See Also:
Activity Based Costing
Standard Costing System
Cost Driver
Value Chain
Implementing Activity Based Costing
Absorption vs Variable Costing
Activity Based Management
Process Costing
Overhead
Job Costing
ABC Costing vs Traditional Costing
In the field of accounting, activity-based costing and traditional costing are two different methods for allocating indirect (
overhead) costs to products.
Both methods estimate overhead costs related to production and then assign these costs to products based on a
cost-driver
rate. The differences are in the accuracy and complexity of the two
methods. Traditional costing is more simplistic and less accurate than
ABC, and typically assigns overhead costs to products based on an
arbitrary average rate. ABC is more complex and more accurate than
traditional costing. This method first assigns indirect costs to
activities and then assigns the costs to products based on the products’
usage of the activities.
Traditional Costing Method
Traditional
costing systems apply indirect costs to products based on a
predetermined overhead rate. Unlike ABC, traditional costing systems
treat overhead costs as a single pool of indirect costs. Traditional
costing is optimal when indirect costs are low compared to direct costs.
There are several steps in the traditional costing process.
1. Identify indirect costs.
2.
Estimate indirect costs for the appropriate period (month, quarter,
year). 3. Choose a cost-driver with a causal link to the cost (labor
hours, machine hours).
4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).
5. Compute the predetermined overhead rate (see below).
6. Apply overhead to products using the predetermined overhead rate.
Predetermined Overhead Rate Calculation
Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount
For example:
$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor
Activity-Based Costing Benefits
Activity
based costing systems are more accurate than traditional costing
systems because they provide a more precise breakdown of indirect costs.
However, ABC systems are more complex and more costly to implement. The
leap from
traditional costing to activity based costing is difficult.
Traditional Costing Advantages and Disadvantages
Traditional
costing systems are simpler and easier to implement than ABC systems.
However, traditional costing systems are not as accurate as ABC systems.
Traditional costing systems can also result in significant
under-costing and over-costing.