What is actual costing vs normal costing?

Actual Costing vs. Normal Costing: Understanding the Difference

In product costing, overhead allocation plays a crucial role in determining the total cost of production. Two distinct approaches exist: actual costing and normal costing, each utilizing different methods of overhead allocation.

Actual Costing

Actual costing allocates actual overhead costs incurred during a specific production period to the products produced during that period. This method provides a more accurate representation of the true cost of production, as it considers the actual amount of overhead incurred, regardless of whether it was underutilized or overutilized.

Advantages:

• Accurate reflection of actual production costs
• Eliminates the need for predetermined overhead rates
• Useful for short-term decision-making and performance evaluation

Disadvantages:

• Can be time-consuming and complex to implement
• May not provide consistent results from period to period due to fluctuations in overhead costs
• Requires accurate tracking of actual overhead costs

Normal Costing

Normal costing, on the other hand, utilizes predetermined overhead rates for cost assignment. This involves estimating the expected overhead costs for the upcoming period and dividing it by the expected production volume to arrive at an overhead rate per unit. The overhead rate is then multiplied by the actual production volume in each period to allocate overhead costs to the products.

Advantages:

• Simpler and less time-consuming to implement
• Provides more consistent results from period to period
• Can be used for longer-term planning and forecasting

Disadvantages:

• May not accurately reflect the actual cost of production due to variances between estimated and actual overhead costs
• Can lead to over or under allocation of overhead costs
• May not be appropriate for short-term decision-making

Choosing the Right Method

The choice between actual costing and normal costing depends on the specific needs of the business. For managers seeking a precise and accurate representation of production costs, actual costing is ideal. However, if consistency and simplicity are priorities, normal costing may be a better option.

In summary, actual costing uses actual overhead costs incurred to allocate overhead, while normal costing employs predetermined overhead rates. Each method has its own advantages and disadvantages, and the best choice for a business should be based on its specific requirements and objectives.