Normal Costing

In a normal cost system, direct materials and direct labor costs are applied to production differently from the way they are applied in standard costing. In normal costing, direct materials and direct labor costs are applied at their actual rates per unit of input multiplied by the actual amount of the direct inputs used for production.

To apply overhead to production, a normal cost system uses a predetermined manufacturing overhead application rate that is calculated the same way as the predetermined manufacturing overhead application rate is calculated under standard costing:

However, under normal costing, that predetermined overhead application rate is multiplied by the actual amount of the allocation base that was used in producing the product, whereas under standard costing, the predetermined rate is multiplied by the amount of the allocation base allowed for producing the product.

Furthermore, in a normal costing system, the predetermined manufacturing overhead application rate is called a normal rate or normalized rate.

Normal costing ⇒ is not appropriate in a process costing environment because it is too difficult to determine the actual costs of the specific direct materials and direct labor used for a specific production run. Process costing is used when many identical or similar units of a product or service are being manufactured, such as on an assembly line. Costs are accumulated by department or by process. In contrast, job costing accumulates costs and assigns them to specific jobs, customers, projects, or contracts. Job costing is used when units of a product or service are distinct and separately identifiable. Normal costing is used mainly in job costing.

The purpose of using a predetermined manufacturing overhead application rate in normal costing is to normalize factory overhead costs and avoid month-to-month fluctuations in cost per unit that would be caused by variations in actual overhead costs and actual production volume. It also makes current costs available, though at the budgeted rate rather than at the actual rate. If actual manufacturing overhead costs were used, those costs might not be known until well after the end of each reporting period, when all the invoices had been received.

Benefits of Normal Costing

• The use of normal costing avoids the fluctuations in cost per unit that occur under actual costing because of changes in the month-to-month volume of units produced and in month-to-month fluctuations in overhead costs.
• Manufacturing costs of a job are available earlier under a normal costing system than under an actual costing system.
• Normal costing allows management to keep direct product costs current because actual materials and labor costs incurred are used in costing the production, while the actual incurred overhead costs that would not be available until much later are applied based on a predetermined rate.

Limitations of Normal Costing

• Using a predetermined factory overhead rate to apply overhead cost to products can cause total overhead applied to the units produced to be greater than the actual overhead incurred when production is higher than expected; and overhead applied may be less than the amount incurred if actual production is lower than expected.
• Normal costing is not appropriate for process costing because the actual costs would be too difficult to trace to individual units produced, so it is used primarily for job costing