Normal cost

From CEOpedia | Management online

Normal cost is defined as the sum of actual direct materials cost, actual labour cost and other direct expense. They are called normal or regular cost and they arise in the normal conditions during the normal operations of the organization.

Normal cost is the term used to describe the annual cost of a pension or survivor plan. It is expressed as a percentage of payroll and represents the amount of money that should be set aside during employees' working years that, with investment earnings, will be sufficient to cover future benefit payments. It applies to future benefits being earned during current employment, not payments to current annuitants[1]

Actuarial Accrued Liability, Unfunded Actuarial Accrued Liability and Normal Cost

The three terms, (actuarial accrued liability, normal cost, and unfunded actuarial accrued liability) are central building blocks for actuarial analysis. The portion of the actuarial present value of future benefits that is allocated the year following each valuation is the plan's normal cost. The actuarial accrued liability is the value of the costs that have accrued to date, as determined at each actuarial valuation. The excess of the actuarial accrued liability over the plan's actuarial assets is the unfunded actuarial accrued liability, which represents the amount for which funds have not as yet been put aside to pay for promised benefits[2]

Normal Cost Methods

Actuaries are far more creative, however, than hand-held calculators. They can and perhaps sometimes do calculate normal cost on a level payment basis, but typically, they calculate payment size to vary over time in one of many possible shapes or patterns, each representing a different normal cost method[3]:

  • For most non-actuaries, payment patterns other than level payments are not often experienced, and so are unfamiliar. Level payments are the norm when financing a car, a house, and in fact in most business transactions. Exceptions in the non-actuarial world of finance are relatively rare, and maybe not fully parallel. As two examples of such exceptions, in a sale of a small business the payment amount is sometimes set at least partially as a function of profitability, and inflation-linked bonds pay out a fixed coupon plus the current inflation rate, a varying term.
  • But most of the normal cost methods in use by actuaries generate streams of notional payments that have no analogue whatsoever in conventional financing. The differences are in two dimensions, the first being that they sometimes aren't even calculated as if they were required to be present value equivalent to the present value of future benefit payments. The second is that the resulting shape of the periodic payment amounts over time is most often anything but level - there may be small payments with negative amortization in early years followed by larger payments in later years, as one very common example.
  • Three of the many commonly used normal cost allocation or payment methods are computed by looking at the benefit formulas to determine the accrued liability and then deriving the normal cost from it (not by computing the present value of the liability and then finding the payment stream that is equivalent to its value). These methods are said to be benefit prorated.

Examples of Normal cost

  • Actual direct materials cost: This refers to the actual cost of the raw materials that are used in the process of manufacturing a product. For example, the cost of steel, wood, plastic, or other materials used to make a product.
  • Actual labour cost: The actual cost of labor involved in manufacturing a product, such as wages, salaries, and benefits paid to the workers. For example, the cost of wages paid to the workers who are assembling a product.
  • Other direct expenses: This refers to other costs associated with the production process, such as shipping costs, machine maintenance costs, and energy costs. For example, the cost of fuel used to power the machinery used in the production process.

Advantages of Normal cost

Normal cost is an effective tool for organizations to track their costs, as it represents the actual expenditure on resources and services used in their operations. The advantages of normal cost include:

  • Accurate tracking of expenses: Normal cost provides an accurate representation of the amount spent on resources and services, which is essential for budgeting, forecasting, and resource allocation.
  • Easy comparison: Normal cost allows organizations to easily compare expenses from different departments, different times, and different locations to determine where best to allocate resources.
  • Flexibility: Normal cost is flexible and can be adjusted to accommodate changes in the organization’s operations or to account for changing market conditions.
  • Transparency: Normal cost is transparent and provides a clear picture of an organization’s costs, allowing for better decision-making.
  • Cost control: Normal cost provides a reliable way to track costs, which helps to control expenses and ensure that resources are allocated efficiently.

Limitations of Normal cost

Normal cost has some limitations that can be listed as following:

  • Normal cost may not include all the costs associated with a product or service. It typically does not include overhead costs, marketing costs, or other indirect expenses.
  • Normal cost does not take into account any special conditions or circumstances that may arise during the production process.
  • Normal cost does not take into account any external factors that may affect the cost of production, such as changes in the cost of raw materials, labor costs, or exchange rates.
  • Normal cost does not consider any non-standard activities that may be required to produce the product or service.
  • Normal cost does not account for any changes in the organization's cost structure over time, such as improvements in efficiency or technological advances.
  • Normal cost may not be an adequate representation of a company's true cost of production, as it doesn't take into account any unexpected costs, such as unanticipated repairs or problems that arise during the production process.

Other approaches related to Normal cost

Apart from the normal cost, there are several other approaches to consider when determining the cost of a product or service.

  • Standard Costing: Standard costing is the practice of substituting an expected cost for an actual cost in the accounting records. The expected cost is the standard cost, which is predetermined. It is a budgeted amount that is used for cost control and external financial statements.
  • Activity-Based Costing: Activity-based costing (ABC) is a system that assigns costs to products and services based on the activities that go into creating them. It is used to determine the cost of activities that are needed to produce goods or services.
  • Marginal Costing: Marginal costing is an accounting system where only variable costs are allocated to the product or service. It is used to analyze the effects of individual cost elements on the overall costs of a product or service.
  • Target Costing: Target costing is a cost management tool used in the product design process. It is used to determine the price of a product or service by setting a target cost and then working backwards to determine the design and production costs that must be met in order to achieve the target cost.

In summary, there are several approaches related to Normal cost, such as Standard Costing, Activity-Based Costing, Marginal Costing and Target Costing. Each of these approaches has its own distinct advantages and disadvantages, which should be taken into consideration when deciding which approach to use.

Footnotes

  1. ↑ M. T. Wrightson et al. 1998, p.5
  2. ↑ B. Barsook, Ch. E. Platten, C. A. Vendrillo 2019, p.98
  3. ↑ M. B. Waring 2011, p.82


Normal cost — recommended articles
Differential cost — Absorbed costs — Allocated cost — Incurred cost — Fixed cost — Irrelevant cost — Sum of years digits method — Direct labor cost — Cost per unit

References

Author: Katarzyna Siedlarczyk

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