The Difference Between Normal Costing and Standard Costing

One of my goals here at Accounting Solver is to demystify accounting terminology. Today we’re looking at costing terms used in manufacturing accounting: standard costing and normal costing.

Components of Manufacturing Cost

Before we get into the difference between normal and standard costing, a review of the components of manufacturing costs is in order. It’s crucial to get a good cost number so that a you know if you’re making a profit.

Manufactured products contain the following costs:

• materials
• direct labor
• manufacturing overhead (based on a predetermined rate)

Tracking these costs from acquisition through the manufacturing process is known as costing and there different methods to do that. One way is to value everything at the actual costs incurred and leave it at that. However, in this article we’re looking at two variations: normal costing and standard costing.

Normal Costing

Normal costing values manufactured products using the costs of the actual components used in production. These costs together make up the product cost, which is used as Cost of Goods Sold (COGS) and for inventory valuation. Differences between the overhead costs assigned to products and actual overhead costs are called variances. Small variances are usually assigned to the cost of goods sold, and large variances are often distributed among the COGS, the Work in Process, and the finished goods inventory accounts.

Standard Costing

Whereas normal costing uses actual costs (or as close as can be determined), standard costing values manufactured products using predetermined costs and rates for materials, direct labor, and manufacturing overhead. These standard costs are used to come up with COGS and to value inventories. If the actual costs vary only slightly from the standard costs, the resulting variances will be assigned to the cost of goods sold. If the variances are significant, they should be prorated to the cost of goods sold and to the inventories.

Standard costing takes the idea of applying a predetermined overhead rate and extends it to materials and direct labor as well. Therefore the variances provide different information to management.

Why Use Standard Costing?

There are several reasons for using a standard costing system:

1. Cost Control: A standard costing system records budgeted amounts through work-in-process, finished goods, and COGS accounts as well as actual costs incurred. The difference between budget and actual costs provides vital information about cost control. In a standard costing system the general ledger tracks the information necessary to provide detailed performance reports showing cost variances.

2. Smoothing out short-term fluctuations in direct costs: When direct costs are averaged, it can give a better picture of the overall business. Differences in costs of materials from various suppliers for example are not reflected in the COGS under standard costing.

As accounting programs become more sophisticated and the cost comes down, more and more highly detailed and real time information is available. Management’s challenge is to choose the system that provides the right information to enable the best business decisions.

Image Credit: sveeta, Flickr