Normal Costing vs. Actual Costing

Instructor: James Walsh

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

Both actual and normal costing methods use actual amounts for direct material and labor costs. The difference is in how the overhead is allocated to each item produced. This lesson will walk you through an example to illustrate both methods.

The Production Process

Fred runs a furniture manufacturing facility in the southern US. He is trying to get a better handle on his production costs. The three cost components of making furniture are:

  1. Direct Materials cost, which is the cost of the wood, cloth, screws and miscellaneous attachments used to make the furniture.
  2. Direct Labor cost, which is the amount of wages he pays his employees to make the furniture.
  3. Overhead, which is the cost of all the other expenses that need to be paid to keep the factory running. That expense includes light and heat bills, security, janitorial, air conditioning and his own salary, plus that of the plant supervisors. That can sure add up to a lot!

The process of costing attaches these costs to items of furniture so that Fred knows exactly what it cost to make them. He needs this information so he can decide on a fair price to charge customers, as well as prepare accurate financial statements.

Let's cost out one of Fred's everyday furniture sets under both methods and see how they differ.

This table and chairs set costs different amounts to make, depending on the costing method.
Table and chairs

Actual Costing

Fred started out using actual costing when his business was small. Actual costing uses actual amounts for the direct materials and labor. Fred has no problem with that since those amounts vary based on actual work done. He allocates the overhead to products based on current information for each overhead item. So if his overhead totaled $45,000 and his shop crew worked 3,000 hours, he would allocate $45,000 / 3,000 or $15 per labor hour worked to each piece of furniture to cover the overhead. That is his overhead allocation rate. His actual cost to produce a piece of furniture is:

Actual cost = Direct Materials cost + Direct Labor cost + Allocated Overhead (labor hours * actual overhead allocation rate).

Fred's bestselling table and chairs set uses $125 worth of materials and 3 direct labor hours to assemble at a cost of $25 per hour. His actual cost for making the table and chairs is $125 + (3 *$25) + (3*$15) = $245.

Problems with Actual Costing

While what he did looks okay, Fred knows there will be problems. He knows that his monthly overhead can change a lot from month to month. His summer air conditioning bills cause it to go way up and that will increase his actual overhead rate quite a bit. Fred knows that will make his costs rise and he really can't charge his customers more in the summer just because they use a lot of air conditioning! He also knows that if he uses actual costing in his financial statements that his income will look like a roller coaster from month to month because of changes in overhead. He wonders what he can do to smooth things out.

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