Activity Based Costing vs Traditional Costing
Costs associated with a product can be categorized as direct costs and indirect costs. Direct cost, is the cost which can be identified with the product, while indirect costs are not directly accountable to a cost object. Cost of materials, direct labour cost such as wages and salaries are examples of direct costs. Administrative costs and depreciation are some of the examples of indirect costs. Identifying total cost of a product is very important to determine the selling price of that product. Wrong or incorrect allocation of costs may lead to determine a selling price, which is less than the cost. Then the profitability of the company becomes questionable. Sometimes, such an incorrect determination of costs may result in pricing the product much more than the cost, then that may lead to losing market share. The total cost of a product varies with allocation of indirect costs. Direct costs are not making problems as they can be directly identifiable.
In traditional costing system, allocation of indirect costs is made based on some common allocation bases such as labour hour, machine hour. The main drawback of this method is that, it pools all the indirect costs and allocates them using the allocation bases to departments. In most of the cases, this allocation method does not make sense as it pools the indirect costs of all products of different stages. In the traditional method, it allocates overheads first to the individual departments then reallocates the costs to products. Especially in the modern world, traditional method loses its applicability as a single company produces larger number of different types of product without using all departments. So, cost experts came up with a new concept call activity based costing (ABC), which was simply reinforced the existing traditional costing method.
Activity Based Costing
Activity based costing (ABC) can be defined as an approach to costing that identifies individual activities as fundamental cost objects. In this method, the cost of individual activities are assigned first, and then, that is used as the basis of assigning cost to the ultimate cost objects. That is in activity based costing, it assigns over heads to each activity first, then reallocates that cost to the individual product or service. Number of purchase order, number of inspections, number of production designs are some of the cost drivers used in allocating overhead costs.
What is the difference between Activity Based Costing and Traditional Costing?
Though the concept of activity based costing is developed from traditional costing method, both of them have some differences between them.
- In the traditional system, a few allocation bases are used to allocate overhead costs, whereas ABC system uses many drivers as allocation basis.
- Traditional method allocates overheads first to the individual departments, whereas activity based costing assigns over heads to each activity first.
- Activity based costing is more technical and time consuming, while traditional method or system is quiet straight forward.
- Activity based costing can give more accurate indication of where cost cuttings can be made than the traditional system; that means, activity based costing facilitates more rigorous or accurate decision making than traditional system.