Definition of Traditional Method in Cost Accounting
The traditional method of cost accounting refers to the allocation of manufacturing overhead costs to the products manufactured. The traditional method is also referred to as the conventional method.
Typically the traditional method meant allocating the manufacturing overhead costs on the basis of the number of units of output, the direct labor hours, or the production machine hours.
Allocating the many different (and ever increasing amounts of) indirect manufacturing costs on the basis of a single factor (such as machine hours) is likely to lead to misleading costs for a manufacturer’s goods. To address this deficiency, the activity based costing (ABC) method attempts to identify all of the diverse activities that occur and assign the costs of those activities only to the products that require the activities.
Example of Traditional Method of Cost Accounting
Assume that a manufacturer has $2,000,000 of manufacturing overhead costs consisting of depreciation, electricity, insurance, compensation of supervisors, production engineers, material handlers, equipment maintenance, etc. The manufacturer has 40,000 production machine hours. Using the traditional method of cost accounting, the company will allocate or assign $50 of overhead of each machine used to produce the output. Applying $50 per machine hour for every product will spread the overhead costs, but will not recognize the variety of activities and efforts that occur with different products.
The traditional method may have been reasonable or at least sufficient for the company’s external financial statements (especially when similar products are manufactured and inventory levels are consistently small). However, the traditional method will be inadequate for determining the true cost for diverse goods being produced and sold to customers with diverse demands.
