A traditional costing system is an accounting approach used to assess the cost of producing products in order to generate a profit.
The traditional allocation method assigns manufacturing overhead expenses based on a single cost driver, such as direct labour hours or machine hours.
While nonmanufacturing costs are not regarded as production costs and are not assigned to products, regardless of whether the costs are based on the products, manufacturing costs are all considered to be a part of the product cost. For instance, the cost of the equipment used to take and process customer orders is not attributed to any specific products, even though it is required to take product orders.
Flaws in the Traditional System of Costing
There are two flaws in traditional costing. One is that, in traditional costing, the selling price of a product depends solely on the costs. The problem with such a method of pricing is that the customers may not find the resulting price acceptable. Also, the competitors may have lower prices or offer better quality for the same price or less.
Using a single cost driver could result in the overall allocation of overhead to one product and the under-allocation of overhead to another, leading to inaccurate total costs and possibly incorrect sales pricing.
This flaw can be addressed by target costing, which seeks to estimate a target price the customers are willing to pay for a certain product and derive a target cost from there. The organisation will then have to apply value engineering to ensure that the actual cost will not exceed the target cost.
Another flaw is that conventional costing only considers current costs when there are past and future costs that are relevant, in one way or another, to the product, such as research and development costs. On the other hand, this flaw can be addressed by lifecycle costing.
Lifecycle costing considers all costs relevant to the product, even those incurred before and after production. The link between target and lifecycle costing is that both use value engineering to reduce costs.
Both try to identify the parts of the product or the processes which do not add value to the customers and reduce the expenses in those areas. In that way, the organisation gets to maximise value and cut costs.
As a result of these flaws, traditional costing systems are being increasingly replaced by more sophisticated costing methods, such as activity-based costing (ABC) and target costing. These newer methods provide a more accurate and comprehensive view of product costs, which can help businesses make better-informed decisions.