Question

which method is better, standard costing or normal costing? Why?

if ABC is so accurate and important to firms, why does GAAP prohibit it's use in the preparation of the firms financial reports?

Answer 1

Normal costing method is better than standard costing. Normal costing uses actual materials and labor costs along with overhead allocated by labor hours times a budgeted overhead rate. The manufacturing overhead is based on a predetermined manufacturing overhead rate and as long as the overhead rate is good it is an accurate costing method and hence is used as a generally accepted accounting principle for the purpose of financial statement preparation. In case of standard costing manufactured products are valued with a predetermined materials cost, a predetermined direct labor cost, and a predetermined manufacturing overhead cost. Normal costing is better as it leads to an overhead rate that is more uniform and realistic for all of the units manufactured during an accounting year.

GAAP prohibits the use of ABC (activity based costing) for the purpose of preparation of a firm’s financial reports. This is because of the fact that product cost computed for external reports purposes must include all of the manufacturing costs and only manufacturing costs. However in case of ABC system product costs will exclude some manufacturing costs and will include some non-manufacturing costs. This is against the principles of GAAP and hence GAAP prohibits the use of ABC for the purpose of preparation of a firm’s financial reports.