What is the major weakness of the traditional method of allocating factory overhead?
Under the traditional method of allocating factory overhead (manufacturing overhead, burden), most of the factory overhead costs are allocated on the basis of just one factor such as machine hours or direct labor hours. In other words, the traditional method implies there is only one driver of the factory overhead and the driver is machine hours (or direct labor hours, or some other indicator of volume produced).
In reality there are many drivers of the factory overhead: machine setups, unique inspections, special handling, special storage, and so on. The more diversity in products and/or in customer demands, the bigger the problem of allocating all the costs of these various activities via only one activity such as the production machine's hours.
Under the traditional method, the costs of performing all of the diverse activities will be contained in one cost pool and will be divided by the number of production machine hours. This results is one average rate that is applied to all products regardless of the number of activities and the complexity of those activities. Since the cost of many of the diverse activities do not correlate at all with the number of production machine hours, the resulting allocations are misleading.
Activity-based costing is intended to overcome the weakness of the traditional method by having various pools of costs and then allocating each pool's costs on the basis of its root cause.
