Activity Based Costing Vs Traditional Costing

activity based costing system

ABC systems excel at being able to assign costs to products that are manufactured and supported by many different types of activities. While most customer costs are related to product costs, some overhead is involved. As a result, you might focus on your most profitable customers and possibly turn away less profitable ones. Additionally, you’ll be better able to understand products’ profit margins and reposition resources to earn the largest margins. A company spent $20,000 in utility bills this year, and it wants to determine how much money is spent on utilities to make its product.

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For example, the number of parts purchased affects the purchasing costs. BAC ltd is considering shifting from the traditional costing method to ABC based costing method, and it has got the following details. Using ABC costing formula, find out the new overhead rates for the company. For a single-product company with fairly stable inventory levels, traditional and ABC methods will yield about the same results. But, for multi-product/service firms, the arbitrary allocation of costs can pretty much “make or break” the perceived profitability of each product or service. As companies have grown larger and more diverse in output, there has been an accompanying concern about how costing occurs.

Break Down Where Your Money Goes With Activity

Once the ABC information was presented, the case was settled, and the initial injunction was lifted. Product-level activities are carried out at the product level, no matter the volume of production.

What are ABC cost drivers?

An activity cost driver is an accounting term. … In activity-based costing (ABC), an activity cost driver influences the costs of labor, maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity.

For example, in a factory, the number of hours a machine runs determines how much electricity is used and how much will have to be spent on maintenance. In this example, the number of machine hours is the cost driver that controls how much electricity is used and the cost of maintenance. The fewer the number of machine hours, the less the cost of electricity and maintenance; whereas, the higher the number of machine hours, the more the cost of electricity and maintenance.

Traditional Costing

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  • Thus, obtaining a method of estimating the costs of the various products produced in the same company in a rigorous and precise way has turned into a really strategic objective .
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  • The floor area was selected to distribute water, cleaning services, heating, and indirect electricity.
  • In this way, long-term variable overheads, traditionally considered fixed costs, can be traced to products.

The first product is GLASSESong, a pair of sunglasses with a built-in music player. The other is CAPlayer, a golf cap with a built-in music player having a very short unobtrusive cord from the cap to the speakers. CGMA is the most widely held management accounting designation in the world with more than 137,000 designees. It was established in 2012 by the AICPAandCIMAto recognise a unique group of management accountants who have reached the highest benchmark of quality and competence.

Step

An ABC system rarely can be constructed to pull all of the information it needs directly from the general ledger. Instead, it requires a separate database that pulls in information from several sources, only one of which is existing general ledger accounts. It can be quite difficult to maintain this extra database, since it calls for significant extra staff time for which there may not be an adequate budget.

activity based costing system

It is reportedly much more expensive to produce than GLASSESong. Following is an analysis of GAME’s cost of production by product.

For direct costs, accountants measure a product unit cost for each direct cost category. The two costing methods differ, however, in the way they assign values to so-called indirect costs for products.

Accounting

ASSIGN REMAINING COSTS TO ACTIVITIES — Remaining costs are assigned to activities. As an example, there may be a separate industrial engineering group that does nothing but machine setup prior to a production run. The cost of this group is easily assigned to the machine setup activity, which in turn will be reallocated to a variety of end products. However, the janitorial group may perform a major cleanup after each machine setup. Perhaps 10% of the janitorial staff’s time should be assigned to machine setup and the other 90% to general maintenance.Some resources are consumed, and no one can agree as to the cost object that should absorb the resource.

What are three advantages of activity-based costing?

What are three advantages of activity-based costing over traditional volume-based allocation methods? More accurate product costing, more effective cost control, and better focus on the relevant factors for decision making.

The examples show how ABC and traditional costing can yield different indirect cost estimates for the same products. This means the two approaches can also estimate product-specific profitability differently. ABC pursues these objectives primarily by making direct costs out of many of the expenses that traditional cost accounting treats as indirect costs.

These estimates, in turn, require an understanding of the full cost per unit of each product. While the direct costs per unit are easy to find, the indirect costs are less noticeable. As a result, the firm will have to uncover indirect product costs through a costing methodology—either traditional cost allocation or Activity Based costing. Note that these rates are lower than those estimated using traditional ABC methods (see again the exhibit “Doing ABC the Traditional Way”). The reason for this difference becomes obvious when we recalculate the quarterly cost of performing the customer service activities. This takes care of the technical drawback of traditional ABC systems we mentioned earlier—the fact that surveyed employees respond as if their practical capacity were always fully utilized. Activity based costing assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours.

Traditional Costing Method

The potential problem with ABC, like other cost allocation approaches, is that it essentially treats fixed costs as if they were variable. This can, without proper understanding, give some people an inaccurate understanding which can then lead to poor decision making. For example, allocating PPE to individual products, may lead to discontinuation of products that seem unprofitable after the allocation, even if in fact their discontinuation will negatively affect the bottom line. Applicability of ABC is bound to cost of required data capture. That drives the prevalence to slow processes in services and administrations, where staff time consumed per task defines a dominant portion of cost. Hence the reported application for production tasks do not appear as a favorized scenario.

