Traditional cost accounting procedures were developed years ago and were built around three product costs: direct material, direct labour and overhead. During that period, overhead cost was low when compared to direct material and direct labour resulting in products costs that were dominantly variable.
Under traditional cost accounting system, the main steps in accounting for overheads are:
First, allocation and apportionment of overheads to various production departments and service departments.
Second, reapportionment of service departments overheads to production departments.
Third, absorption of production departments overheads by the end- products. Thus, overheads are aggregated at the production cost centre and are assigned to units produced.
Assignment or absorption is based on average rate(s) determined by dividing the overhead expenses by the volume of units produced e.g., labour hours or machine hours or direct wages etc. These rates assume that products which take more time to manufacture, generate more overheads. Thus, in the traditional cost accounting system high volume products are over-costed and low volume products are under-costed.
Again, use of an average rate calculated using volume as denominator, for assigning overhead expenses to products or services distorts product or service cost, if the firm produces variety of products. Usually the demand of different products on resources or activities is not uniform.
Over the last few decades, changes in manufacturing and business environments, global competitions and other developments have forced companies to develop in all aspects of their business, including performance measurement and cost management.
Automation and other radical technological changes have decreased labour costs and increased the overhead costs. Nowadays overhead costs have assumed greater importance and there is a need for a more sophisticated system for accounting of overhead cost.
Rolta Ltd produces and sells two products A and B.
The company gives you the following information relating to two product lines:
Compute overhead cost per unit of each product using traditional costing system (direct labour hour rate)
Traditional Costing System:
As shown above, each unit of products A and B absorbs the same amount of material handling costs even though product B consumes more material moves than product A. Thus, conventional costing fails to trace the large number of material moves for Product B.