What is the difference between normal costing and standard costing?

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The table below summarizes the differences between the normal costing system and an actual cost system. Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications.

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Under normal costing, only variable production costs – direct material and direct labor – are included in the cost of goods sold. The fixed manufacturing overhead costs assigned to production units remain as inventory until they are absorbed into unit product costs. If overheads exceed production, then rather than raising finished-goods inventories, a company will incur losses on its work-in-process (wip) inventories and product costs. This approach applies actual direct costs to a product, as well as a standard overhead rate.

1. If the variance is significant, it should be prorated to the cost of goods sold, the work-in-process inventory, and the finished goods inventory based on their amounts of applied overhead.
2. 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.
3. The three product costs are used for calculating the cost of goods sold and the cost of the various inventories.
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Assume that a manufacturer experiences an additional $200,000 in manufacturing overhead costs (air conditioning and other) in each of the months of June, July, and August. A similar costing system is normal costing, where the key difference is the use of a budgeted amount of overhead. Actual costing will result in a greater fluctuation in overhead allocations, since it is based on short-term costs that can unexpectedly spike or dip in size. Normal costing results in less fluctuation in overhead allocations, since it is based on long-term expectations for overhead costs. 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.

The calculation of the standard overhead rate for use in the normal costing system is as follows. Using normal costing, the company applies the manufacturing overhead to products at a rate of $22.50 per MH ($12,600,000/560,000 MH) throughout the year. It is not a product cost computer software program like the standard and normal costing systems. As shown above, normal costing results in an overhead rate that is uniform and realistic for all units manufactured during an accounting year.

Difference Between Actual Costing and Normal Costing

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A normal or absorption-costing system does not allocate manufacturing overhead costs; rather, these costs are added to the cost of goods sold as incurred. As a result, during periods in which manufacturing overhead costs exceed production volume, there is an accumulation of manufacturing overhead in the work-in-process and finished goods inventory accounts. 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. 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. Absorption costing is the process of including all manufacturing overhead cost in factory overhead at the end of a given accounting period.

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This is the simplest costing method available, requiring no pre-planning of standard costs. However, it can take longer to formulate a valuation for ending inventory and the cost of goods sold, since actual costs must be compiled and allocated. 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. 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.

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. Both normal costing and actual costing systems use actual prices customizing invoice title 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. 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.

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). An actual costing system is a product costing system that adds actual direct material, actual direct labor, and actual manufacturing overhead costs to the work-in-process inventory. Normal costing refers to a product costing system that adds actual direct material, actual direct labor, and applied manufacturing overhead costs to the work-in-process inventory. They are the actual cost of materials, the actual cost of labor, and the actual overhead costs incurred. Overhead costs are allocated using the actual quantity of the allocation base experienced during the reporting period.

Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year. 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. These standard costs are used to calculate the manufacturer’s cost of goods sold and inventories. Additionally the table below summarizes the differences between the normal costing system and the standard cost system.

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. 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. Thus, the key point in an actual costing system is that it only uses actual costs incurred and allocation bases experienced; it does not incorporate any budgeted amounts or standards.

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. If there is a difference between the total amount of overhead costs applied to the products and the total amount of actual overhead costs incurred, the difference is referred to as a variance. If the amount of the variance is not significant, it will usually be assigned to the cost of goods sold. If the variance is significant, it should be prorated to the cost of goods sold, the work-in-process inventory, and the finished goods inventory based on their amounts of applied overhead.

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