Weaknesses of traditional costing
2. Similarities and differences when compared to activity based costing (ABC)
Let us consider the following case scenario. Company ABC (a fictitious entity) produces and sells two different types of hightech speakers: the Standard Model and the Luxury Model. Due to intense competition, speaker prices have fallen significantly. The company believes there are no other ways to reduce costs for the two speaker models. The Standard Model is profitable, but the Luxury Model can result in losses. The company considers whether it needs to discontinue the Luxury model.
Input data for analysis:
Standard Model 
Luxury Model 

Direct material (per unit) 
$30 
$40 

Direct labour (per unit) 
$10 
$20 

Total direct costs 
$40 
$60 

Fixed production overhead: 

Machine cost 
$500,000 
0.25 hours 
0.5 hour 
Setup cost 
$420,000 
200 units per setup 
250 units per setup 
Quality inspection cost 
$100,000 
50 units per inspection 
100 units per inspection 
Total overhead 
$ 1,020,000 

Quantity, units 
15,000 
10,000 
5,000 
Firstly, the number of machine hours is calculated under both traditional costing and ABC methods:
Machine Hours = 10,000 × 0.25 hours + 5,000 × 0.5 hours = 5,000 hours
The Standard Model requires 2,500 hours and the Luxury model requires 2,500 hours.
Secondly, under the traditional costing model, the fixed production overhead absorption rate (FOAR) equals $204 per machine hour (i.e., $1,020,000 ÷ 5 000 hours).
Under the ABC method the number of activities is calculated as follows:
 To determine the number of setups: (10,000 ÷ 200) + (5,000 ÷ 250) = 50 (Standard Model) and 20 (Luxury Model) = 70 in total.
 To determine the number of quality inspections: (10,000 ÷ 50) + (5,000 ÷ 100) = 250 inspections (200 and 50 for Standard and Luxury Models, respectively).
Finally, overhead costs are allocated to the two models as follows:
Traditional Costing Model
Overhead Costs (Standard Model) = $204 × 0.25 hours ×10,000 units = $510,000
Overhead Costs (Luxury Model) = $204 × 0.5 hours × 5,000 units = $510,000
ABC Model
Machine Cost 
= $500,000 x 
2,500 
= $250,000 
5,000 
Machine cost for the Luxury Model would be the remaining amount: $500,000  $250,000 = $250,000.
Setup Cost 
= $420,000 x 
50 
= $300,000 
70 
Setup cost for the Luxury Model would be the remaining amount: $420,000  $300,000 = $120,000.
Quality Cost 
= $100,000 x 
200 
= $80,000 
250 
Quality cost for the Luxury Model would be the remaining amount: $100,000  $80,000 = $20,000.
The results under the two methods are compared in the operating statements below:
Traditional Costing 
ABC Costing 

Standard 
Luxury 
Standard 
Luxury 

Direct costs 
$ 40,000 
30,000 
Direct costs 
$ 40,000 
30,000 
Fixed overheads 
510,000 
510,000 
Machining costs 
250,000 
250,000 
Set up costs 
300,000 
120,000 

Quality inspections 
80,000 
20,000 

Total cost 
550,000 
540,000 
Total cost 
670,000 
420,000 
Cost per unit 
55 
108 
Cost per unit 
67 
84 
Selling price (**) 
80 
100 
Selling price (**) 
80 
100 
Profit/(loss) per unit 
25 
(8) 
13 
16 
(*) Total direct costs are calculated by multiplying the perunit cost by the quantity produced: $40 x 10,000 = $40,000 and $60 x 5,000 = $30,000.
(**) Represents an assumed selling price for the purposes of this analysis.