Normal Costing: Definition, Example & Formula

Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

Normal costing is a fast and fairly accurate way to calculate production costs. This lesson will present the formula for normal costing and illustrate its use with an example.

Production Concepts

Paul is the plant manager at a Cars-a-Lot, a vehicle assembly plant. Assembling a vehicle takes three things.

1. direct material - all of the components of the vehicle, like the doors, seats and engine.
2. direct labor - the people on the line who attach the components to the frame of the vehicle.
3. overhead - everything else needed to keep the plant running, including electricity, janitorial services, security, property taxes, and Paul's own salary as well as that of the plant supervisors.

All three of these items cost something. The employees and overhead items need to be paid. The components of vehicles were all purchased for cash or on credit. Now Paul needs a way to attach those costs to the vehicles his plant produces. Otherwise he will never know what price to sell them for.

The Normal Costing Method

Cars-a-Lot uses normal costing to calculate the cost of production runs. The normal costing method uses the actual direct material and labor costs, while estimating the overhead costs. That way, Paul can use the actual wages he pays his employees and the actual costs of the components of a vehicle.

He will allocate the overhead costs based on a standard rate determined by the budget. First he adds up all of those overhead items, and divides that by the number of budgeted labor hours, which is his allocation base. The formula for standard rate looks like this:

For example, if Paul's plant has \$750,000 of budgeted overhead and 50,000 in budgeted labor hours, the rate is \$750,000 / 50,000 = \$15.00 per labor hour.

Normal Costing for a Production Run

Paul is assembling ten jumbo size trucks for a dealership in the Midwest. He is going to use the normal costing formula to calculate what it cost to produce them. The normal costing formula is:

Normal cost = Materials + Labor cost + (Labor hours * Overhead Rate)

Paul knows from his inventory costs that \$200,000 worth of direct materials are in those trucks. He also knows that it took 1,700 labor hours to assemble them for a labor cost of \$51,000. He uses a standard rate for overhead allocation of \$15 per labor hour that he calculated before. Now he is ready to plug the numbers into the formula.

• \$200,000 + \$51,000 + (1,700 * \$15.00) = \$276,500

Paul's assembly plant will be charged with \$276,500 in cost of goods sold for producing these vehicles. The dealership will add to that its own layers of cost for employee pay, sales commissions, and dealership profit, then come up with a suggested sales price for the vehicles.

The biggest advantage for normal costing is that it's a fairly accurate method if the budgeted numbers for the standard overhead rate are good. It uses a smoother longer term rate for overhead allocation rather than actual numbers, which can include large variation and spikes in price.

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