Definitions and meanings:
Activity based costing:
Activity based costing is a method of cost allocation of overhead costs such that, for each different activity, a different cost driver is applied which is best suited for that activity. The cost driver is specifically selected for each activity.
Traditional costing is a costing method used to allocate overhead costs based on a single cost driver according to the consumption of a volume of production resources. This single cost driver can be based on machine hours, labor hours etc. and is used for all the different activities.
Julian Co. manufactures fizzy drinks and plans the production of 20,000 drinks for the month of July. The direct labor hours estimated for the month of July are 900, direct machine hours are 600 and the estimated overheads are $6,000. These overheads can be segregated into three categories; $1,000 for direct supervision for 350 machine hours, $3,500 for logistics for 540 direct labor hours and $1,500 for 30 production set-ups. By applying traditional costing, the cost driver for the production of drinks would be based on a single activity level, either labor hours or machine hours, so:
- Predetermined overhead rate (labor hours) = $6,000/900 = $6.7 per direct labor hour
- Predetermined overhead rate (machine hours) = $6,000/600 = $10 per machine hour
Therefore, for every labor hour spent, a cost of $6.7 or for every machine hour spent a cost of $10 would be added to the cost of drink.
If we apply activity based costing, this technique will segregate and identify the most suitable cost driver for the incurred overheads:
|Direct Supervision||350 Machine Hours|
|Logistics||540 Labor Hours|
|Production Set-ups||30 Set-ups|
- Predetermined overhead rate (direct supervision) = $1,000/350 = $2.9/hour
- Predetermined overhead rate (logistics) = $3,500/540 = $6.5/hour
- Predetermined overhead rate (production set-ups) = $1,500/30 = $50/hour
So, the overheads will be allocated at a rate of $2.9 per machine hour spent, $6.5 per labor hour and $50 per production set up.
Differences between activity based costing and traditional costing:
The main points of difference between activity based costing and traditional costing are given below:
1. Primary Focus:
The primary focus of traditional costing is the apportionment of overhead costs to the activities of production. Irrespective of the specific allocation of resources, traditional costing sets a single metric for every activity involved in production and allocates costs based on the consumption of that metric. Although, activity based costing is also used for cost allocation but it adopts a different approach. Under activity based costing, appropriate cost drivers are determined for every different activity and cost is then allocated according to these cost drivers.
Traditional costing method is easy to implement as a single cost driver is set for all activities and overheads are simply divided into fixed and variable overheads. Activity based costing is difficult to implement because it involves choosing a suitable basis of absorption and absorbing overheads on that same basis is a complicated and time-consuming exercise. Additionally, in some cases it becomes difficult to determine a proper basis for the allocation of an activity.
Traditional costing can only be used for the absorption of manufacturing overheads but activity based costing can effectively be used to allocate manufacturing as well as non-manufacturing overheads like selling, administration etc. This is because activity based costing considers the actual center of cost for the period cost and then allocates it.
4. Management use:
The figures extracted by traditional costings can be included into cost figure of statement of profit or loss because it only inculcates product costs but activity based costing can only be used for management purposes. The main reason being activity based costing is based on the subjectivity of the user and two users may not find a cost metric suitable for the same activity. However, activity based costing can be actively used by the management of a company to make better cost pools and allocate costs more accurately.
5. Effectiveness of operations:
Activity based costing improves business processes in long term. This is because management of a company needs to investigate deeply into production activities and related costs. This highlights the reasons for certain costs being incurred, which can ultimately help control and manage these costs. Traditional costing does not compel management to look for different cost centers and so it becomes difficult for management to gather incremental data about production activities.
Activity based costing vs traditional costing – tabular comparison
A tabular comparison of activity based costing and traditional costing is given below:
|Uses multiple cost drivers for multiple activities.||Uses identical cost driver for different activities.|
|Is difficult to implement and requires time and effort.||Is straightforward and easy to implement.|
|Cover product cost only.||Can cover both product as well as period costs.|
|The values can be used in external financial statements.||The values cannot be used in reports of external reporting.|
|Effectiveness of operations|
|Enhances management knowledge about activities related to production process.||Does not provide opportunity to identify any specific reasons for costs incurred.|
Conclusion – activity based costing vs traditional costing:
Traditional costing is a conventional method of costing and is an easily understandable method by the management of a company. Its use is suitable for companies that have low overhead cost. In medium to large size companies where overheads are relatively high, the use of activity based costing may be preferred.
Managers may resist the use of activity based costing because not only it increases the amount of work required to identify all overhead operations but also it needs specialist management costing knowledge and experience.