Traditional costing definition
/What is Traditional Costing?
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. This approach has been used because it is relatively easy to track direct labor hours or machine hours - in essence, traditional costing applies overhead in a manner that is low-cost, rather than being an accurate reflection of the manner in which overhead is actually consumed.
Problems with Traditional Costing
There are several inherent problems with traditional costing, which are as follows:
Inaccurate cost allocations. Traditional costing typically allocates overhead based on a single cost driver, such as direct labor hours or machine hours. This approach assumes all overhead costs are proportional to the chosen cost driver, which is often not true. It does not account for the complexity of modern operations where multiple cost drivers might be at play, leading to over- or under-costing of products.
Distorted product costs. Products with high production volumes often get allocated more overhead than they actually consume, making them appear more expensive than they are. Conversely, low-volume or complex products may consume more overhead but are allocated less, leading to under-costing.
Lack of decision-making insight. The distorted overhead allocations resulting from a traditional costing system make it difficult to set competitive and profitable pricing.
Ignores non-manufacturing costs. Traditional costing focuses heavily on manufacturing costs (direct materials, direct labor, and overhead) and often neglects non-manufacturing costs, such as marketing, distribution, and customer service, which are increasingly significant.
Inflexibility. Traditional systems are not well-suited to adapt to changes in production processes, technologies, or market demands. This rigidity makes them less effective in dynamic environments.
Example of Traditional Costing
As an example of traditional costing, factory overhead is charged to products at the rate of $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 $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.
When to Use Traditional Costing
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, and this approach can be both fast and low-cost, allowing an accounting department to close the books more quickly.
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The Difference Between Activity-Based Costing and Traditional Costing
Activity-based costing was developed to circumvent the cost allocation problems associated 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. The result is more justifiable cost allocations, though more time is required to derive these allocations.