![]() However, this method can be misleading, because it doesn’t take into account all of the activities that go into making a product. In traditional costing, indirect costs are allocated to products based on a single allocation base, such as machine hours or direct labor hours. Summary of Differences between Traditional Costing and Activity-Based Costing System:Įxhibit 4.What is Activity-Based Costing (ABC)? DefinitionĪctivity-based costing (ABC) is a costing method that assigns indirect costs to products based on the activities that are associated with producing those products. Proponents of ABC are concerned about future competitive positions and use historical cost only as a baseline for improvement. While activity-based costs are also calculated using historical resource costs, the orientation is different. In a competitive situation, where competitors have been proactive in eliminating waste and improving activities, an organization can go out of business while meeting its standards. These historical costs often include rework, duplication, waste, redundancy, and inefficiency.Īccepting historical costs as a given and reflecting these costs in standards does not support continuous improvement. It is not unusual for an organization to use actual historical cost as the basis for developing manufacturing cost standards. (3) Use of Historical Costs:Īnother difference between traditional and activity-based costing is the historical orientation. Thus, in ABC, there is no need to allocate/reapportion overheads of service departments. But ABC creates separate cost pools for service activities as well and overhead costs of these service activities (service departments) are assigned directly to specific products through applying cost driver rates. In traditional costing, overhead costs of service departments are allocated/reapportioned to production departments and therefore in this costing system finally only fewer cost pools exist. But, in ABC, many activity-based cost pools or cost centres are created. ![]() In traditional costing, overheads are pooled/collected department- wise. But in ABC, in the first stage, overhead costs are assigned to each major activity and not to departments. In traditional costing, in the first stage, overhead costs are allocated to production departments. It can be observed that both the costing systems follow a two stage allocation procedure. Traditional Costing and Activity-Based Costing System : Exhibit 4.6 presents an overview of product cost determination under traditional costing and ABC system. By establishing the link between these cost drivers and fixed overhead costs, they are finally traced to individual products. In this way ABC improves product costing procedure (as compared to traditional costing) because it recognises that many so-called fixed overhead costs vary in proportion to changes other than production units. In summary, in ABC, each overhead activity has a overhead cost pool at the organizational level, each overhead activity has a cost driver with its unit of measurement and each cost driver has its unit cost i.e. The overhead cost is allocated, in this manner, to the component for all the overhead activities the component used. Now, by multiplying the units of cost driver actually used by the component by this cost driver rate, one can get the actual cost of that overhead activity performed on the component. This gives the actual cost per unit of the cost driver of that activity. Also, unit cost of each activity driver is worked out by dividing the total overhead cost pool of that activity by the total units of the cost driver used at the organizational level. This is called the overhead cost pool of that activity. On each overhead activity, the total cost of that overhead activity is collected at the organizational level. how many units of that cost driver were actually used by the component. Each overhead activity is measured in terms of its cost driver i.e. In ABC, there is a need to find out the actual overhead activities performed on the component. In fact, there is no rationale to it since the component may not have actually attracted the overheads to it in this manner of percentages. ![]() Generally, this percentage is either the percentage of the labor cost or as the percentage of the material cost of the component or labor or machine hours as compared to the overall labor cost or overall material cost or total labour or machine hours of the entire organization. In conventional costing system, it is done by loading a percentage of the total overhead cost of the organization to the component. To this will be added, the portion of overheads of the organization that actually got consumed by this component.
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