This most often occurs when direct labor is a large part of the product cost. The traditional allocation system assigns manufacturing overhead based on a single cost driver, such as direct labor hours, direct labor dollars, or machine hours, and is optimal when there is a relationship between the activity base and overhead. Advantages and Disadvantages of the Traditional Method of Calculating Overhead The image below compares the cost per unit using the different cost systems and shows how different the costs can be depending on the method used. It can be concluded, then, that the cost and subsequent gross loss for each unit’s sales provide a more accurate picture than the overall cost and gross profit under the traditional method. Activity-based costing is a more accurate method, because it assigns overhead based on the activities that drive the overhead costs. ![]() When technology is a large portion of the product cost, the overhead costs tend to be driven by multiple drivers, so using multiple cost drivers in the ABC method allows for a more precise allocation of overhead.Īs shown with Musicality’s products, not only are there different costs for each product when comparing traditional allocation with an activity-based costing, but ABC showed that the Solo product creates a loss for the company. When direct labor is a large portion of the product cost, the overhead costs tend to be consistently driven by one cost driver, which is typically direct labor or machine hours the traditional method appropriately allocates those costs. The difference between the traditional method (using one cost driver) and the ABC method (using multiple cost drivers) is more complex than simply the number of cost drivers. In many cases, the ABC method is more expensive in terms of time and other costs. Table 6.6 compares overhead in the two systems. When making their decision regarding which method to use, the company must consider these costs, both in time and money. However, for many products, the allocation of overhead is a more complex issue, and an activity-based costing (ABC) system is more appropriate.Īnother factor to consider in determining which of the two major overhead allocation methods to use is the cost associated with collecting and analyzing information. ![]() For some companies, the often less-complicated traditional method does an excellent job of allocating overhead. ![]() For example, knowing the cost to produce a unit of product affects not only how a business budgets to manufacture that product, but it is often the starting point in determining the sales price.Īn important component in determining the total production costs of a product or job is the proper allocation of overhead. Calculating an accurate manufacturing cost for each product is a vital piece of information for a company’s decision-making.
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