Normal Costing
Normal costing is a method used in cost accounting where the actual costs of direct materials and direct labor are used, but overhead costs are estimated using a predetermined overhead rate.
In other words, normal costing uses a mix of actual costs and estimated costs:
- Direct Materials: These are the actual costs of the materials directly used in the production of goods.
- Direct Labor: These are the actual wages and other labor costs directly associated with the production of goods.
- Overhead: These are estimated or indirect costs associated with production, such as utilities, depreciation, and maintenance. The overhead is usually applied based on a certain activity driver, like direct labor hours or machine hours.
The term “normal” in normal costing refers to the normal or average rate at which overhead costs are applied.
This method provides a balance between precise cost tracking (using actual costs for direct materials and labor) and practicality (using estimated overhead rates, which would be too time-consuming and costly to track in detail). Normal costing is often used in situations where overhead costs fluctuate, making it difficult to assign exact overhead costs to each unit of production.
Example of Normal Costing
Let’s consider a fictional company, “ABC Furniture Co.” that manufactures tables. The company uses normal costing in its cost accounting practices. Here’s how it might look:
- Direct Materials: ABC Furniture Co. uses actual costs for its direct materials. If it uses $50 worth of wood to produce each table, this $50 is the actual direct materials cost per table.
- Direct Labor: ABC Furniture Co. also uses actual costs for direct labor. If it pays its workers $20 in wages for the time spent to produce each table, this $20 is the actual direct labor cost per table.
- Overhead: Let’s say ABC Furniture Co. estimates its overhead costs based on machine hours. If it costs the company ,000 per month to run the machinery for 2,000 hours, the predetermined overhead rate would be ,000 / 2,000 hours = $5 per machine hour. If each table takes 2 hours of machine time to produce, the overhead cost assigned to each table would be $5/hour x 2 hours = $10.
So, using normal costing, the total cost of producing each table (cost per unit) for ABC Furniture Co. would be:
- Direct Materials: $50
- Direct Labor: $20
- Overhead: $10
Total cost per unit = $50 (direct materials) + $20 (direct labor) + $10 (overhead) = $80 per table.
Thus, using normal costing, ABC Furniture Co. would estimate that it costs $80 to produce each table. This cost includes both actual costs (direct materials and labor) and an estimate for overhead costs based on a predetermined overhead rate.
