Skip to content

Management Accounting · Activity Based Costing

Limitations of Traditional Costing and Why ABC Is Needed

Updated 10 October 2026 · Fact-checked

Traditional costing absorbs all overheads using one volume-based rate, such as direct labour hours or machine hours. This ignores what actually causes overhead, so low-volume complex products are under-costed and high-volume simple products are over-costed. ABC fixes this by tracing overheads to activities and then to products using cost drivers.

Understand Limitations of Traditional Costing and Need for ABC

Every product needs a share of factory and other overheads. In traditional costing, you collect overheads in a few cost centres or in one pool. You then divide the pool by one volume measure, such as direct labour hours, machine hours or direct labour cost. The result is a single absorption rate. Each product takes overhead in proportion to its volume measure.

This worked well when direct labour was the main cost and products were similar. Today overheads are large and cover set-ups, inspection, material handling, scheduling, engineering changes and so on. These costs do not rise with labour hours. They rise with the number of set-ups, inspections, orders or part numbers. A rate based on labour hours cannot capture that.

The result is cost distortion. Suppose a product is made in small batches and needs many set-ups and inspections. It uses few labour hours per unit, so it picks up little overhead. It is under-costed. A simple, high-volume product uses many labour hours, so it picks up too much overhead. It is over-costed. This is called cross-subsidisation: one product's cost is hidden in another's.

Distorted costs lead to wrong decisions. Management may under-price complex products and win orders that lose money. It may over-price simple products and lose customers to competitors. It may drop a product that is actually profitable. Distorted costs also weaken cost control, because nobody sees what drives overheads.

Activity Based Costing (ABC) was developed to answer this. It first identifies the activities that consume resources, collects cost in an activity cost pool, and picks a cost driver for each pool. It then charges products by how much of each activity they use. The basic idea: products consume activities, and activities consume resources.

Key rules to remember

Traditional overhead absorption rate (OAR)
OAR = Total overheads ÷ Total base (labour hours, machine hours or other volume measure)
One rate for all products. Overhead charged to a product = OAR × the product's base units.
ABC cost driver rate
Cost driver rate = Cost of the activity pool ÷ Total quantity of the cost driver
Calculated for each activity pool, for example cost per set-up or cost per inspection.
ABC overhead charged to a product
Overhead = Σ (Cost driver rate × Driver units used by the product)
Add across all activity pools. Divide by units produced for overhead per unit.
Direction of distortion
Under-costed: ABC cost > traditional cost. Over-costed: ABC cost < traditional cost
Treat ABC as the more accurate figure when you compare. The gap shows the distortion.

How to solve Limitations of Traditional Costing and Need for ABC questions

Use this method for theory questions on limitations and for short comparison questions between traditional costing and ABC.

  1. 1Read what is asked: limitations, need for ABC, difference, or a numerical comparison of the two systems.
  2. 2State how traditional costing works: overheads pooled and absorbed on one volume base such as labour or machine hours.
  3. 3Point out the flaw: many overheads are driven by activities such as set-ups, orders and inspections, not by volume.
  4. 4Show the effect: low-volume complex products are under-costed and high-volume simple products are over-costed (cross-subsidisation).
  5. 5Link the effect to decisions: wrong pricing, wrong product mix, wrong drop or keep decisions, weak cost control.
  6. 6Explain how ABC responds: activity pools, cost drivers, and charging by consumption of activities.
  7. 7For numbers, compute the traditional overhead per unit and the ABC overhead per unit, then compare and state which product is under or over-costed.
  8. 8Close with a one-line conclusion on what management should do with the corrected cost.

Quickest way: Three-line answer plus compare-and-conclude

When to use it: Use this for 4 to 6 mark theory parts, or when a numerical question asks you to comment on the difference between the two methods.

  1. Write the flaw in one line: single volume-based rate ignores what causes overhead.
  2. Write the result in one line: low-volume complex products under-costed, high-volume simple products over-costed.
  3. Write the remedy in one line: ABC uses activity pools and cost drivers.
  4. For numbers, work out overhead per unit under both methods and note the gap for each product.
  5. Finish with the decision impact: review prices, product mix and any drop decision using the ABC cost.

Common mistakes in Limitations of Traditional Costing and Need for ABC

  • Saying traditional costing is wrong because it uses overhead absorption at all.

    Students mix up absorbing overheads with using a single volume-based base.

    Fix: Say the flaw is the single volume-based rate that ignores the real cost drivers. ABC also absorbs all overheads; it does so on a better basis.

  • Reversing under-costing and over-costing.

    Students forget that low-volume products use few labour hours but many activities.

    Fix: Remember: complex low-volume products are under-costed by traditional costing, and simple high-volume products are over-costed. Check by comparing the two unit costs.

  • Claiming ABC changes total overhead.

    The unit costs change, so students think the total changes too.

    Fix: Total overhead absorbed is the same under both methods. Only the split between products changes. Verify by adding up both totals.

  • Listing limitations without stating the effect on decisions.

    Students stop at the technical flaw.

