Manufacturing firms can use actual cost tracking or normal costing to account for production costs. With actual costing, the direct materials, direct labor and a portion of the actual factory overhead costs are used to calculate the total and per-unit manufacturing costs. Actual cost tracing is the dollars and cents spent to manufacture your goods. Normal costing actual direct materials and direct labor costs but uses a budgeted amount for factory overhead costs. While not as accurate as actual costing, normal costing will smooth out the unusual cost fluctuations that occur with actual costing.
Each individual cost component is tracked as the units move through the manufacturing process. As inventory is taken out of storage and placed on the production line, the quantity and cost of each item is calculated as an actual direct materials cost. The number of hours worked and the pay rate for each employee is used to calculate the direct labor cost. The actual factory overhead is calculated by tracking the indirect costs and dividing that amount by the actual number of units produced.
Tracking your costs involves calculating the actual costs of the direct materials, direct labor and factory overhead. For example, it takes $2 of direct materials and 4 labor hours at $10 per hour, or $40, to produce one completed unit at $42 per unit. The actual indirect costs are $1 per unit. Your total actual cost per unit is $43. If you produce 10,000 units, your actual manufacturing costs are 10,000 multiplied by $43, or $430,000.
Normal costing uses actual direct materials and direct labor costs, but adds budgeted factory overhead to track manufacturing costs. The budgeted factory overhead is calculated using your indirect costs and production estimates. Estimates are based on actual indirect costs and units produced from prior manufacturing runs. Since indirect costs like utilities, rent and depreciation remain fixed over time, normal costing can be used as a benchmark to monitor production costs.
Calculating the normal factory overhead rate uses the accounting data from prior periods. For example, the past two production run costs are $19,000 and $21,000, or $40,000. The actual units produced are 8,000 and 12,000, or 20,000. Divide the $40,000 costs by the 20,000 units produced to get your normal factory overhead cost of $2 per unit. If your actual direct materials are $5 per unit, the actual direct labor is $8 per unit and the normal factor overhead is $2 per unit, it costs you $15 to manufacture one unit. Since your normal costs remain fixed, any unusual price change is the result of higher direct materials or direct labor costs.