantities, prices, and overhead rates throughout.

Additionally the table below summarizes the differences between the normal costing system and the standard cost system.

Normal Costing Example

To Illustrate, suppose a manufacturing business absorbs overhead based on direct labor hours and budgets total overhead of 75,000 and direct labor hours of 25,000 for an accounting period.

Standard Overhead Rate

The calculation of the standard overhead rate for use in the normal costing system is as follows.

Standard rate = Budgeted overhead / Budgeted hours
Standard rate = 75,000 / 25,000 = 3.00

Assume a job actually uses 100 machine hours and has an actual direct material cost of 240, and an actual direct labor cost of 570. In this case the total production cost is calculated using the normal costing formula as follows.

Normal Cost

Normal cost = Actual material cost + Actual labor cost + Actual labor hours x Standard overhead rate
Normal cost = 240 + 570 + 100 x 3.00
Normal cost = 1,110

If the actual overheads for the business were 87,000 instead of the budgeted 75,000, and actual labor hours used were 21,750 instead of the budgeted 25,000, then the actual overhead rate is:

Actual Overhead Rate

Actual rate = Actual overhead / Actual hours
Actual rate = 87,000 / 21,750 = 4.00

And the actual cost of production is calculated as follows.

Actual Cost

Actual cost = Actual material cost + Actual labor cost + Actual labor hours x Actual overhead rate
Actual cost = 240 + 570 + 100 x 4.00
Actual cost = 1,210

Treatment of Normal Costing Variances

In the above example there was a difference of 100 (1,210 – 1,110) between the overhead allocated by the normal costing system and the actual overhead. Any under or over absorption of overhead is treated in a similar manner to that found in standard cost variance analysis and either included in cost of goods sold or if significant allocated between the cost of goods sold and the inventory of the business.

Reasons for Using a Normal Absorption Costing System

As we have seen above, the normal costing system uses both actual and standard costs and therefore in terms of accuracy, sits somewhere between the actual and standard cost systems.

Under the system the direct costs are based on actual costs and the overheads are based on actual quantities at a standard rate. By using the standard rate, which is effectively fixed, the product cost is not subject to sudden variations throughout the accounting period. This allows the business to base decisions such as product pricing, on stable product costs.

In addition, providing the actual direct costs are known, use of the normal cost system allows the product costs to be reported as soon as a job is complete rather having to wait until all actual overheads have been accumulated and allocated.