IMPROVING TRADITIONAL COSTS

Traditional costing is the allocation of factory overhead to products based on the volume of
production resources consumed. Under this method, overhead is usually applied based on
either the amount of direct labor hours consumed or machine hours used. The trouble with
traditional costing is that factory overhead may be much higher than the basis of allocation,
so that a small change in the volume of resources consumed triggers a massive change in the
amount of overhead applied. This is a particularly common issue in highly automated
production environments, where factory overhead is quite large and direct labor is close to
nonexistent. Any systematic costing method that was used before the advent of activity-based
costing in the 1990s is classified as a traditional costing system today.

For example, a traditional costing calculation might find that factory overhead should be
charged to products at the rate of Rs 500 per direct labor hour, so if there is a slight change
in the production process that increases direct labor by one hour, the cost of the product has
just increased by Rs. 500 of overhead. Such a large change in applied overhead is
nonsensical, since there is not always a direct relationship between the volume of
production resources and factory overhead.

Activity-based costing was developed to circumvent this issue with traditional costing,
using a more detailed analysis of the relationship between overhead costs and cost-drivers.
Many cost-drivers may be used to create a more well-founded allocation of overhead costs.

Traditional costing still works well for financial statement reporting, where it is simply
intended to apply overhead to the number of produced units for the purpose of valuing
ending inventory. There is no consequence from a management decision-making
perspective. Since Traditional costing systems apply indirect costs to products based on a
predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as
a single pool of indirect costs. Traditional costing is optimal when indirect costs are low
compared to direct costs.

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TRADITIONAL COSTING

Traditional costing adds an average overhead rate to the direct costs of manufacturing products.
The overhead rate gets applied on the basis of a cost driver, such as number of labor hours
required to make a product.

Traditional costing adds an average overhead rate to the direct costs of manufacturing products
and is best used when the overhead of a company is low compared to the direct costs of
production. Activity-based costing identifies all of the specific overhead operations related to the
manufacture of each product.

Pros and Cons of Traditional Costing

 Traditional costing is best used when the overhead of a company is low compared to the
direct costs of production. It gives reasonably accurate cost figures when the production
volume is large, and changes in overhead costs do not create a substantial difference
when calculating the costs of production. Traditional costing methods are inexpensive to
implement.
 Companies usually use traditional costing for external reports, because it is simpler and
easier for outsiders to understand. However, it does not give managers an accurate picture
of product costs because the application of overhead burden rates is arbitrary and applied
equally to the cost of all products. Overhead costs are not allocated to the products that
actually consume the overhead activities.
 The traditional costing method is best used for manufacturers that only make a few
different products.
Activity-Based Costing ABC Costing Approach

Activity-based costing identifies all of the specific overhead operations related to the
manufacture of each product. Not all products require the support of all overhead costs, so it is
not reasonable to apply the same overhead costs to all products.

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Accountants created the ABC method to solve the problems of inaccuracy that result from the
traditional costing approach. Managers needed more accurate costing methods to determine
which profits were actually profitable and which were not.

A fundamental difference between traditional costing and ABC costing is that ABC methods
expand the number of indirect cost pools that can be allocated to specific products. The
traditional method takes one pool of a company's total overhead costs to allocate universally to
all products.

Pros and Cons of Activity-Based Costing

 Activity-based costing is the most accurate, but it is also the most difficult and costly to
implement. It is more suited to businesses with high overhead costs that manufacture
products, rather than companies that offer services. Companies that manufacture a large
number of different products prefer an activity-based system because it gives more
accurate costs of each product. With activity-based allocation of overhead costs, it is
easier to identify areas where expenses are being wasted on unprofitable products.

Deciding between traditional or activity-based costing is not easy. It depends on the purpose of
the reporting and information. Managers need accurate product costs and prefer to use an
activity-based accounting system. Even though this system is costlier, it provides better
information that will enable managers to make more profitable decisions in the long-term.

For external reporting, companies still use the traditional costing system, but it is becoming
obsolete as outsiders demand more accurate information about businesses.

Advantages and Disadvantages of Traditional Costing System

The traditional costing system in accounting is the allocation of factory overhead to products
which is based on the volume of consumed production resources. Companies using this method
will apply overhead to either the number of machine hours used or the direct labor hours which
were consumed.

Under traditional costing, one would add an average overhead rate to the direct costs of
manufacturing goods or providing services. It is applied on the basis of cost driving, reflecting
what is required to produce finished products.

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Many companies are transitioning away from this accounting option because its accuracy is
dependent upon direct costs being high and indirect costs being low. If you’re thinking about
moving away from the traditional costing system, there here are its advantages and disadvantages
to consider first.

Advantages of the Traditional Costing System

1. It offers accurate cost figures with large production volumes.

The traditional costing system is best used when an organization has low overhead costs
compared to the direct production costs they pay. When volumes are large and overhead costs
don’t create a significant difference when calculating costs, then it provides an accurate figure
that can then be added as a rate to the finished goods or services.

2. It is cheap to implement.
There are no fancy calculations or forms required to determine the average overhead rate under
the traditional costing system. All it calculate the amount of time it takes to produce a specific
product or provide a unique service. Then the average rate of labor or machine use costs per
hour, multiplying it by the length of time necessary to create saleable goods and services.

3. It creates reports which are easier to understand.

If you’re trying to determine what goods or services offer the best profit ratios for an
organization, outsiders will prefer to use the traditional costing system. The reports generated by
this calculation are often easier to read and understand because it puts everything into a dollars
and cents category. For investors, employees, or other interested parties, the traditional costing
system makes it possible to understand some of the basics of a company’s financial picture.
Activity-based costing cannot be accurately used for external reports because of the multiple
activity rates involved.