High Challenge has decided to allocate overhead on the basis of machine hours. We have discussed three different methods of allocating overhead to products—plantwide allocation, department allocation, and activity-based costing. Remember, total overhead costs will not change in the short run, but the way total overhead costs are allocated to products will change depending on the method used. However, users of ABC indicated their systems were more adequate than traditional systems in providing useful information for performance evaluation and cost reduction. Activity-based costing attempts to overcome the perceived deficiencies in traditional costing methods by more closely aligning activities with products.

activity based costing system

It appears ABC has proven to be too much work for many and too complicated for many companies to use and maintain over time. The author insists that “the solution to problems with ABC is not to abandon the concept.” He goes on to outline a new ABC program which he and his co-author, Steven R. Anderson, call time-driven ABC. Although not fully developed in this article, the new time-driven ABC method is described as a simplification of the original ABC method. Once all of these costs are determined and noted, the information must be input into a computer application.

The top portion of the following analysis applies the per-activity cost information to show how the total cost of CAPlayer is less than the total cost of GLASSESong. The lower portion compares costs and revenues to determine product profitability. Unallocated cost is included in the total column only; it is important, but not tied to either product. Product profitability is portrayed differently under alternative costing methods.

Activity-based costing method is a new and more effective cost system. ABC analysis recognizes that product A uses more activity pool resources than product B. Finally, the examples show that ABC requires more data and a more detailed analysis than the traditional PVB allocation approach. Manufacturing firms do not set up production machines for each product unit. They are set up instead for the production run of each product model.

Rather than applying all factory overhead on some simple basis such as labor hours, it requires the development of numerous cost pools that must be individually allocated. Let’s say employees report that they spend about 70% of their time on customer orders, 10% on inquiries or complaints, and 20% on credit checks. Activity-based costing is a methodology for more precisely allocating overhead costs by assigning them to activities. Once costs are assigned to activities, the costs can be assigned to the cost objects that use those activities. The system can be employed for the targeted reduction of overhead costs. ABC works best in complex environments, where there are many machines and products, and tangled processes that are not easy to sort out.

This requires abandoning the traditional division between product and period costs, instead seeking to find a more direct linkage between activities, costs, and products. This means that products will be charged with the costs of manufacturing and nonmanufacturing activities. It also means that some manufacturing costs will not be attached activity based costing system to products. CIMA Official Terminology describes activity-based costing as an approach to the costing and monitoring of activities, which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects. The latter use cost drivers to attach activity costs to outputs.

Time

Under Activity Based costing, an activity pool is the set of all activities necessary for completing a task, such as processing purchase orders, or performing machine setups. The indirect cost allocation for B is therefore 94.8% of this, or $995,750. The indirect cost allocation for A is therefore 94.8% of this, or $426,750. The easy approach is to use ABC software in conjunction with a company’s existing accounting system. The traditional system continues to be used as before, with the ABC structure an extra to be called upon when specific cost information is required to help make a particular decision.

Manufacturing overhead must be accurately allocated to a product’s cost for manufacturing companies to set product sales prices and determine if products are producing profits. In this example, the overhead charged to the hollow ball using ABC is $0.52 and much higher than the $0.35 calculated under the traditional method. The $0.52 is a more accurate cost for making decisions about pricing and production.

  • Although some may argue that costs untraceable to activities should be “arbitrarily allocated” to products, it is important to realize that the only purpose of ABC is to provide information to management.
  • Look at the overhead rates computed for the four activities in the table below.
  • Or imagine the activities involved in making a complex product such as an automobile or computer.
  • It is based on the review of literature on the design and implementation of ABC.
  • It has extensive reporting functions, multi-user plans and an intuitive interface.

Take control of asset TCO and prevent nasty cost surprises later. When the competition gets serious, the edge goes to those who know how and why real business strategy works. Essentials for mastering the case-building process and delivering results that win approval, funding, and top-level support.

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Canby J. B. T. Applying activity-based costing to healthcare settings. Comparing the result of ABC and TCS revealed that a significant difference between the TCS and ABC results; ABC system assigned lower costs for occupancy bed-day. On the other hand, cost price of occupancy bed-day should be less than the TCS by 30%. In this study, was aimed to determine the cost price of medical services by ABC in Kashani Hospital, Shahrekord City, Iran, and compare the results with those of TCS.

Identification of non-value adding activities helps the management to control cost. Improved cost-basis available both at head office and plant level for better decision making. The final words of comment over ABC system are that adoption, implementation and operation of the system is not an end in itself. The benefits can be derived by translating the system design and its operation into action-oriented managerial performance.

Author: Donna Fuscaldo