    Fix: Add the consequence, such as wrong pricing, wrong product mix or wrongly dropping a profitable product, to earn the full marks.

  • Treating all overheads as activity driven in ABC.

    Students assume ABC removes the need for any arbitrary allocation.

    Fix: Say some facility-sustaining costs have no clear driver and may still be spread on a reasonable base. Do not claim ABC is perfectly accurate.

Worked examples

Example 1

Rao Components Ltd makes two products, Alpha and Beta. Overheads are ₹3,00,000, of which ₹1,20,000 relates to machine set-ups and ₹1,80,000 relates to machine running. Alpha: 1,000 units, 1 machine hour per unit, 5 set-ups. Beta: 200 units, 1 machine hour per unit, 15 set-ups. Total machine hours are 1,200 and total set-ups are 20. Compute overhead per unit under traditional costing (machine hour basis for all overheads) and under ABC (set-ups for set-up cost, machine hours for running cost). Comment.

Show the solution
  1. Traditional rate = ₹3,00,000 ÷ 1,200 hours = ₹250 per machine hour.
  2. Alpha overhead per unit = 1 × ₹250 = ₹250. Total = ₹2,50,000.
  3. Beta overhead per unit = 1 × ₹250 = ₹250. Total = ₹50,000.
  4. ABC set-up rate = ₹1,20,000 ÷ 20 = ₹6,000 per set-up.
  5. ABC running rate = ₹1,80,000 ÷ 1,200 = ₹150 per machine hour.
  6. Alpha: set-up = 5 × ₹6,000 = ₹30,000; running = 1,000 × ₹150 = ₹1,50,000; total = ₹1,80,000; per unit = ₹180.
  7. Beta: set-up = 15 × ₹6,000 = ₹90,000; running = 200 × ₹150 = ₹30,000; total = ₹1,20,000; per unit = ₹600.
  8. Check: ₹1,80,000 + ₹1,20,000 = ₹3,00,000, equal to the traditional total.
  9. Comment: traditional costing over-costs Alpha (₹250 against ₹180) and under-costs Beta (₹250 against ₹600). Beta is a low-volume product with many set-ups.

Answer: Traditional: ₹250 per unit for both. ABC: Alpha ₹180 per unit, Beta ₹600 per unit. Alpha is over-costed and Beta is under-costed; Alpha subsidises Beta.

Example 2

Explain why traditional costing may lead to wrong pricing and product decisions, and how ABC helps. Answer for 6 marks.

Show the solution
  1. Describe the method: traditional costing pools overheads and absorbs them on one volume base such as direct labour hours or machine hours.
  2. Give the flaw: modern overheads such as set-ups, inspection, ordering and material handling vary with the number of activities, not with volume.
  3. Give the distortion: complex low-volume products use few hours but many activities, so they are under-costed. Simple high-volume products are over-costed.
  4. Give the decision effect: under-costed products may be priced too low and sold at a loss. Over-costed products may be priced too high and lose sales. A profitable product may be dropped by mistake.
  5. Give the control effect: overheads are not linked to their causes, so managers cannot see where to reduce cost.
  6. Explain ABC: it forms activity cost pools, finds a cost driver for each, and charges products by their use of each activity.
  7. Conclude: ABC gives more reliable product costs, so pricing, mix and cost control decisions improve.

Answer: Traditional costing distorts costs by using one volume-based rate, which under-costs complex low-volume products and over-costs simple high-volume ones. This causes wrong pricing and product decisions. ABC traces overheads through activities and cost drivers, giving more accurate costs for decisions.

Exam tips

  • In theory answers, use the sequence flaw, distortion, decision effect, ABC remedy. It covers the points examiners look for.
  • In numerical comparisons, always add up both methods' total overheads and show they match. It protects you from calculation slips and earns marks.
  • State clearly which product is under-costed and which is over-costed, and give the rupee difference per unit.
  • For MCQs, remember the key words: single volume-based rate, cross-subsidisation, cost drivers. Options that say ABC reduces total overhead are wrong.
  • Do not call ABC perfect. Mention that it needs more data and effort, which is covered in its limitations.

Practice questions from Activity Based Costing

Limitations of Traditional Costing and Need for ABC in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Limitations of Traditional Costing and Need for ABC: frequently asked questions

What are the main limitations of traditional costing?

It uses one or a few volume-based rates, so it ignores what really causes overheads. It distorts product costs by under-costing complex low-volume products and over-costing simple high-volume ones. This leads to poor pricing, product mix and control decisions.

What is the difference between traditional costing and ABC?

Traditional costing absorbs overheads on a volume base such as labour or machine hours. ABC traces overheads to activities and then to products using cost drivers such as number of set-ups or inspections. Total overhead is the same; its split between products differs.

Why was ABC developed?

Overheads became a large part of total cost, while direct labour became a small part. Absorbing them on labour hours gave misleading product costs. ABC was developed to link overheads to the activities that cause them.

Does ABC always give a different product cost from traditional costing?

Not always. If all products consume activities in the same proportion as the volume base, the two methods give similar costs. Differences are large when products vary in volume, batch size and complexity.