What is the difference between standard costing and normal costing?

Standard vs. Normal Costing: Navigating the World of Manufacturing Costs

In the dynamic world of manufacturing, accurately tracking costs is crucial for pricing, budgeting, and ultimately, profitability. Companies utilize various costing methods to achieve this, and two of the most prevalent are normal costing and standard costing. While both aim to provide a clear picture of production expenses, they differ significantly in their approach and the degree to which they rely on actual versus estimated data.

Normal Costing: A Hybrid Approach

Normal costing can be understood as a “middle ground” between purely actual and completely predetermined costing methods. It seeks to incorporate a degree of realism by tracking the actual costs of direct materials and direct labor. Think of it as meticulously recording the exact amount spent on raw materials like steel or wood, and accurately tallying the wages paid to the factory workers.

However, the crucial difference lies in the treatment of overhead costs. Instead of meticulously tracking every utility bill, depreciation expense, or supervisor salary on a real-time basis, normal costing utilizes a predetermined overhead rate. This rate is calculated in advance, usually at the beginning of the accounting period, based on an estimated level of activity (e.g., machine hours, direct labor hours). The overhead is then applied to the products based on this predetermined rate.

Why use a predetermined overhead rate?

Directly assigning actual overhead costs to individual products is often cumbersome, impractical, and can lead to fluctuating cost figures. Imagine a factory experiencing a spike in electricity bills due to extreme weather. Attributing that single, anomalous cost directly to the products manufactured during that period would unfairly skew their perceived cost. A predetermined rate smooths out these fluctuations, providing a more stable and predictable cost picture.

Standard Costing: Setting the Bar High

Standard costing, on the other hand, takes a far more proactive approach. It involves setting predetermined “standards” for all costs, including direct materials, direct labor, and overhead. These standards represent the expected cost per unit based on careful analysis and best-practice scenarios.

Essentially, standard costing establishes a “perfect world” benchmark for each cost element. For direct materials, this might be the expected price per unit and the standard quantity needed for each product. For direct labor, it could be the standard wage rate per hour and the standard time required to complete a specific task. And for overhead, it’s a predetermined rate based on an ideal level of activity.

The Power of Variance Analysis

The real strength of standard costing lies in its ability to facilitate variance analysis. By comparing actual costs to these pre-established standards, companies can identify deviations (variances) and investigate the reasons behind them. Were material prices higher than expected? Did employees take longer than anticipated to complete tasks? Did overhead costs exceed the budgeted amount?

Analyzing these variances allows management to pinpoint inefficiencies, identify areas for improvement, and ultimately, enhance cost control. It’s a proactive tool for identifying and addressing problems before they significantly impact profitability.

Choosing the Right Approach: A Matter of Needs and Resources

The decision to employ normal costing or standard costing hinges on a company’s specific needs, resources, and operational complexity.

• Normal costing is generally easier to implement and maintain, requiring less upfront analysis and ongoing monitoring. It’s often favored by smaller businesses or companies with less sophisticated accounting systems.

• Standard costing demands a more significant investment in analysis and system development. It’s best suited for larger organizations with more complex operations and a strong emphasis on cost control and continuous improvement. It provides valuable insights for planning, budgeting, and performance evaluation.

In Summary:

Ultimately, understanding the differences between normal and standard costing is crucial for businesses seeking to optimize their cost accounting practices. The choice between these methods depends on a careful evaluation of the company’s specific needs and the resources available to implement and maintain the chosen system. By aligning the costing method with their strategic objectives, companies can gain a clearer understanding of their costs, improve decision-making, and enhance their overall profitability.