Traditional Costing Examples and ABC Costing Metrics

Introduction

Cost allocation is the backbone of any manufacturing or service operation. Two of the most common approaches are traditional costing and activity‑based costing (ABC). This guide explains how each method works, shows practical examples, and gives you a ready‑to‑use checklist to move from a flat‑rate system to a data‑driven ABC model.

Traditional Costing Overview

Traditional costing assigns overhead to products using a single cost driver – typically direct labor hours or machine hours. The method is straightforward, requires minimal data, and is attractive for small firms that lack sophisticated accounting systems.

Key Characteristics

• One overhead rate for the entire factory.
• Cost driver is usually labor hours, machine hours, or material volume.
• Easy to calculate and update.
• Often less accurate for complex product mixes.

Traditional Costing Example

Imagine a workshop that employs 5 workers, each logging 1,000 hours per year. The total overhead (rent, utilities, supervision) is $500,000. The traditional overhead rate is:

Overhead Rate = Total Overhead ÷ Total Labor Hours
               = $500,000 ÷ (5 × 1,000)
               = $100 per labor hour

If Product A consumes 200 labor hours, its allocated overhead is 200 × $100 = $20,000. Product B uses 800 hours, so its overhead is $80,000.

Limitations of Traditional Costing

• Assumes every hour consumes the same amount of overhead.
• Distorts product cost when low‑volume, high‑complexity items share the same rate as mass‑produced items.
• Can mask the true cost of a supervisor’s efficiency improvements.
• Fails to capture non‑labor drivers such as equipment setups, quality inspections, or order processing.

Activity‑Based Costing (ABC) Overview

ABC breaks overhead into multiple cost pools and assigns each pool to products using the activities that actually drive the cost. This yields a more nuanced view of where money is spent and helps managers make better pricing, outsourcing, and process‑improvement decisions.

Core Steps to Build an ABC Model

1. Identify activities – e.g., machine setup, order entry, quality inspection, packaging.
2. Create cost pools – group overhead costs by activity (e.g., $120,000 for setups, $80,000 for inspections).
3. Choose cost drivers – measurable factors that cause each activity (e.g., number of setups, inspection hours).
4. Calculate activity rates – divide each pool’s total cost by its driver total.

       Setup Rate = $120,000 ÷ 240 setups = $500 per setup
       Inspection Rate = $80,000 ÷ 400 inspection hrs = $200 per hr
       

5. Assign costs to products – multiply each product’s activity usage by the appropriate rate.

Why ABC Beats Traditional Costing

• Highlights high‑cost activities that are invisible in a single‑rate model.
• Improves product‑level profitability analysis.
• Supports strategic decisions such as product mix, make‑or‑buy, and process redesign.
• Provides a foundation for continuous improvement initiatives (Lean, Six Sigma).

Industry‑Specific ABC Examples

1. Discrete Manufacturing (e.g., automotive parts)

Key activities: machine setups, tooling changes, quality inspections.

Using ABC, a low‑volume custom part that requires 5 setups and 8 inspection hours may show a true cost of $6,500, whereas the traditional rate spreads $100 per labor hour and understates the cost.

2. Process Manufacturing (e.g., chemicals)

Activities: batch coordination, environmental compliance, material handling.

ABC reveals that a batch with high waste disposal fees consumes disproportionate overhead, prompting a redesign of the waste‑reduction process.

3. Service Industry (e.g., IT support)

Activities: ticket triage, problem resolution, system monitoring.

ABC can allocate the cost of a support desk based on the number of tickets handled and the average resolution time, giving a clearer picture of service profitability.

Quick ABC Implementation Checklist

Download our ready‑made ABC Costing Excel Template to automate steps 2‑5 and keep your data up‑to‑date.

Conclusion

Traditional costing is quick but can hide costly inefficiencies. Activity‑based costing adds the granularity needed for modern, multi‑product businesses. By following the step‑by‑step guide and using the downloadable template, you can transition to a more accurate costing system and make smarter strategic decisions.

Start building smarter cost models today with the Activity‑Based Costing Excel Template.