Traditional Costing Method and its Limitations

Costing is used in the business strategies for determining the manufacturing cost of any product as compared to the revenues generated by the product. The system of costing determines the production overhead and allocates the overheads to the business products. If the traditional costing method is used it assigns the costs to the products on the basis of average rate of overhead. It pools all the indirect cost in the production process and applies the costs on equal basis through one appropriate cost driver like machine hours (Hilton and Platt 2013). However, though the traditional costing system is easy to use it has various limitations that encourage using any other suitable method for computing the cost of the product. Various limitations of traditional costing are as follows –

• Recovery rate for overhead are used on the basis of labour hour or machine hour. Though this method of allocating the overhead is easy to use, it is less useful for taking any decision as the decision has implication over the period of 3-5 years whereas few fixed costs become variable in the long run.
• Splitting the costs into variable and fixed is generally unrealistic. Reason behind this is that splitting of the cost will give inaccurate product cost if the business grows (Kaplan and Atkinson 2015).

Therefore, it is time to move into a new costing system from the traditional one. The method that can be reliably used and that will overcome the issues faced with the traditional approach is activity based costing (ABC) approach (Myrelid and Olhager 2015). ABC approach determines all the activities related to the production and assigns the costs to the activities and thereby determines the product’s cost. It is considered as more accurate as it takes into consideration the important factors before allocating the cost to the product. Though it is time consuming and complicating it is more thorough and it considers non-manufacturing costs as well like managerial costs and administrative costs (Mahal and Hossain 2015). It has the following advantages over the traditional costing –

• Accurate cost of the product –it brings reliability and accuracy while determining the product cost through focussing on effect and cost relationship under the cost incurrence. It identifies that the the activities involves the costs and not the products. Under the advanced manufacturing technology and environment where the support functions comprises the large portion of the total costs, ABC delivers more realistic costs for the product (Monroy, Nasiri and Peláez 2014).
• Information regarding cost behaviour – ABC recognizes real nature of the cost behaviour and it assist in reducing the costs and recognizing the activities that do not add any value to product. With the ABC approach the managers are able in controlling various fixed overhead costs through exercising more control on various fixed costs through exercising more control over activities that caused the fixed overhead costs (Sigüenza Guzmán, Van den Abbeele and Cattrysse 2014).
• Better decision making – ABC approach improves the decision made by the managers as more reliable cost data for product can be used. It further helps in fixing the selling prices of the products as more of the correct product cost data will be available.
• Management of cost – ABC delivers rate of cost driver and information related to transaction volumes that are useful in managing the performance appraisal and cost management for the responsibility centres (Whitecotton, Libby and Phillips 2013).

Example of Traditional costing vs ABC costing

Historically, the company allocates all overhead costs using total direct labour hours, but is now considering introducing activity-based costing (ABC). The accountant has produced the following analysis

3 cost drivers that creates the overheads are –

• Delivery to the retailer – number of deliveries of caravans to the retail showrooms
• Set – ups – number of items assembly line process is re-set for accommodating the production run of different type of the caravan
• Purchase order – number of the purchase orders

Annual cost driver volume related to each of the activity is as follows

Annual overhead costs related to the activities are as follows –

All direct labour is paid at $20 per hour. The company holds no stocks. At a board meeting there was some concern over the introduction of activity-based costing.

Computation as per traditional approach –

Computation as per ABC approach –

Computation of profit –

It can be identified that the profit has been changed for each product as allocation has been made more systematically.

The major judgement used in the ABC approach is availability of the source data. As it is not always available judgements and estimates are used for allocating the overhead to various cost drivers. Further, data production is based on the management’s judgement otherwise it will produce significant unfavourable outcome (Weygandt, Kimmel and Kieso 2015).

Various limitations of ABC costing approach are –

• It is not useful for the small companies
• If overhead are small ABC costing is not useful
• It shall not be used for preparing the monthly income statement
• Some of the companies produce only 1 product or very few products and hence, ABC approach is not applicable for them (Kapi? 2014).

Yes, I would be happy using the above calculation for the decision making purpose. The reason behind this is ABC approach is considered as a tool for management’s decision making through association of costs to the activity which establish a clear relationship among related costs and source of the activity demand. Through ABC the management is able to find out the area where the costs are actually incurred, costs initiations and the areas where the efforts shall be applied for curbing the inflationary cost.

Reference

Hilton, R.W. and Platt, D.E., 2013. Managerial accounting: creating value in a dynamic business environment. McGraw-Hill Education.

Kapi?, J., 2014. Activity Based Costing-ABC. Business Consultant/Poslovni Konsultant, 6(32).

Kaplan, R.S. and Atkinson, A.A., 2015. Advanced management accounting. PHI Learning.

Mahal, I. and Hossain, A., 2015. Activity-Based Costing (ABC)–An Effective Tool for Better Management. Research Journal of Finance and Accounting, 6(4), pp.66-74.

Monroy, C.R., Nasiri, A. and Peláez, M.Á., 2014. Activity Based Costing, Time-Driven Activity Based Costing and Lean Accounting: Differences among three accounting systems’ approach to manufacturing. In Annals of Industrial Engineering 2012 (pp. 11-17). Springer, London.

Myrelid, A. and Olhager, J., 2015. Applying modern accounting techniques in complex manufacturing. Industrial Management & Data Systems, 115(3), pp.402-418.

Sigüenza Guzmán, L., Van den Abbeele, A. and Cattrysse, D., 2014. Time-driven activity-based costing systems for cataloguing processes: a case study.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2015. Financial & managerial accounting. John Wiley & Sons.

Whitecotton, S., Libby, R. and Phillips, F., 2013. Managerial accounting. McGraw-Hill Higher Education.