The principles of the activity and traditional based cost systems

Published: Last Edited:

This essay has been submitted by a student. This is not an example of the work written by our professional essay writers.

Costing systems are the programs that supply information about the value of direct labor hours and numbers of units produced. With the help of data such as product cost, the managers can generate estimation of cost associated with different activity carried in the organization. The costs systems operate by taking total cost as basic for calculation. Costing is essential for every organization, as every manufacturing and other department has to be assigned accurate budget for proper operation (Hansen, Mowen and Guan, 2006).

Costing system provide information that is useful to managers for minimizing waste and allocating resources to different departments. However, it is important for the managers to understand that the resources necessary for designing and implementing the cost system should not exceed than the benefit drew out from the system (Thomsett, 2002).

Estimation of costs can be done with the help of two systems known as Traditional costing and Activity based costing.

Traditional cost system was developed by the organization, General Motors. The organization used this system to calculate the total manufacturing cost that is sum of all the costs related to individual operations. However, the cost that matters the most to organization is profitability, which is required for improving the competitiveness. This cost estimation is done by activity based costing. The basic preface of activity based cost system is that the organization is an integrated process and operates when there is proper supply of parts and raw materials at respective plants. It continues until the final good reaches the customer (Drury, 2008).

The traditional cost accounting system is based on the factors such as Wages and salaries, employee benefits, supplies, traveling allowances, depreciations and other fixed charges, operating expenses and miscellaneous (Dury, 2008). Activity bases accounting system is based on evaluation of suppliers, purchase order, expedite deliveries and supplies, purchase orders, expenditure on internal process, maintaining check of item quality and deliveries, resolving the problems and internal administration. From the above description on the factors that form base of accounting system, it can be stated that Traditional costing system operates in independent manner and Activity based costing system is an interdependent activity (Blocher, 2006).

The main problems related to use of traditional costing system is limited economic focus. The benefits offered are intangible and remain unmeasured. These all the factors that might prove to be bottleneck for the company can be cleared by the help of activity management cost (Thomsett, 2002).

The traditional cost system follows the mentioned principles:

Traditional costing used cost allocation method. In cost allocation method, the costs are estimated based on the future.

This costing system does not take into consideration the factor of why and where cost goes.

This method does not give proper focus on the variances.

This method is not flexible, time oriented, and inaccurate.

The operational managers do not give any consideration to knowing the activities that are costly.

The focus is fiscal.

The cost of product and services are not associated with actual efforts improved.

Activity based costing system follows the mentioned principles

It measures the actual performance of the organization, taking into consideration every cost associated with activities.

With the help of this system the managers there is proper relation of consumption and expenses is maintained.

In activity based costing cost of activities are calculated based on resources that are consumed.

This method helps the managers to draw proper insight of sources of cost and the impact that might happen on and due to decisions taken.

Activity based costing system enables manager to realize the performance breakouts and take action accordingly (Traditional Costing vs. Activity-Based Methods, Exac cost, 2010).

The Traditional cost system depends largely on the volume variance. The volume variance is measured as the cost of labor and machines used for manufacturing the number of items. If number of item produced are less than the expected, then actual cost are likely to increase. This means the labor and the overheads used in manufacturing of products were not planned in proper manner. On the contrary, activity based costing system provides impeccable focus on the manufacturing of product. According to Hall (2008) many companies in US and UK and China have adopted activity based costing system, with the help of this system the managers of account and other department should keep separate tracks of costs differently. This is required to manufacture individual units in such manner that product design is manufactured in batches and manufacturing facility operates in efficient manner. Taking into consideration, the discussion activity based costing system is gives focus on overall organizational activities and traditional cost system focuses on individuals and machineries. Hence, use of activity cost system can be managed more efficiently than standard costing system (Daly, 2002).

The main motive of activity and traditional cost system is increasing profits. Traditional cost system focuses on large volume production of products, which is impossible if there is keeps on focusing on simple factors direct material, labor, and operational overheads. However, if there is no focus given on variable elements such as supplies of major and minor parts, electricity and other power resources, the actual cost of product can not be calculated. It is obvious that there is not just work of labor and machinery in producing finished goods (Cokins, 2001). It is necessary to consider fixed as well as variable overheads. Activity based costing system considers variable and fixed overheads, which helps in knowing the right number of activities involved in producing finished good. This process is known as unitizing fixed cost. Hence, the traditional cost system’s objective is to control cost, but activity based cost system plays more vital role of analyzing these factors to maintain the production in efficient manner (Anklesaria, 2008).

