Calculating the costs of the goods or services offered is essential for businesses to maintain profitability. Direct costs like supplies and the labor of employees who manufacture a product or deliver a service provide some of the information that companies need to assess their expenses accurately. But they also must account for indirect costs like overhead expenses relating to facilities, utilities or administration. Traditional costing is one of two ways to assign overhead costs to goods or services.
Traditional costing assigns expenses according to an average overhead rate. Companies calculate this rate by pooling all indirect costs and applying them equally in a common unit, like machine hours. Then they calculate the cost of each product or service using the same rate. This is less complex than the alternative method of activity-based costing, which calculates the cost of each product or service based on the specific expenses involved.
Since it is less complicated than activity-based costing, a company’s accountants don’t have to spend as much time performing calculations for traditional costing. Nor do they have to create costly systems for tracking expenses. Therefore, traditional costing is also less expensive than activity-based costing.
Though activity-based costing took hold in the 1990s, it lacks the history of traditional costing, which goes back even further. Many companies still prefer traditional costing because they understand it well and trust its reliability. It remains effective when overhead is low compared to direct costs, such as producing a single item or several similar items.
Companies often use traditional costing in financial statements because outsiders can assess the value of products or services more easily than they could with activity-based costing.
Many businesses shun traditional costing because its lack of detailed calculations distorts actual overhead expenses. It skews vital measures like a product’s profitability by assigning costs arbitrarily instead of considering each activity for a particular product.
Business owners and managers often prefer activity-based costing because it helps them reduce waste by showing them every indirect cost for each specific product or service. Traditional costing doesn’t provide that ability because it looks at overhead costs in general.
Traditional costing typically doesn’t factor in unexpected expenses. This means it could cost a company more to produce a product than it projected.
Activity-based costing emerged as a popular alternative to traditional costing because the latter is often too simplistic for today’s businesses. It doesn’t analyze non-manufacturing costs as activity-based costing does. Nor does it work for companies with many different products or services due to the wide variety of expenses associated with each.