Actual Costing vs Normal Costing: Which Costing Method is Best?

Determining the costs of production is a crucial aspect of running a manufacturing business. The costing method a company uses can significantly impact the valuation of inventory, cost of goods sold, and gross margins. Two of the most common costing methods are actual costing and normal costing. But which method is better for your business?

In this comprehensive guide we’ll cover everything you need to know about actual costing and normal costing including

• Definitions of each method
• Key differences between the two
• Pros and cons of each system
• Examples to illustrate the different systems
• Guidance on when to use each costing method

Let’s dive in!

What is Actual Costing?

Actual costing, also known as actual absorption costing, is a costing method that includes all actual manufacturing costs incurred during a period This includes

• Actual direct material costs
• Actual direct labor costs
• Actual manufacturing overhead costs

Under actual costing, the full actual costs of production are allocated to units produced. Total actual manufacturing costs for the period are divided by the number of units produced to derive a per unit product cost.

The key steps in actual costing are:

1. Identify all actual production costs
2. Divide costs into direct material, direct labor, and manufacturing overhead
3. Allocate overhead to production using an appropriate cost driver
4. Add up all actual production costs for the period
5. Divide total costs by units produced to get per unit product cost

A few key traits of actual costing:

• Uses actual costs, not budgets or standards
• Absorbs all manufacturing costs into product costs
• Can value inventory higher than normal costing

Let’s look at an example to see actual costing in action.

Example:

A company had the following actual production costs last month:

• Direct material: $50,000
• Direct labor: $20,000
• Manufacturing overhead: $30,000

Total production costs were $100,000.

The company produced 5,000 units last month.

Using actual costing, the per unit product cost is:

Total costs / Units produced

$100,000 / 5,000 units = $20 per unit

The $20 per unit cost would be applied to value inventory and cost of goods sold.

What is Normal Costing?

Normal costing, also known as variable costing, is an alternative to actual costing. Under normal costing, only direct material and direct labor costs are included in product costs. Manufacturing overhead is treated as a period expense in the period incurred.

The key steps in normal costing are:

1. Identify total production costs
2. Separate into variable costs (direct material, direct labor) and fixed overhead
3. Include variable costs in product costs
4. Treat fixed overhead as a period expense

Some key traits of normal costing:

• Product costs include only variable costs
• Fixed overhead is expensed immediately
• Inventory valuations tend to be lower

Here is an example of normal costing:

Example:

Using the same production data from the actual costing example:

• Direct material: $50,000
• Direct labor: $20,000
• Overhead: $30,000

Under normal costing:

• Product costs = direct material + direct labor
  = $50,000 + $20,000 = $70,000

• Overhead of $30,000 is expensed in the period

With 5,000 units produced, the per unit cost is:

Product costs / Units produced

$70,000 / 5,000 units = $14 per unit

As you can see, the per unit cost is lower under normal costing since overhead is excluded.

Key Differences Between Actual and Normal Costing

Now that we’ve defined both methods, let’s recap the major differences:

• Actual costing absorbs all actual production costs into inventory
• Normal costing expenses fixed overhead costs immediately
• Actual costing increases inventory values compared to normal costing

Pros and Cons of Actual Costing

Pros of actual costing:

• Matches all costs of production to revenues generated in the same period. This adheres to the matching principle under GAAP.

• Avoids problems with under or over-applied overhead that can arise under normal costing. Overhead costs are fully absorbed.

Cons of actual costing:

• Can overstate inventory values on the balance sheet since all overhead is included in inventory costs, regardless of production volume.

• Reduces apparent profitability in periods of high production volume. More overhead gets absorbed compared to periods with low production.

• Allocating all overhead to production makes cost control difficult. Inefficiencies are not highlighted since all costs are absorbed.

Pros and Cons of Normal Costing

Pros of normal costing:

• Matches costs to production volume. Overhead is only absorbed up to the level of production activity.

• Highlights production inefficiencies. Unabsorbed overhead reflects inefficient use of fixed assets.

• Results in lower inventory valuations that can be more realistic.

Cons of normal costing:

• Violates the GAAP matching principle since overhead is expensed immediately.

• Requires adjusting entries at year-end to close under/over-applied overhead.

• Makes comparison between periods difficult since overhead costs fluctuate each period.

As you can see, each method has its own pros and cons. Choosing between actual and normal costing depends on your specific company and situation.

When Should You Use Each Costing Method?

So when should you use actual costing vs normal costing? Here are some general guidelines:

Use actual costing when:

• You want to adhere to GAAP matching principle
• Production volume is stable from period to period
• Your overhead costs are relatively fixed

Use normal costing when:

• You have wide swings in production volume
• You want to match costs closely to production volume
• Seeing unabsorbed overhead helps control costs

For example, actual costing tends to work better for companies with continuous production runs and minimal seasonal fluctuations.

Normal costing tends to be preferable for companies with large seasonal volume changes or cyclical production schedules.

However, keep in mind these are just general guidelines. Assess your specific company and industry to determine the best system for your operations.

Hybrid Costing System

Some companies use a hybrid costing system that combines aspects of both actual and normal costing. This allows them to get some of the benefits of both methods.

A hybrid system will typically:

• Use normal costing during the year
• Make adjusting entries at year-end to absorb over/under-applied overhead
• Report under both normal and actual costing methods

This provides more accurate product costing during the year based on activity levels. But the company still adheres to GAAP matching principles at year-end.

Implementing a New Costing Method

Changing your company’s costing method requires careful planning and execution. Here are some tips for successfully implementing actual or normal costing:

• Analyze production patterns and overhead behavior to model the impact
• phase-in the new method slowly over several periods to smooth the transition
• Communicate changes early to stakeholders and train accounting staff
• Review impact on key metrics like gross margin, inventory, and net income
• Get external auditors on board with approach before making the switch

Changing costing methods is like turning a massive ship – it requires patience and care to get it right. But the long-term benefits will be well worth the effort.

Key Takeaways on Actual vs Normal Costing

• Actual costing includes all manufacturing costs in product costs, while normal costing only includes direct material and labor.
• Actual costing adheres to GAAP matching principles but can overstate inventory. Normal costing expenses overhead immediately.
• For stable, continuous production actual costing is preferable. For variable production,