What is Traditional Costing?

Traditional Costing

Traditional costing, often referred to as absorption costing or full costing, is an accounting method used to allocate production costs to products or services. The method primarily divides costs into two categories: direct costs and indirect costs.

• Direct Costs: These are costs that can be directly traced and attributed to specific products. Common examples include raw materials and direct labor.
• Indirect Costs or Overheads: These are costs that cannot be traced directly to specific products but are instead spread out or ‘absorbed’ among a range of products. Common examples include utilities, rent, and factory maintenance.

Here’s how traditional costing works:

• Direct Costs Allocation: Direct costs like raw materials and labor are directly traced and attributed to each product.
• Indirect Costs Allocation : Indirect costs are allocated based on a predetermined overhead rate, often calculated using a simple, single cost driver like machine hours or labor hours.For instance, if the predetermined overhead rate is per machine hour, and a product uses 10 machine hours, it would be allocated in overhead costs.

The major feature (and limitation) of traditional costing is its simplicity in overhead allocation. It typically uses broad averages to assign the overhead costs to products regardless of the actual amount of resources each product consumes, which can sometimes lead to cost distortions.

This is especially the case in companies with diverse product lines where some products might be more complex and resource-intensive than others. In such scenarios, activity-based costing (ABC) might be more appropriate since it identifies multiple activities in the company and assigns the cost of each activity to products based on actual consumption.

Example of Traditional Costing

Let’s delve into a fictional scenario to illustrate traditional costing in a practical context.

Dreamy Mattresses Inc.

Dreamy Mattresses Inc. manufactures two types of mattresses: Basic and Premium. They want to allocate costs using the traditional costing method.

Direct Costs per Mattress:

• Basic:
  • Materials: $100
  • Direct Labor: $50
• Premium:
  • Materials: $150
  • Direct Labor: $70

Overhead Costs:

• Total monthly overhead (includes utilities, factory rent, machine maintenance): $60,000.

Production Information:

• Dreamy Mattresses Inc. uses machine hours as the basis for allocating overhead.
• Total machine hours used in a month: 10,000 hours.
• Predetermined overhead rate = Total Overhead Costs / Total Machine Hours = $60,000 / 10,000 hours = $6 per machine hour.
• Basic mattress requires 2 machine hours.
• Premium mattress requires 4 machine hours.

Cost Allocation Using Traditional Costing:

• Basic Mattress:
  Direct Costs:
  • Materials: $100
  • Labor: $50
  Overhead Allocation:
  • 2 machine hours x $6/hour = $12
  Total Cost for Basic Mattress:
  • $100 + $50 + $12 = $162
• Premium Mattress:
  Direct Costs:
  • Materials: $150
  • Labor: $70
  Overhead Allocation:
  • 4 machine hours x $6/hour = $24
  Total Cost for Premium Mattress:
  • $150 + $70 + $24 = $244

Summary:

• Each Basic mattress is assigned a production cost of $162.
• Each Premium mattress is assigned a production cost of $244.

Using the traditional costing method, Dreamy Mattresses Inc. can now determine the cost of producing each type of mattress. This method gives a simplified overhead allocation based on machine hours, making it easy to compute. However, as mentioned earlier, this simplicity can sometimes lead to cost distortions if there’s significant diversity in the products being manufactured.