Many companies, especially small and medium-sized businesses, use the traditional volume-based costing system to allocate factory overhead costs to individual products or services. Volume-based costing system is simple and easy to use and understand, and it does not cause much product cost distortions if a company produces goods with very similar production volumes and batch sizes, or in other words, the company uses simple production. When using volume-based costing system, a company determines factory overhead rates for the entire production (i.e. plant-wide rate) or for each department separately (i.e. department-rate). Single plant-wide and multiple production department rate methods are shown in the illustration below.
Illustration 1: Overhead rates in volume-based costing
Volume-based costing system can be also used by companies that manufacture products or offer services that require a small amount of factory overhead costs or use the same amount of activity. However, such companies should also have stable technology and similar distribution systems for their products or services. Overall, when factory overhead costs have a high correlation with direct labor-costs, traditional costing system can be a relatively appropriate system to use.
Even though traditional costing system can be used relatively effectively in some cases, it has many limitations. Because volume-based costing uses an aggregate rate rather than a specific one, it loses a lot of information and control over product costs. A selected volume-based cost driver (e.g. direct labor-hours) might have little to do with how factory overhead costs accumulate. This can cause not only product price distortions, but it can also decrease the incentives for department managers to control product costs.
On the other hand, an activity-based costing (ABC) system is a complex cost system that provides detailed and accurate information about each product’s cost and thus each product’s profitability. The ABC system is very expensive and time-consuming system to implement due to the high cost of collecting, measuring, and recording production information, especially for companies that produce many different products that require hundreds of various activities. For a large company, it might take millions of dollars and many years to develop and implement an ABC system. Despite its high cost, ABC systems have many benefits to offer.
