# 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 consisting of both variable and fixed overheads allocated to production and absorbed in the total cost of the product.

 Product Cost Direct labor and material Variable and fixed overhead

## 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 differences between the normal costing system and an actual costing system are summarized in the table below.

Actual vs Normal Costing Systems
System Direct labor and material Variable and fixed overhead
Actual AQ x AP AQ x AR
Normal AQ x AP AQ x SR
Variables used in the table
AQ = Actual quantity
AP = Actual price
AR = Actual overhead rate
SR = Standard overhead rate

## 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 costing system which uses standard quantities, prices, and overhead rates throughout.

The differences between the normal costing system and the standard costing system are summarized in the table below.

Standard vs Normal Costing System
System Direct labor and material Variable and fixed overhead
Standard SQ x SP SQ x SR
Normal AQ x AP AQ x SR
Variables used in the table
AQ = Actual quantity
AP = Actual price
AR = Actual overhead rate
SQ = Standard quantity
SP = Standard price
SR = Standard overhead rate

## Normal Costing Example

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.

The standard overhead rate for use in the normal costing system is calculated 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, the total production cost is calculated using the normal costing formula as follows.

```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 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 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 costing 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 costing 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 costing 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.

Normal Costing System and Product Costs February 2nd, 2017

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