Difference between traditional costing and activity based costing

Costing is used in accounting. It helps the company and the business in the long run. It comes under the commerce stream. Account’s people used to use this method and implement them based on the kind of product.

Table of Contents Show

Activity Based Costing vs Traditional Costing
Advantages and Disadvantages of the Traditional Method of Calculating Overhead
What is the difference between activity
What is activity
Is ABC better than traditional costing?
What is the difference between activity

Table of Contents

Activity Based Costing vs Traditional Costing
Comparison Table Between Activity Based Costing and Traditional Costing
What is Activity Based Costing?
What is Traditional Costing?
Main Differences Between Activity Based Costing and Traditional Costing
Conclusion
References

Activity-based costing and traditional costing are two such methods used for accounting.

Activity Based Costing vs Traditional Costing

The main difference between Activity-based costing and traditional costing is that the factors that are taken into consideration when we are assigning the price for overhead products. Traditional costing uses a predetermined method to calculate the overhead product rate. It would be good if you use activity-based costing for correct accuracy.

Calculating an accurate manufacturing cost for each product is a vital piece of information for a company’s decision-making. For example, knowing the cost to produce a unit of product affects not only how a business budgets to manufacture that product, but it is often the starting point in determining the sales price.

An important component in determining the total production costs of a product or job is the proper allocation of overhead. For some companies, the often less-complicated traditional method does an excellent job of allocating overhead. However, for many products, the allocation of overhead is a more complex issue, and an activity-based costing (ABC) system is more appropriate.

Another factor to consider in determining which of the two major overhead allocation methods to use is the cost associated with collecting and analyzing information. When making their decision regarding which method to use, the company must consider these costs, both in time and money. Table 9.4 compares overhead in the two systems. In many cases, the ABC method is more expensive in terms of time and other costs.

The difference between the traditional method (using one cost driver) and the ABC method (using multiple cost drivers) is more complex than simply the number of cost drivers. When direct labor is a large portion of the product cost, the overhead costs tend to be consistently driven by one cost driver, which is typically direct labor or machine hours; the traditional method appropriately allocates those costs. When technology is a large portion of the product cost, the overhead costs tend to be driven by multiple drivers, so using multiple cost drivers in the ABC method allows for a more precise allocation of overhead.

Table 9.4 Overhead in Traditional versus ABC Costing By: Rice University OpenStaxCC BY-NC-SA 4.0 TraditionalABCOverhead assignedSingle cost driverMultiple cost driversOptimal usageWhen direct labor is a large portion of the product costWhen technology is a large portion of the product costOrientationCost drivenProcess driven

As shown with Musicality’s products, not only are there different costs for each product when comparing traditional allocation with an activity-based costing, but ABC showed that the Solo product creates a loss for the company. Activity-based costing is a more accurate method, because it assigns overhead based on the activities that drive the overhead costs. It can be concluded, then, that the cost and subsequent gross loss for each unit’s sales provide a more accurate picture than the overall cost and gross profit under the traditional method. Table 9.4 compares the cost per unit using the different cost systems and shows how different the costs can be depending on the method used.

Figure 9.18 By: Rice University Openstax CC BY NC SA

Advantages and Disadvantages of the Traditional Method of Calculating Overhead

The traditional allocation system assigns manufacturing overhead based on a single cost driver, such as direct labor hours, direct labor dollars, or machine hours, and is optimal when there is a relationship between the activity base and overhead. This most often occurs when direct labor is a large part of the product cost. The theory supporting the single cost driver is that the cost driver selected increases as overhead increases, and further analysis is more costly than it is valuable. Each method has its advantages and disadvantages. These are advantages of the traditional method:

All manufacturing costs are classified as material, labor, or overhead and assigned to products regardless of whether they drive or are driven by production.
All manufacturing costs are considered to be part of the product cost, whereas nonmanufacturing costs are not considered to be production costs and are not assigned to products, regardless of whether the costs are based on the products. For example, the machines used to receive and process customer orders are necessary because product orders must be taken, but their costs are not allocated to particular products.
There is only one overhead cost pool and a single measure of activity, such as direct labor hours, which makes the traditional method simple and less costly to maintain. The predetermined overhead rate is based on estimated costs at the budgeted level of activity. Therefore, the overhead rate is consistent across products, but overhead may be over- or underapplied.

Disadvantages of the traditional method include:

The use of the single cost driver does not allocate overhead as accurately as using multiple cost drivers.
The use of the single cost driver may overallocate overhead to one product and underallocate overhead to another product, resulting in erroneous total costs and potentially setting an incorrect sales price.
Traditional allocation assigns costs as period or product costs, and all product costs are included in the cost of inventory, which makes this method acceptable for generally accepted accounting principles (GAAP).

While ABC systems more accurately allocate the costs based on the various resources used to make the product, they cost more to use and, therefore, are not always the best method. Management needs to consider each system and how it will work within its own organization. Some advantages of activity-based costing include:

There are multiple overhead cost pools, and each has its own unique measure of activity. This provides more accurate rates for applying overhead, but it takes more time to implement and results in a higher cost.
The allocation bases (i.e., measures of activity) often differ from those used in traditional allocation. Multiple cost pools allow management to group costs being influenced by similar drivers and to consider cost drivers beyond the typical labor or machine hour. This results in a more accurate overhead application rate.
The activity rates may consider the level of activity at capacity instead of the budgeted level of activity.
Both nonmanufacturing costs and manufacturing costs may be assigned to products. The main rationale in assigning costs is the relationship between the cost and the product. If the cost increases as the volume of the product increases, it is considered part of overhead.

There are disadvantages to using ABC costing that management needs to consider when determining which method to use. Those disadvantages include:

Some manufacturing costs may be excluded from product costs. For example, the cost to heat the factory may be excluded as a product cost because, while it is necessary for production, it does not fit into one of the activity-driven cost pools.
It is more expensive, as there is a cost to collect and analyze cost driver information as well as to allocate overhead on the basis of multiple cost drivers.
An ABC system takes much more to implement and operate, as information on cost drivers must be collected in an objective manner.

The advantages and disadvantages of both methods are as previously listed, but what is the practical impact on the product cost? There are several items to consider at the product costs level:

What is the difference between activity

Activity-based costing systems differ from volume-based costing systems by tracing uses of resources to activities and linking activity costs of products, services, or customers. The first stage assigns factory overhead costs to activities or activity cost centers by using appropriate resource consumption cost drivers.

What is activity

Traditional costing adds an average overhead rate to the direct costs of manufacturing products and is best used when the overhead of a company is low compared to the direct costs of production. Activity-based costing identifies all of the specific overhead operations related to the manufacture of each product.

Is ABC better than traditional costing?

Activity-based costing is a more accurate method, because it assigns overhead based on the activities that drive the overhead costs.

What is the difference between activity

Whereas activity-based management focuses on business processes and managerial activities driving organizational business goals, activity-based costing seeks to identify and reduce cost drivers by optimizing resources.