Actual Costing vs Normal Costing: Making Informed Decisions in Manufacturing Business

This method lets you track every variation in expenses that affect the final cost of each unit. Direct materials refer to the raw materials or components directly used in manufacturing. Direct labor encompasses the wages and benefits paid to the workers directly involved in producing the goods or providing the services.

normal costing vs actual costing

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Head To Head Comparison Between Standard Cost vs Actual Cost (Infographics)

In high volume production of standard parts, standard costing still rules. In lot-controlled environments manual issues are the norm for inventory control. Problems can arise in actual costing when the margins on jobs are relied on too heavily. These actual costs are just the costs directly attributed to the job. These costs are never comprehensive of all costs for a business and in the best implementations represent gross margin at best. These systems must account for fixed overhead and normally this is just the standard application of overhead absorption costing—labor hours X work center overhead rate.

It is employed when your business manufactures bespoke products customized to specific customers instead of delivering standardized products. This implies that for every job order, you need to account for all the costs incurred for that specific order separately, ranging from direct raw materials and labor to overheads. Standard costs are the estimation of costs for predetermined products and arise from the units of material, labor and other production costs for a specific time period.

Example of How Actual Costing Provides Accurate Cost Information

Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs. Finance Strategists is a leading financial literacy non-profit organization priding itself on providing accurate and reliable financial information to millions of readers each year. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. Consultants and software vendors often use this oversimplification to sell automated purchasing software that promises to increase the number of purchase orders buyers can process each year. Logically, this attribution of cost makes complete sense, but most often, it presents an overly optimistic cost savings target that will never be achieved.

ABC costing provided interesting insights into the real drivers of indirect costs but has proved to be impractical to implement as an ongoing real-time costing system. Here, the estimated cost allocation base could be the estimated machine hours or labor hours. To avoid these estimation problems, the actual costing approach generally uses the number of hours spent on the job as a proxy to determine the overheads. Intuitively, this means that if a job takes 1 hour to complete and another takes 2 hours, then the job that took 2 hours will have twice the overhead. But let’s get a little more technical and dive into the mathematical formula for it. Nevertheless, if their extended normal costing method is based on realistic numbers, the average production cost over the year as a whole will work out to about $150.

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Even if this scenario is realized, the fixed costs of the purchasing department are not reduced and may even increase, due to software cost amortization or annual maintenance fees. If the number of purchase orders processed in a year remains static to the level before the software is implemented this fixed cost will not change or increase slightly on a per purchase order basis. Considering fixed costs can be 50% of total costs, the implied savings from the activity-based cost per purchase order estimate will never be realized. There are a lot of costing methods available for businesses to improve profit margin.

Actual costing is a method of cost allocation that involves tracking and assigning costs based on the actual expenses incurred during the production process. It provides a highly accurate measure of the true costs involved in manufacturing products or providing services. Unlike normal costing, which relies on estimates for allocating overhead, actual costing captures the exact costs of direct materials, direct labor, and overhead. To illustrate how normal costing allocates costs using predetermined rates, let’s consider the furniture manufacturing company mentioned earlier.