The traditional costing system in accounting is the allocation of factory overhead to products which is based on the volume of consumed production resources. Companies using this method will apply overhead to either the number of machine hours used or the direct labor hours which were consumed.
Under traditional costing, one would add an average overhead rate to the direct costs of manufacturing goods or providing services. It is applied on the basis of cost driving, reflecting what is required to produce finished products.
Any systematic costing method that was used before the advent of activity-based costing in the 1990s is classified as a traditional costing system today.
Many companies are transitioning away from this accounting option because its accuracy is dependent upon direct costs being high and indirect costs being low. If you’re thinking about moving away from the traditional costing system, there here are its advantages and disadvantages to consider first.
List of the Advantages of the Traditional Costing System
1. It offers accurate cost figures with large production volumes.
The traditional costing system is best used when an organization has low overhead costs compared to the direct production costs they pay. When volumes are large and overhead costs don’t create a significant difference when calculating costs, then it provides an accurate figure that can then be added as a rate to the finished goods or services.
2. It is cheap to implement.
There are no fancy calculations or forms required to determine the average overhead rate under the traditional costing system. All you must do is calculate the amount of time it takes to produce a specific product or provide a unique service. Then you take the average rate of labor or machine use costs per hour, multiplying it by the length of time necessary to create saleable goods and services.
3. It creates reports which are easier to understand.
If you’re trying to determine what goods or services offer the best profit ratios for an organization, outsiders will prefer to use the traditional costing system. The reports generated by this calculation are often easier to read and understand because it puts everything into a dollars and cents category. For investors, employees, or other interested parties, the traditional costing system makes it possible to understand some of the basics of a company’s financial picture. Activity-based costing cannot be accurately used for external reports because of the multiple activity rates involved.
4. It is still able to tract all direct costs.
Traditional costing might not offer the specificity of activity-based costing, but it still offers the ability to trace direct costs. Anything that is related to a specific product, including direct labor and materials, is included with this information. It follows GAAP principles to offer a reasonably analysis of production costs when an organization is producing a handful of products or services to their targeted demographics.
5. It applies one rate to the entire system.
The reason why the traditional costing system was developed in the first place was that it could quickly accommodate the high cost of machine or human labor into the finished products being offered. Instead of incorporating multiple costs that must be calculated to determine an outcome, this system utilized one rate for overhead allocation which applies to the entire business operation. That means your accounting department only needs to run one set of books, unlike activity-based costing, which must run two sets of books.
6. It keeps workers more productive.
If a company uses an activity-based costing system, then their workers are forced to take the time to assign costs each day. The accounting department will spend several hours per week assigning costs to the various products or services offered. Imagine having 15 cost activities, called pools, with rates that must be assigned to 200 different products. With the traditional costing method, you might use estimates more often, but there are fewer cost assignment procedures which must be completed.
7. It streamlines the accounting process.
Imagine that your company only produces one product. You could track all of the activities which create overhead costs to find specific data patterns. At the end of the day, however, all of the costs will still fall into an overhead category which will be assigned to that one product that is produced. By using the traditional costing method, you’re able to streamline that process to keep details reasonably accurate without boosting your labor costs to reach that number.
8. More than one different costing approach is used.
Under the traditional costing system, you have multiple approaches to consider when looking for the best option to convey information about cost. Your options include volume-based costing, the French cost accounting approach, and planned marginal cost accounting. Each specific system offers advantages and disadvantages to consider, based on the structure of the organization and the number of products which are offered.
List of the Disadvantages of the Traditional Costing System
1. It offers limited accuracy, even in the best of situations.
Traditional costing may work when there are a handful of products being manufactured with low overhead costs. It does not offer the same accuracy when trying to look at the actual expenses that are incurred by an organization. It tends to distort the actual expense, looking at the profitability of products or services by arbitrarily assigning costs for all activities instead of considering the cost of each action required to bring the product to sale.
2. It wants to ignore unexpected circumstances.
Any unanticipated expenses are ignored when the traditional costing system is used. That is because the overall average is factored into the product. It may cost an organization more to manufacture goods or provide services after the first projections are made, and there is no way for this accounting system to take that into account. When companies dig into their raw figures for detailed data, they might find that their products or services earned a lot less (or a lot more) than they anticipated at the end of the year.
3. It isn’t always a helpful system.
The traditional costing system does not show enough specifics to identify where waste might be occurring within the system. The indirect costs of manufacturing products or providing services are not accounted for under this system. It only looks at the overhead costs in general, ignoring the specifics for the overall number. For that reason, some organizations prefer to use activity-based costing if they suspect that there are cost-cutting measures that could be implemented.
4. Its simplicity may be too simple.
The modern business must analyze non-manufacturing costs as part of their overall accounting process. It must evaluate the vast variety of expenses that are associated with an offer of numerous products or services. You cannot receive that information from the traditional costing system. Although the calculations are easy, and the information is easy to convey to others, the overall lack of data is limiting to organizations which offer numerous items for sale.
5. It does not account for non-manufacturing costs.
When you look at the cost of producing goods or services today, there are numerous costs which must be paid that do not apply to the production cycle. The traditional costing system wouldn’t look at marketing, sales, or outreach costs because those occur after the manufacturing process. If those costs are high, then this system might indicate profitability for a company when none exists. Its failure to analyze non-manufacturing costs is one of its greatest weaknesses.
These traditional costing system advantages and disadvantages show us that its strengths are found in its simplicity. The rate calculations are straightforward, understood by others, and inexpensive to determine. Up until the 1980s, this system was viewed as being an accurate option to use. With a shift to online marketplaces and the speed of modern business, however, the disadvantages of this system show it may have limited applications.
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