Limitations of Traditional System - Activity Based Costing, Cost Management | Cost Management - B Com PDF Download

Drawbacks on Traditional Costing System

The steady increase in global competition has put pressure on organizations to outdo each other pertaining to quality, cost and delivery. The obsolete methods and processes used in costing systems hinder the progress of organizations. 'There remains, however, a major - and largely unnoticed - obstacle to the lasting success of this revolution in the organization and technology of manufacturing operations. Most companies still use the same cost accounting and management control systems that were developed decades ago in a competitive environment drastically different from that of today' (Kaplan, 1984, p. 95).

The traditional cost accounting system is the product of evolution of the manufacturing operations, which was focussed on producing few products that had high direct labour input. These systems were highly efficient in dealing with mass production that was witnessed in the early twentieth century. Kaplan (1984) points that the traditional systems will not be sufficient to encompass all the processes of a manufacturing company. Further, in the todayís competitive environment, the products are delivered with low direct labour content; therefore, depending on the traditional systems will not provide an adequate picture of manufacturing efficiency and effectiveness.

The use of the traditional costing system is specifically beneficial when there is only one product or a few similar products that need the same production process and production-related activities (Crosson & Needles, 2011). The cost allocation in traditional manufacturing is through routing manufacturing process which has direct labour costs or labour hours because it uses repeated processes that involves high labour content. Hoque (2005) defends that such allocation using direct labour hours or direct labour costs is sufficient. Cooper and Kaplan (1988b) argue that "distorted cost information is the result of sensible accounting choices made decades ago, when most companies manufactured a narrow range of products. In production, the costs of labour and materials were the most important production factors that could be traced to the individual products. Distortions from allocating factory and corporate overhead by burden rates on direct labour were minor" . Further, the process of collecting and analysing the data is complicated and expensive resulting in allocation of costs to such sophisticated resources. However, today, the current scenario is different due to the development of product lines and marketing methods; the companies produce a wide variety of products (Cooper & Kaplan, 1988b; Drury, 2012). From this angle, direct labour no more encompass most of the production, instead is restricted to a small portion. As a result, the direct labour hours or machine hours of manufacturing do not provide adequate information for product calculation. At the same time, expenses involving factory support operations, engineering, distribution, marketing, and other overhead functions have increased (Cooper & Kaplan, 1988b; Glad & Becker, 1996, Garrison et al., 2006). From the 50s through the 70s of the last century, the overheads represented approximately 25 percent of the total cost of the product, while today it represents approximately 50 percent of the total cost of the product due to the steady increase in the size of companies and the trend in replacing humans with machines (automation), and the improved production technology in a modern manufacturing environment (Crosson & Needles, 2011). Due to these causes, the traditional costing system is unable to evaluate the cost of resources used for producing the products or services accurately (Atkinson et al., 2012; Cooper, 1990; Cooper & Kaplan, 1991).

Furthermore, it contributes to poor decision making and distortion of costs (Johnson & Kaplan, 1987) resulting in distorted signals about the relative profitability of different products (Atkinson et al., 2012) and global competitiveness (Freidank, 1997). It also has a cascading effect on product mix, pricing, process technology, etc., as decisions are made on the distorted cost information (Kishore, 2005).

The cost and the cause of costs should be established; unfortunately, the traditional costing system does not address this challenge. Almost all of the companies that employ the traditional costing system use it to assign overheads to product at unit-level allocation bases only, which is proportional to the number of units produced (e.g., direct labour hours, direct labour costs and machine hours) (Turney, 2005). The traditional costing system uses volume-driver allocation bases, which is founded on the assumption that when the number of hours put in is greater so also is its costs. However, this paradigm remains false for most of the components of the overheads (Cooper & Kaplan, 1988a).