Weaknesses of traditional costing
May 30, 2015
In this accounting guide we will look at the main principles of the traditional costing model and compare it with activity-based costing (ABC).
Overhead costs should be allocated to finished goods using a suitable basis in order to arrive at profitability figures for products a company manufactures.
Nearly 60 years ago the traditional costing concept was developed to tackle the task. This method assumed that overhead costs are related to the number of units produced, labour hours or machine hours. This method was also a modern, efficient, and accurate method of accounting for product costs.
Until recently, the arguments in favor of this method are its simplicity, popularity and a low cost to operate.
The traditional costing method assumes that overhead costs are related to the production volume. It was indeed valid many years ago when production systems were based on the labor intensive or machine intensive mass production of commonly standard items. The direct costs were high and indirect costs were low; therefore, any inaccuracy in the charging of overhead costs to products was not significant.
Nowadays, the traditional costing method is not suitable for complex manufacturing environment, where goods are produced by smaller customized batches leading to high proportion of overhead activities – such as order handling or quality control – which are not related to the production volume. For the same reason, traditional costing is not well-suited to costing of services.