How activity based costing is different towards traditional costing?

Article 1

Activity-Based vs. Traditional

Costing
by Andrea Hayden

Costing is used in business accounting strategies as a way of determining the cost of manufacturing a
product in relation to the revenue generated by that product. Costing systems determine the overhead
of production and then allocate those overhead costs to a business products.

There are two common methods for allocating these indirect costs to products. Both of these methods
assess overhead costs and then attach these costs to products based on certain cost drivers. A cost
driver is any component that costs money or any factor that is related to a cost occurring, such as the
volume produced or the number of labor hours.

The first of these methods is activity-based costing, which is sometimes referred to as ABC. Activity-
based costing determines all activities associated with production, assigns a cost to those activities and
then determines the cost of the product.

The other method is traditional costing, which assigns costs to products based on an average overhead
rate. This method pools all indirect costs in production and applies those costs equally across the board
using one appropriate cost driver, such as machine hours.

ABC vs. Traditional

Activity-based costing is more accurate because it takes important factors into account before assigning
a cost to a product. However, for this same reason, it is a bit more complicated and time-consuming. Its
also more thorough and considers nonmanufacturing expenses as well, such as administrative and
managerial costs.

Traditional costing is a much easier way of determining the cost of a product, since it relies solely on
assigning average overhead rates. This also means it wont always be as accurate, because it doesnt
factor in nonmanufacturing expenses or determine which overhead costs actually affect specific
products.

A simple example of these costing methods can be demonstrated with the costs of living in an
apartment with roommates. Two roommates in an apartment will typically split the costs of rent,
utilities and groceries, and they have a couple of options for doing so. They could simply total the cost of
all of the bills and divide it exactly in two. This would be similar to traditional costing.

The roommates also have the option of determining who uses specific utilities and paying only for what
each one uses. They can then create an itemized bill for each roommate. For example, if one roommate
doesnt use the internet and the other doesnt use cable, they wont have to pay those parts of the bill.
This method is similar to activity-based costing.

Which Should You Use?

Both forms of costing have various benefits as well as disadvantages. Determine which form of costing
will be best suited for your project by considering your specific needs and your timeframe.

Activity-based costing should be used when accuracy is crucial, because it is the most precise. Although
it is costly to implement, it should be used for:

Times when overhead is high, because small changes in each product cost can make a large
difference overall. This method makes it easy to visualize and understand all indirect costs and
activities.

Internal use, because decision-makers will be able to see all relevant spending and can
document all indirect costs accurately. This method is good for finding areas of wasteful
spending.

Traditional costing should be considered when time is limited or when accuracy wont be affected much
by production activities. Traditional costing is most effective for:

Times when overhead is low compared to the direct costs, because this is when it will be the
most accurate. This works well when there are a large number of similar items (or a single item)
being produced.

External use, because it will be easier for outsiders to determine the value of products.

Choosing appropriately between activity-based and traditional costing methods wont be easy, but its a
decision that shouldnt be neglected. Taking the time to understand how each method affects your
business could help you save money in the long run, leaving you with extra money to reinvest where you
see fit.
Article 2

Traditional Costing Vs. Activity-Based Costing

by Rose Johnson

Costing systems helps companies determine the cost of a product related to the revenue it generates. Two
common costing systems used in business are traditional costing and activity-based costing. Traditional costing
assigns manufacturing overhead based on the volume of a cost driver, such as the amount of direct labor hours
needed to produce an item. A cost driver is a factor that causes cost to incur, such as machine hours, direct
labor hours and direct material hours. Activity-based costing allocates the costs of manufacturing a product
according to the activities needed to produce the item. Managers should understand the advantages and
disadvantages of both systems to meet the needs of their business.
Understanding Traditional Costing

Many manufacturing companies use the traditional costing system to assign manufacturing overhead to
units produced. Users of the traditional costing method make the assumption that the volume metric is
the underlying driver of manufacturing overhead cost. Under traditional costing, accountants assign
manufacturing costs only to products. Traditional accounting fails to allocate nonmanufacturing costs
that also are associated with the production of an item, such as administrative expenses. Companies
commonly use traditional accounting in external financial reports because it provides a value for the
cost of goods sold.

Pros and Cons of Traditional Costing

An advantage of using traditional-based costing is that it aligns with Generally Accepted Accounting
Principles, or GAAP. Easy implementation for companies that provide one product also is a plus.
However, traditional costing is an outdated costing system in many companies because those
manufacturing companies now use machines and computers for much of their production. Computers
and machines make the system outdated because it often uses direct labor hours to calculate cost. Cost
is not appropriately assigned because direct labor hours is not the best cost driver to use. Traditional
costing negates other cost drivers that may contribute to the cost of an item. Another disadvantage of
solely using the traditional costing system is that it can lead to bad management decisions because it
excludes certain nonmanufacturing costs.

