Definition Of Traditional Cost Accounting
Traditional Cost Accounting, often known as the Traditional Costing Method, is a cost allocation approach that assigns both direct and indirect costs to individual products, services, or departments. Typically, a single cost driver, such as direct labor hours or machine hours, forms the basis for this allocation.
Brief Explanation
Under the traditional costing approach, all production costs – including direct costs like labor and raw materials and indirect expenses like factory overhead – are gathered and apportioned based on a predetermined overhead rate. This popular method gives business leaders a comprehensive picture of the cost of products and the overall cost of production.
Traditional cost systems, despite their widespread use, often yield less accurate costs compared to the activity-based system. This inaccuracy is particularly evident in businesses with diverse products and complex manufacturing processes. The reason is it uses a single cost driver to allocate all overhead costs, leading to potential product cost distortions.
This system’s cost behavior typically differentiates between variable costs, which change with the production volume, and fixed costs, which remain steady regardless of output. Cost accountants utilizing the traditional method often use standard costing for simpler cost comparison and variance analysis to compare the actual and standard costs.
Types of Traditional Cost Accounting
Traditional cost accounting mainly includes two types:
1. Job Order Costing:
This is used when products are unique or made according to customer specifications. Here, costs are accumulated by individual job orders, and cost driver rates are typically determined by the amount of direct labor hours or direct material used.
2. Process Costing:
Used when homogeneous products are produced in mass quantities. Costs are collected and averaged across all units, giving an average cost per unit.
Example
Imagine a furniture manufacturing company that makes tables.
The Direct Costs associated with making a table include:
1. Direct Labor:
The wages of the workers who are directly involved in the manufacturing process. Let’s say it amounts to $500 per table.
2. Direct Material:
The cost of the raw materials required for making a table, i.e., wood, screws, etc. Suppose this cost is $300 per table.
The Indirect Costs or Overhead Costs include items like:
1. Factory Rent: Let’s assume it’s $2000 per month.
2. Utilities (Electricity, Water, etc.): Let’s take it as $1000 per month.
3. Depreciation of Machinery: Assume $500 per month.
The company produces 50 tables per month.
The first step is to calculate the total direct and indirect costs:
1. Total Direct Costs: Direct Labor + Direct Material = $500 + $300 = $800 per table.
2. Total Indirect Costs: Rent + Utilities + Depreciation = $2000 + $1000 + $500 = $3500 per month.
The next step is to calculate the overhead rate. In traditional cost accounting, overhead costs are usually allocated based on direct labor costs or labor hours. For simplicity, let’s use direct labor cost as the allocation base here.
Overhead Rate = Total Indirect Costs / Total Direct Labor Costs = $3500 / (50 tables * $500) = 0.14.
Now, we calculate the total cost per table:
Total Cost per Table = Direct Material + Direct Labor + (Overhead Rate * Direct Labor) = $300 + $500 + (0.14 * $500) = $870.
So, according to the traditional cost accounting method, the total cost of manufacturing one table is $870.
Importance of Traditional Cost Accounting
Traditional cost accounting plays an integral role in managing business issues. It offers insight into the annual cost of capacity used, operating costs, and potential profit margins. Tracking the input costs and costs to products based on a single factor enables businesses to make accurate cost estimates and control them effectively.
Advantages of Traditional Cost Accounting
1. Simplicity and Ease:
Traditional costing systems are simpler and easier to understand. The calculation of costs is straightforward, making it a popular and common method of accounting among many business owners.
2. Adherence to Accounting Principles:
Traditional cost accounting follows Generally Accepted Accounting Principles (GAAP), making it a widely used costing method in financial accounting.
3. Lower Implementation Costs:
Compared to the activity-based costing method, the implementation of traditional cost accounting is less expensive and less time-consuming.
Disadvantages of Traditional Cost Accounting
1. Inaccurate Product Cost Information:
Traditional cost accounting may not always provide the most accurate cost allocation methods and tends to offer less accurate product cost information, particularly for businesses with diverse finished products and complex manufacturing processes. It can lead to distortions in the cost of products as it uses a single cost driver to allocate all overhead costs.
2. Non-Volume-Related Cost Drivers:
Traditional costing systems often overlook non-volume-related cost drivers, like marketing and administrative costs resulting in inaccurate cost allocation.
3. Unprofitable Products:
Due to inaccurate overhead allocation, traditional cost accounting might incorrectly identify profitable products as unprofitable (and vice versa).
In conclusion, despite its limitations—especially when compared to activity-based costing systems—traditional cost accounting continues to serve as a functional and efficient tool for many businesses. It’s particularly useful for businesses where the categories of cost vary little across different products, and overhead costs form a small portion of the total cost. By understanding its advantages, disadvantages, and its role in calculating the true costs of production, business leaders can make informed decisions regarding its applicability in their specific contexts.