4. It is still able to tract all direct costs.

Traditional costing might not offer the specificity of activity-based costing, but it still offers the
ability to trace out direct costs. Anything that is related to a specific product, including direct

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labor and materials, is included with this information. It follows GAAP principles to offer a
reasonably analysis of production costs when an organization is producing a handful of products
or services to their targeted demographics.

5. It applies one rate to the entire system.

The reason why the traditional costing system was developed in the first place was that it could
quickly accommodate the high cost of machine or human labor into the finished products being
offered. Instead of incorporating multiple costs that must be calculated to determine an outcome,
this system utilized one rate for overhead allocation which applies to the entire business
operation. That means accounting department needs to run only one set of books, unlike activity-
based costing, which must run two sets of books.

6. It keeps workers more productive.

If a company uses an activity-based costing system, then their workers are forced to take the time
to assign costs each day. The accounting department will spend several hours per week assigning
costs to the various products or services offered.

For eg. Imagine having 15 cost activities, called pools, with rates that must be assigned to 200
different products. With the traditional costing method, one might use estimates more often, but
there are fewer cost assignment procedures which must be completed.

7. It streamlines the accounting process.

Imagine that a company produces only one product. Financial department track all of the
activities which create overhead costs to find specific data patterns. At the end of the day,
however, all of the costs will still fall into an overhead category which will be assigned to that
one product that is produced. By using the traditional costing method, it is able to streamline that
process to keep details reasonably accurate without boosting labor costs to reach that number.

8. More than one different costing approach is used.

Under the traditional costing system, there are multiple approaches to consider when looking for
the best option to convey information about cost. It includes volume-based costing, the French

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cost accounting approach, and planned marginal cost accounting. Each specific system offers
advantages and disadvantages to consider, based on the structure of the organization and the
number of products which are offered.

Disadvantages of the Traditional Costing System

1. It offers limited accuracy, even in the best of situations.

Traditional costing may work when there are a handful of products being manufactured with low
overhead costs. It does not offer the same accuracy when trying to look at the actual expenses
that are incurred by an organization. It tends to distort the actual expense, looking at the
profitability of products or services by arbitrarily assigning costs for all activities instead of
considering the cost of each action required to bring the product to sale.

2. It wants to ignore unexpected circumstances.

Any unanticipated expenses are ignored when the traditional costing system is used. That is
because the overall average is factored into the product. It may cost an organization more to
manufacture goods or provide services after the first projections are made, and there is no way
for this accounting system to take that into account. When companies dig into their raw figures
for detailed data, they might find that their products or services earned a lot less (or a lot more)
than they anticipated at the end of the year.

3. It isn’t always a helpful system.

The traditional costing system does not show enough specifics to identify where waste might be
occurring within the system. The indirect costs of manufacturing products or providing services
are not accounted for under this system. It only looks at the overhead costs in general, ignoring
the specifics for the overall number. For that reason, some organizations prefer to use activity-
based costing if they suspect that there are cost-cutting measures that could be implemented.

4. Its simplicity may be too simple.

The modern business must analyze non-manufacturing costs as part of their overall accounting
process. It must evaluate the vast variety of expenses that are associated with an offer of

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numerous products or services. But the information cannot be received from the traditional
costing system. Although the calculations are easy, and the information is easy to convey to
others, the overall lack of data is limiting to organizations which offer numerous items for sale.

5. It does not account for non-manufacturing costs.

When the cost of producing goods or services are observed today, there are numerous costs
which must be paid that do not apply to the production cycle. The traditional costing system
wouldn’t look at marketing, sales, or outreach costs because those occur after the manufacturing
process. If those costs are high, then this system might indicate profitability for a company when
none exists. Its failure to analyze non-manufacturing costs is one of its greatest weaknesses.

The advantages and disadvantages of traditional costing system reveals that its strengths are
found in its simplicity. The rate calculations are straightforward, understood by others, and
inexpensive to determine. Up until the 1980s, this system was viewed as being an accurate
option to use. With a shift to online marketplaces and the speed of modern business, however,
the disadvantages of this system show it may have limited applications.

Activity Based Costing Costing vs Traditional Costing

In the field of accounting, activity-based costing and traditional costing are two different
methods for allocating indirect (overhead) costs to products.
Both methods estimate overhead costs related to production and then assign these costs to
products based on a cost-driver rate. The differences are in the accuracy and complexity of the
two methods. Traditional costing is more simplistic and less accurate than ABC, and typically
assigns overhead costs to products based on an arbitrary average rate. ABC is more complex and
more accurate than traditional costing. This method first assigns indirect costs to activities and
then assigns the costs to products based on the products’ usage of the activitie
Traditional Costing Method
Traditional costing systems apply indirect costs to products based on a predetermined overhead
rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect

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costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There
are several steps in the traditional costing process, including the following:
1. Identify indirect costs.
2. Estimate indirect costs for the appropriate period (month, quarter, year).
3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).
4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter,
etc.).
5. Compute the predetermined overhead rate (see below).
6. Apply overhead to products using the predetermined overhead rate.
Predetermined Overhead Rate Calculation

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver

Amount
For example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

Activity-Based Costing Benefits

Activity based costing systems are more accurate than traditional costing systems. This is
because they provide a more precise breakdown of indirect costs. However, ABC systems are
more complex and more costly to implement. The leap from traditional costing to activity based
costing is difficult.