Normal costing is used to derive the cost of a product. This approach applies actual direct costs to a product, as well as a standard overhead rate. It includes the following components:
- Actual cost of materials
- Actual cost of labor
- A standard overhead rate that is applied using the product's actual usage of whatever allocation base is being used (such as direct labor hours or machine time)
If there is a difference between the standard overhead cost and the actual overhead cost, you can either charge the difference to the cost of goods sold (for smaller variances) or prorate the difference between the cost of goods sold and inventory.
Normal costing is designed to yield product costs that do not contain the sudden cost spikes that can occur when you use actual overhead costs; instead, it uses a smoother long-term estimated overhead rate.
It is acceptable under the generally accepted accounting principles and international financial reporting standards accounting frameworks to use normal costing to derive the cost of a product for financial reporting purposes.
Normal costing varies from standard costing, in that standard costing uses entirely predetermined costs for all aspects of a product, while normal costing uses actual costs for the materials and labor components.
For a more accurate view of the direction in which product costs are headed, it is better to use actual costs, since they match the current amount of actual overhead costs. Standard costs are the least usable from a management perspective, since the costs used may not equate to actual costs. The accuracy level of normal costs is between actual costs and standard costs.