Product costing is essential for businesses to determine expenses accurately and set pricing strategies. There are three main costing methods used in managerial accounting: Actual Costing, Normal Costing, and Standard Costing. Each method differs in how direct and indirect costs are assigned to products.
For detail pl review the post
- https://solbiztech.com/blog/sbt-blog-1/cost-classifications-explained-direct-indirect-fixed-and-variable-costs-in-managerial-accounting-17
- https://solbiztech.com/blog/sbt-blog-1/the-flow-of-costs-in-manufacturing-processes-documents-and-accounting-entries-19>
- https://solbiztech.com/blog/sbt-blog-1/product-cost-measurement-methods-a-comprehensive-guide-20
1. Actual Costing Method
Definition: The Actual Costing Method assigns costs to products based on actual direct materials, direct labor, and actual overhead incurred during production.
Characteristics:
- Uses real-time cost data.
- Overhead is allocated using actual overhead rates.
- Provides the most accurate cost information.
- Not ideal for companies with fluctuating costs.
Formula: Actual Cost Per Unit= (Actual Direct Materials+Actual Direct Labor+Actual Overhead ) /Total Units Produced
Example: A company manufactures 1,000 mobile phones in a month. The actual costs incurred are:
- Direct materials: 25,000
- Direct labor: 15,000
- Overhead: 10,000
Total actual cost = 50,000 Actual Cost Per Unit=50,000/1,000=50 per unit
Pros & Cons:
- ✅ Highly accurate as it reflects actual costs.
- ✅ Useful for analyzing cost fluctuations.
- ❌ Hard to use in real-time decision-making.
- ❌ Requires detailed tracking, making it time-consuming.
2. Normal Costing Method
Definition: The Normal Costing Method assigns actual costs for direct materials and direct labor but uses a predetermined overhead rate to allocate overhead costs.
Characteristics:
- Uses budgeted overhead rates instead of actual overhead.
- Helps in smooth cost planning despite fluctuations in indirect costs.
- Provides quicker cost estimates compared to actual costing.
Formula: Normal Cost Per Unit=(Actual Direct Materials+Actual Direct Labor+Applied Overhead) / Total Units Produced
Where: Applied Overhead=Predetermined Overhead Rate × Actual Activity Base
Example: A company produces 1,000 units of product and incurs:
- Direct materials: 25,000
- Direct labor: 15,000
- Predetermined overhead rate: 150% of direct labor cost.
Overhead applied = 150% × 15,000 = 22,500 Total normal cost = 25,000 + 15,000 + 22,500 = 62,500
Normal Cost Per Unit=62,500 / 1,000= 62.50 per unit
Pros & Cons:
- ✅ Faster than actual costing since overhead is estimated.
- ✅ More practical for budgeting and decision-making.
- ❌ Less accurate than actual costing, leading to overhead over-applied or under-applied adjustments.
3. Standard Costing Method
Definition: The Standard Costing Method assigns pre-determined standard costs to direct materials, direct labor, and overhead. These costs are based on past data, historical averages, or industry benchmarks.
Characteristics:
- Costs remain fixed until updated.
- Variance analysis helps compare actual costs vs. standard costs.
- Useful for performance evaluation and cost control.
Formula: Standard Cost Per Unit= (Standard Direct Materials+Standard Direct Labor+Standard Overhead) / Total Units Produced
Example: A company sets standard costs per unit for 1,000 units:
- Standard materials cost: 20 per unit
- Standard labor cost: 10 per unit
- Standard overhead cost: 15 per unit
Total standard cost per unit = 20 + 10 + 15 = 45 per unit
If actual costs exceed this, variance analysis identifies inefficiencies.
Pros & Cons:
- ✅ Efficient for setting budgets and controlling costs.
- ✅ Helps identify cost variances for corrective action.
- ❌ Can become inaccurate over time if not updated.
- ❌ Not suitable for customized production with variable costs.
Comparison of Costing Methods
| Criteria | Actual Costing | Normal Costing | Standard Costing |
|---|---|---|---|
| Overhead Allocation | Actual overhead | Estimated (pre-determined rate) | Pre-determined standard rate |
| Accuracy | Very High | Moderate | Low (without variance analysis) |
| Ease of Use | Time-consuming | Easier than actual | Easiest |
| Suitability | Small-scale or cost-sensitive businesses | Companies needing fast cost estimates | Large-scale manufacturing |
| Variance Analysis | No | Minor adjustments | Extensive variance analysis |
Final Thoughts
Choosing the right costing method depends on the business model, industry, and need for accuracy.
Author:
Mohsin Yaseen
On behalf of the SolBizTech Team
https://www.linkedin.com/in/rmyasin