Traditional Versus Activity Based Costing-Free-Samples for Students

Question: Compare Traditional Costing with Activity Based Costing (ABC). Do you feel ABC is an improvement over traditional costing? Answer: Introduction In business there is occurrence of multiple costs in manufacturing of goods or rendering of services. The manufacturing organizations have to distribute the cost occurred for raw material,, labour, and overhead to the goods produced in order to determine the overall cost of the manufactured goods. In costing there are various methods for allocating the all the costs to the goods and services. Some of important cost allocation methods are traditional costing method and activity based costing method. In this essay, there will discussion on both of these costing methods and difference between them will also be explained. The traditional costing method and activity based costing method both are used to allocate the indirect cost incurred during the manufacturing of goods or providing the services. The main role of both these costing methods is to calculate the overhead costs and allocate them to the products using the certain cost drivers. Comparison of Traditional costing method and activity based costing method The traditional costing method of cost allocation is most easy and frequently used method for allocating the factory overhead to the products. The main reason why the traditional costing method is frequently used is because of its simplicity and easy to apply characteristics. Under this costing method, all the overhead cost (factory overhead) are allocated to the different products using the single cost driver such as direct labour hour method or machine hour method or direct material used method (Cooper and Kaplan,1991). There are many potential problems associated under this method like use of single recovery cost driver to allocate all the overhead irrespective of overhead consumed under respective product or not. This problem give rise to critical cost issues that can harm the companys performance. Under traditional costing method, the cost allocation takes place in two stages. In first stage, all the overheads are calculated by reporting all the overhead cost to the cost centers . In second stage, all the overheads cost are distributed form the cost center to the different products in the proportion of cost driver used by each of the product in the respective period (Hayden, 2017). The traditional costing method of cost allocation does not help in effective operating management performance system that will help managers to obtain the relevant information about the products to help in improvement of business performance. The users of the traditional costing method make unrealistic assumption that volume metric is the most common underlying driver of the manufacturing overhead cost. Under the traditional costing assigns all types of overheads using the single recovery rate among the products manufactured by the company. The traditional costing method of cost allocation has failed after company has started using the machines and other different tools for manufacturing of products. The modern manufacturing process involves many activities to produce any product and it is completely wrong to allocate the overhead costs using the allocation base that has no relation with the activities used in the manufacturing of products. To solve all these problems, the new costin g method has been introduced known as activity based costing system (Bromwich and Bhimani, 2005). The activity based costing method is very unique and most accurate method of cost allocation as this method completely based on the actual consumption basis. As per this method the complete manufacturing process has been divided into many stages and each stage consumes some costs. The certain activities can differ depending upon the products manufactured by the company. Every activity used in the manufacturing process critically based on some cost driver such as if product is processed through certain machine than the cost driver will be machine hours. The activity based costing system identifies the activities that are performed to make the product fit for the consumption and then allocate overhead cost linked with particular activity to the products using the recovery rate that define cost driver in respective activity. For example, the overhead cost associated with the use of machines will be apportioned among the products using the machine hour rate recovery rate not by the labor hour recovery rate (Cooper and Kaplan, 1991). The major advantage of this method is that it recognizes the relationship between the costs, activities and products, and by using this relationship it allocate the all the overhead costs to the products using the most real allocation method which helps he manager in improving the business performance and eliminate any non-value added activities (Hayden, 2017). The below table clearly shows the difference between the traditional costing method and activity based costing method: Basis of Difference Traditional Costing Method Activity based costing method Cost Pool Traditional costing method used one cost driver or maximum two Activity based costing method used multiple cost driver that itself represents the activities undertaken in the production Rate applied This costing method uses volume based cost driver This costing method uses activity based costing driver which is non-financial in nature Benefits Simple, inexpensive and easy to apply Provide accurate product costing and help in performance evaluation It is important to understand the difference between the traditional costing method and activity based costing method using the numerical example. Example: Following the cost incurred of the manufacturing of the two products P and Q by ABC Company. Direct Material cost $ 15,000.00 Direct Labour cost $ 45,000.00 Overhead Costs Setup the machine $ 9,500.00 Material receiving cost $ 5,500.00 Other information Labour hours 450 Hours (P: 60hrs and Q: 40 hrs) Number of Setups 95 (P: 45 and Q: 50) Number of Requisite 55 (P: 35 and Q: 20) Material P: $ 10000 Q: $ 5000 Cost Allocation using the traditional costing method Traditional Costing Method Particulars P Q Direct Material cost $ 10,000.00 $ 5,000.00 Direct Labour cost $ 25,000.00 $ 20,000.00 Overhead cost $ 8,333.33 $ 6,666.67 Total Cost $ 43,333.33 $ 31,666.67 Cost Allocation under activity based costing Activity Based Costing Method Particulars P Q Direct Material cost $ 10,000.00 $ 5,000.00 Direct Labour cost $ 25,000.00 $ 20,000.00 Overhead Costs Setup the machine $ 4,500.00 $ 5,000.00 Material receiving cost $ 3,500.00 $ 2,000.00 Total Cost $ 43,000.00 $ 32,000.00 Conclusion It can be said that traditional cost method provides only the basis for cost allocation not the performance measuring method as per costing techniques. On the other hand activity based costing is useful method for cost allocation as it can also be used for performance measurement. References Bromwich, M. and Bhimani, A., 2005.Management accounting: Pathways to progress. Cima publishing. Cooper, R. and Kaplan, R.S. 1991. Profit Priorities from Activity-Based Costing. [Online]. Available from: https://hbr.org/1991/05/profit-priorities-from-activity-based-costing [Accessed on: 28 February, 2018]. Hayden, A. 2017. Activity-Based vs. Traditional Costing. [Online]. Available from: https://quickbooks.intuit.com/r/pricing-strategy/activity-based-vs-traditional-costing/ [Accessed on: 28 February, 2018]