Traditional costing is a way of predicting the profitability of a product. During the 1990s, it was succeeded by activity-based costing (ABC), which took into account the cost of every activity that took place within a company. Traditional and activity-based costing techniques are key parts of business accounting within an organization.
During traditional costing for a product or project, the potential costs are divided into direct and indirect categories. Direct costs are easily quantifiable and include, for example, the costs of raw materials and labor. Costs that are not easily quantified are classified as indirect costs or overhead.
Traditional costing looks to divide the total cost of a product by the direct labor cost. This calculation determines the cost of the product per item. The direct labor costs in this equation are only estimation. If traditional costing for a product means that each unit costs $1.00 USD, the company then adds its profits to the product. If this product is then sold for $1.20, then the company may assume a profit of $0.20 per item; however, if the estimated cost of the product is wrong, then the company runs the risk of making less money than expected.
This accounting system relies upon the almost arbitrary arrangement of indirect costs. There is also little attention to the causes of cost and cost variance, or the difference between estimated costs and real costs. A consequence of this approach can be improperly costing an item. If a product’s cost is not accurately known, it is more difficult to predict its profitability.
The system of traditional costing is sometimes considered to be less favorable than newer costing systems, such as ABC and lean costing, because it does not look at cause and effect. Other types of allocation systems look at each activity and assign a cost to it. In comparison, traditional costing lumps all the activities together and attempts to guess their overall cost.
Traditional costing does offer an advantage when direct costs are high. This is the case in manufacturing, where costing can be applied to such overhead categories as material costs, labor costs, and unit costs. In the latter half of the 20th century, the proportion of direct costs fell against the proportion of indirect costs, making traditional costing ineffective. It is even more ineffective when used in multi-product companies.
One of traditional costing's major advantages is its simplicity; it is easy to calculate overhead rates. This means that businesses across the world understand the traditional cost accounting system. These systems are also relatively cost effective themselves, making them cheaper than ABC methods.