In today’s uncertain business environment, it might become difficult to operate in rigid system that allocated cost to number of activities. Activity based costing system is not an improvement in the traditional standard accounting system, but an enabler for an establishment of the first time true management system. It is necessary to have flexible system, as rigid allocations do not work for an organizations having decentralized management system (Baumol and Blinder, 2007). Thus, application of activity based cost system over the traditional cost system helps the management to know the factors that are immeasurable and identify circumstances wherein the objectives get out of line on spending decision. Hence, it can be said that traditional cost system has control emphasis on cost and activity cost system has it on activities carried in the organization (Lee and Epstein, 2004).

The traditional costing system is generally estimates that the cost of whole organization is driven form the number of products and services are delivered. On the other hand, the activity based cost system allows non-linearity of costs in the organization by recognizing the fact that units of goods produced do not cause some costs (Grossman and Livingstone, 2009).

This can be explained with the help of comparison chart of traditional and activity costing system drawn by a university.

From the figure it is easy to determine that traditional accounting system is the method that provides information about the cost of resources that are being supplied to realize the organizations mission. On the other hand, activity based costing system provides data about the activities that are carried in the company for obtaining their profits. Thus, using activity-costing system is more advantageous compared to traditional costing system (Druker, 2007).

A research carried by an organization stated that it is no possible to engage activity based costing system until there is strong accounting and information system. Yet if the system is weak, more learning is done. Thus, the traditional costing system cannot be ignored for implementation of activity costing system. The activity costing system is therefore, an advancement of traditional costing system (Mitchell, Coles, 2003).

The Activity based costing system is a decision-making activity. This costing system develops pure conceptual measure of costs. The traditional costing system is an activity that works on fixed costs that are predetermined. Thus, there is no scope for analysis and taking decision related to cost of the products (Baggaley, 2003). Expenses related to indirect cost form base for decision-making process to allocate budget. Activity costing system calculates estimation of resources to be consumed by the cost object known as cause-and-effect allocations. Traditional costing system does not have such tool to calculate cost objects (Oliver, 2000).

The is great difference in calculation methodology of traditional cost system and activity based costing system, as ABC can help in eliminating cross subsidies.

In activity costing system, the drivers (employees, workers and officials) are the cause of activity, and the activity that happened in the organization, is the effect of drivers. The second factor that makes Activity costing system flexible is that it offers better attention directing information system that periodically identifies all the potentially non-profitable products that have to be studies precisely (Pearce, 2010). Traditional costing system does not show such areas of cost. Most of the product decisions cannot be taken independently, as there are product interdependencies in the joint resources that have long-term relation and should be assigned to the products (Drury, 2009).

The traditional costing system operates based on calculation of services or products consume resources (Joachimsthaler, Aaker, 1999). Activity cost system operates on the principle that products consume activities and the activities consume resources. The traditional costing system is also known as process costing or job costing. However, activity based costing system is provide combination of job and process costing system (Galliers and Leidner, 2003).

Traditional cost system cannot calculate accurate cost compared to activity cost management (Owen, 2006). The Activity based costing system states that at the time of overheads are high, products are diverse and the errors cost becomes high. This increases the competition in the market to great extent (Drucker, 2006).

The best way to chalk out the procedure of traditional and activity based cost system is by an example. The traditional cost system assumes cost for certain operation. For instance this system states that heat treatment is required. The activity based costing system finds the answer, whether it is actually required and where can it be done best. This system provides great integration of many activities such as process analysis, value analysis, costing, and quality management. Many researches have stated that the activity costing system can reduce the cost in the organization by one-third of overall expenses. The activity based costing helps in knowing the factors that did not allow traditional costing to be successful for many companies. The main reason for this is not that the traditional costing system technique, but traditional costing system’s assumptions are wrong (Thomsett, 2002).

For instance, banks are trying to apply conventional cost accounting measures to the business for figuring out the costs of individual services and operations. Now it is important to find the main cost for result. This cost is serving the customers. It is a fixed cost. This is the place where activity cost system applies. It determines the most necessary activities for retention of customer and increase the profitability.

In addition to great benefits, the Activity based costing system offers a helping hand to the managers. It is known as Activity based management. This management system helps in identifying and giving proper focus on all the critical changes that have to be made such that the management can takes action for fulfilling the need. Business process reengineering is like activity-based management that significantly improves the performance and savings (Whittington and Delaney, 2007).