Understanding Activity-Based Costing

Activity-based costing provides a more accurate view of product cost, but companies typically use it as a
supplemental costing system. The allocation bases used in activity-based costing differ from those used
in traditional costing. Activity-based costing determines every activity associated with producing an item
and allocates a cost to the activity. The cost assigned to the activity is then assigned to products that
require the activity for production.

Pros and Cons of Activity-Based Costing

Greater costing accuracy is the primary benefit of activity-based costing. Companies assign cost only to
the products that require the activity for production. This method eliminates allocating irrelevant costs
to a product. Other advantages of activity-based costing include an easy interpretation of cost for
internal management, the ability to enable benchmarking and a greater understanding of overhead
costs. Implementing an activity-based costing system within a company requires substantial resources.
This can prove a disadvantage for companies with limited funds. Another disadvantage of using activity-
based costing is that it is easily misinterpreted by some users.
Article 3

The Disadvantages & Advantages of Activity-Based Costing

by Eileen Rojas

Activity-based costing is a way to allocate costs based on the amount of resources a product or service
consumes. The use of ABC is especially important to businesses that provide customized products or services.
A customized production environment requires ABCs allocation of actual indirect costs to a product to
identify its true cost. Implementing ABC can be a challenging task for any business and the process carries
several advantages and disadvantages.

Expensive Implementation

Setting up an ABC system can be expensive and time-consuming. As business activities are analyzed, they
must be broken down into each activitys individual components. The entire process can use up valuable
resources as data are collected, measured and entered into the new system. Businesses may also need the
assistance of a consultant who specializes in the setup of an ABC system and can provide training on its use.
Using software can add an additional expense to the implementation but it can be used to automate many of the
manual aspects involved in using ABC.

Misinterpretation of Data

Reports produced by an ABC system contain information, such as product margins, that vary from the
information reported for a traditional cost method. Its also possible that some activity-based costs may be
irrelevant in certain decision-making scenarios; for example, ABC does not conform to accounting standards
and should not be used for external reporting. Since traditional cost figures tend to be the norm, interpreting
ABC data along with regular accounting information can be confusing and lead to bad decision-making. The
use of software can streamline the process of maintaining an ABC system and simplify its integration with
regular cost accounting information.

Improves Business Processes

An ABC system allocates indirect costs based on a products cost driver, or the factor that creates the cost. As
costs are allocated per product, a picture starts to emerge of which business processes are performing well and
which ones need to be improved. ABC can be used to identify non-valued added activities and can help to
better allocate resources to efficient and profitable activities. The use of ABC can also add value to the
continuous improvement of business processes.

Identifies Wasteful Products

The ABC method accounts for costs similar to the way production work is performed, allowing your business
to better understand where overhead costs are going. The data can identify wasteful products and unnecessary
costs, so that resources can be used productively. The method also helps to fix the price of products or services
that are excessive or incorrect. Overall product and service quality can improve as ABCs data details
production and cost issues that need to be resolved.
Example of Traditional Costing
by Steve Lander

Manufacturing organizations typically use traditional costing as a method of determining what it costs to make
products. It combines an actual cost with a factor to calculate how to allocate indirect costs, called a cost
driver. The key benefit of traditional costing is that it is simpler to do than other systems, like activity-based
costing, even though it is also less accurate.
Traditional Costing Basics

Traditional costing starts with a metric. For instance, a company may look at two products -- one takes one
labor hour to make while the other takes two labor hours. It then takes all of its indirect costs and adds them
up. Once it has determined what it spends, it divides the costs by the amount of the metric to find an indirect
cost per hour that it can apply to the product.

Calculating Traditional Costing

Say a company that makes widgets makes 1 million of them per year. To do it, it could require five full-time
employees, each working 2,000 hours, plus another three supporters, also working 2,000 hours each. In the
process of making widgets, it spends $1 million. Its overhead rate would be the result of dividing the $1
million in cost by the 10,000 hours of direct labor. This works out to $100 per hour.

Typical Cost Drivers

Part of setting up a traditional costing system is deciding on cost drivers. For instance, a company could
choose to measure labor hours, although measuring machine hours might be a better metric for a highly
mechanized facility. Other metrics could include the miles traveled for a transportation operation or the
amount of material handled for a mining company that processes ore.

Traditional vs. ABC

The problem with traditional costing is that it uses a single flat rate to allocate costs. For instance, if a factory
makes two products, and one line manager is able to reduce her production costs, the cost savings would end
up being allocated across both products produced, dampening the impact of the manager's success. Activity-
based costing systems add additional levels of granularity, making it easier to more accurately measure and
allocate costs.