Explaining traditional costing with an example

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SOURCE: https://www.business-case-analysis.com/activity-based-costing.html

In one accounting period, accounting period, the firm produces and sells 900,000 units of product A at $3.00 each and 2,100,000 units of product B at $2.00 each.

Traditional costing: Finding direct costs

Table 2 below shows the resulting revenues and direct costs for these sales.

Products Compared Product A Product B Total
1. Units produced & sold 900,000 2,100,000 3,000,000
2. Selling price / unit $3.00 $2.00
3. Direct labor cost / unit $0.50 $0.50
4. Direct materials cost / unit $0.75 $0.50
5. Sales revenues [ = 1 * 2 ] $2,700,000 $4,200,000 $6,900,000
Direct costs
6. Direct labor costs [ = 1 * 3 ] $450,000 $1,050,000 $1,500,000
7. Direct materials costs [ = 1 * 4 ] $675,000 $1,050,000 $1,725,000
8. Total Direct costs [ = 6 + 7 ] $1,125,000 $2,100,000 $3,225,000
 Table 2. Sales revenues and direct costs for Products A and B

Traditional costing: Finding indirect or overhead costs

The company’s cost accountants will also find cost totals for the period’s production support activities. In traditional cost accounting, these are called “overhead” or “indirect costs,” which Table 3 shows below.

Indirect Components

Prod. A & B Indirect % of Total Indirect
Materials purchasing $180,000 12.6%
Machine setups $375,000 26.4%
Product packaging $280,000 19.7%
Machine testing & calibration $300,000 21.1%
Machine maintenance & cleaning $287,000 20.2%
Total Indirect      $1,422,500 100.0%
 Table 3. Indirect cost components for Traditional costing

Traditional cost accounting: Calculating direct and indirect costs

The simple form of traditional cost accounting appearing here uses only the total indirect cost line from Table 3. Traditionally, firms allocate this cost total to each product, A or B, based on proportional usage of a given resource. The resource chosen for this purpose is usually one of the direct cost items. Note especially that this approach is also called production volume based (PVB) cost allocation, for obvious reasons.

Under PVB cost allocation, the total indirect cost could be allocated to Products A and B based on factors such as the proportion of total

  • Production machine time used by each product.
  • Direct labor costs used by each product.
  • Factory floor space used by each product.

Other factors may also apply. For this example, the firm’s accountants chose to allocate indirect costs referring to direct labor costs. The indirect cost total from Table 3 above is $1,422,500. The direct labor total (line 6 from Table 1) is $1,500,000. From these figures, the firm allocates indirect labor cost to each product as a percentage of the product’s own direct labor cost:

 Indirect labor cost / direct labor cost proportion:
= $1,422,500 / $1,500,000
= 0.948 = 94.8%

  • For product A, Direct labor costs are $450,00  (Table 2, line 6). The indirect cost allocation for A is therefore 94.8% of this, or $426,750.
  • For product B, Direct labor costs are $1,050,000  (Table 2, line 6). The indirect cost allocation for B is therefore 94.8% of this, or $995,750.

Traditional costing: Allocating indirect costs

Table 4, below, shows how this allocation produces indirect cost estimates per unit. And, the table also shows the traditional costing solutions for gross profit and gross margin for each product unit.

Products Compared

Product A Product B Total
9. Units produced and sold
[Table 2, line 1]
900,000 2,100,000 3,000,000
10. Total direct costs
[Table 2, line 8]
$1,125,000 $2,100,000 $3,225,000
11. Total indirect costs
[allocation shown above]
$426,750 $995,750 $1,422,500
12. Revenues per unit
[Table 2, line 2 ]
$3.00 $2.00
13. Direct costs / unit
[ = 10 / 9 ]
$1.25 $1.00
14. Indirect costs / unit
[ = 11 / 9 ]
$0.47 $0.47
15. Gross profit / unit
[ = 12 − 13 − 14 ]
$1.28 $0.53
16. Gross profit margin
[ = 15 / 12 ]
42.5% 26.3%
 Table 4. Gross profit and gross margin calculation for each product, using
traditional cost accounting approaches for indirect costs.

Conclusions: Traditional cost allocation (or product volume based allocation) example:

  • Estimated Indirect cost per unit is the same for both products, $0.47 (Table 4, line 14). This must be the case, because indirect costs for both products use the same allocation rate ( 94.8%) applied to direct labor costs, based on the same direct labor rate ($0.50 / unit).
  • On a per unit basis, this traditional costing finds Product A more profitable than product B: The gross margin rate of 42.5% for A compares with a gross margin of 26.3% for B.
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