Normal Costing

Definition

Normal costing is a method of assigning production costs to products that combines actual direct materials and direct labor costs with an estimated overhead rate for manufacturing overhead. This approach simplifies the costing process by using a predetermined overhead rate rather than tracking actual overhead costs, allowing companies to more easily estimate product costs during a specific accounting period. Normal costing is essential for job order costing systems and helps track work in process through job cost sheets.

5 Must Know Facts For Your Next Test

1. Normal costing uses a predetermined overhead rate, which is based on estimates, making it easier for businesses to apply overhead without waiting for actual costs to be known.
2. It helps in providing timely information about product costs, crucial for pricing decisions and financial reporting.
3. Normal costing is particularly useful in job order costing systems, as it allows for the tracking of costs for specific jobs or batches of products.
4. Any differences between applied and actual overhead are typically adjusted at the end of the accounting period through an over- or under-applied overhead account.
5. This method provides a consistent approach to costing that can improve budgeting and performance evaluation by using standard rates.

Review Questions

• How does normal costing facilitate decision-making in a job order costing system?
  • Normal costing aids decision-making by providing timely estimates of production costs using a predetermined overhead rate along with actual direct materials and labor costs. This combination allows managers to quickly assess the profitability of jobs and make informed pricing and production decisions without waiting for actual overhead costs to be determined. Additionally, it helps in identifying trends and variances in production costs, which can lead to better operational strategies.
• Discuss the impact of using a predetermined overhead rate on the accuracy of cost assignments in normal costing.
  • Using a predetermined overhead rate in normal costing impacts cost accuracy by streamlining the allocation process but can also lead to variances. While it simplifies cost assignment during a period, the reliance on estimates means that there may be discrepancies between applied and actual overhead. These variances are reconciled at the end of the period, but they can influence financial statements and decision-making if not carefully monitored, potentially affecting budget forecasts and operational assessments.
• Evaluate how normal costing contributes to effective inventory management within job order costing systems.
  • Normal costing enhances inventory management by providing a clear framework for tracking costs associated with work in process (WIP) and finished goods. By applying a consistent method of cost allocation through predetermined rates, businesses can maintain accurate records of inventory value and turnover rates. This clarity helps managers make informed decisions about production schedules, resource allocation, and financial planning, ultimately leading to better control over inventory levels and reduced carrying costs.

Related terms

Predetermined Overhead Rate: A rate calculated at the beginning of an accounting period to allocate manufacturing overhead costs to products based on estimated activity levels.

Job Order Costing:

A costing method that assigns costs to specific units or batches of products, allowing for precise tracking of production costs for each job.

Work in Process (WIP): An account that represents the total costs incurred for products that are in the production process but not yet completed.