The traditional method of cost accounting tends to the allocation of manufacturing overhead prices to the products manufactured. The traditional method (as well recognized as the conventional method) assigns or allocates the factory’s indirect costs to the items produced on the basis of volume for instance the number of units produced, the direct labor hours, or the production machine hours. We will make use of machine hours in our conversation.
By means of only machine hours to assign the manufacturing overhead to products, it is involving that the machine hours are the primary cause of the factory overhead. Conventionally, that may have been sensible or no less than enough for the company’s outer financial statements. However, in recent decades manufacturing overhead has been driven or caused by a lot of other factors. For instance, some customers are probable to demand additional manufacturing operations for their diverse products. Other customers simply want great quantities of uniform products.
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If a manufacturer desires to know the true cost to manufacture particular products for particular customers, the traditional method of cost accounting is inadequate. Activity based costing (ABC) was developed to defeat the inadequacies of the traditional method. In its place of just one cost driver for example machine hours, ABC will use a lot of cost drivers to assign a manufacturer’s indirect costs. A small number of of the cost drivers that would be used under ABC comprise the number of machine setups; the pounds of material purchased or used the amount of engineering change orders, numerous machine hours and so on.
The limitations of traditional cost allocations
Traditional cost allocations are frequently based on volume for example number of products manufactured, number of unswerving labor hours, number of production machine hours, number of square feet, etc. unluckily, it is becoming additional numerous that the common costs or indirect costs that need allocation are not caused by volume. Additionally we can say that traditional cost allocations are frequently based on something other than the root causes of the costs.
It is feasible that a significant amount of manufacturing overhead may not be sourced by production machine hours, yet the overhead is assigned using those hours. for instance, a few of a manufacturer’s low volume products may need important amounts of engineering changes, extra inspections, frequent machine setups with extraordinarily short production runs, special handling, additional storage and so on. To assign these unique costs to all products on the basis of numerous productions machine hours (in its place of allocating those costs based on their root reasons) will effect in individual product costs that are erroneous and misleading.
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