Traditional Costing Versus Activity Based Costing Accounting Essay

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I would strongly recommend that you have to implement the ABC costing in your organization, given the fact you analyze the cost and benefit of ABC implementation and find out that ABC would benefit in managing the costs in a better way.

Let me first explain the traditional costing system, which you are currently using for many years. i.e. allocating the overhead expenses to the products using the basis as labour hours, then I would elaborate on the weaknesses of this and why activity based costing is suggested by your accountant, how this would improve your pricing decisions and thereby reflect in increasing profitability.

Traditional costing system

Indirect costs such as supervisors' salaries are not directly traced in to the products; rather allocation basis is used in charging the costs to the products. A common allocation base such as labour hours or machine hours are used in allocating the cost. Let me explain why this is not appropriate using a simple example. We both have ordered different menus today. I have ordered a seafood meal, which is costing $35 whereas you have chosen the vegetarian combo, which is only $20. If we are going to split this expense by two: each will share $27.50. In this situation, you are the loser where your actual consumption was only worth for $20. This is what happening in your current costing! By using the traditional allocation basis, some products would be over cost while some would be under cost. Rarely some products stay at the right cost (Akyol, Tuncel and Bayhan, 2005). ABC costing is used in identifying the true cost, thereby pricing decision can be effectively made.

The improvement of cost accounting is needed to: (Hilton, Maher and Selto, 2008, p. 147)

Trace as many cost directly to the goods or services as possible

Categories indirect overheads

Use cost allocation to assign indirect overheads to products

In satisfying the above three points activity based costing is introduced.

Activity Based Costing (ABC)

ABC is a costing method, which assign costs to activities and then to goods and services based on how much of each activity is used in producing a particular product or service.

This method helps in identifying the most and least profitable customers and products.

It also used in accurately forecasting on costs, profits and resources in accordance to change in production volume and cost of resources.

Overall activity based costing will enable to track on which activity or product is causing poor financial results which in your case is important to identify even though you have a proper markup and still experiencing a loss. This could be the reason of your accountant to suggest on implementing ABC costing.

You should also realize why organizations resist implementing ABC even there are valuable benefits derived by the system.

ABC is time consuming

Each and every activity has to be identified.

Implementing ABC is high cost. Since it request for additional record keeping, computer system and hire additional analysts.

Wastes become visible which managers do not prefer!

Four steps of identifying cost using ABC is as follows (Hilton, Maher and Selto, 2008, p. 147)

Identify and classify the activities related to the company's products

Estimate the cost of activities identified

Calculate a cost driver rate for each activity.

I wish to explain the terms cost-driver rate, cost driver and cost driver base here (Hilton, Maher and Selto, 2008, p. 153)

Cost-driver rate: estimated cost of resource consumption per unit of cost driver for each activity

Cost driver: A factor that decides the cost of an activity. e.g. Maintenance cost is an indirect overhead; the cost driver could be number of machine hours.

Cost driver base: Is the base used to trace or assign costs to activities. This could have a cause and effect relationship with the activity and its cost, and be measurable.

Assign activity costs to products

ABC adds value to an organization with complex production process, multiple products and in highly competitive market. Since ABC has both cost and benefits, it is necessary to indentify whether benefits outweigh the costs. (Hilton, Maher and Selto, 2008, p. 163-165) has mentioned few indications on when to implement a ABC system.

Indirect overhead are significant compare to direct cost and are allocated using a simple cost driver like labour hours. (which is true in your company)

Production of goods and service are complex and require many different process and materials.

Standard high volume goods show loss or small profit while complex low volume goods show high profit.

When different departments feel unfair of the cost allocated to the product

Company losses bits while it thought were priced relatively low and vice versa.

Company has not changed its costing system in spite of major changes it has made to its operations.

Company is facing high competition and has diversified customer base.

I would like to share a research outcome that professors Kennedy and Graves found from their studies in UK that companies who adopted ABC significantly outperform the others over the three years after implementing it. (Hilton, Maher and Selto, 2008, p. 164)

Companies like Boeing, IBM, P&G and HP have implemented activity based costing and improved on production cost. Tetronix Inc. found that one of its products, printed circuit board was generating negative margin of 46% (Ross and Perry, 1999, p.375).

Considering the high costs ABC systems specifically while different cost driver bases are used, some analysts proposed Time Based ABC. This is a method of ABC, that uses time as a cost driver base to replace some or all parts of ABC system with multiple cost driver bases.

Activity based costing can lead to activity based pricing. This is a most powerful tool, which can be used in converting unprofitable customers in to profitable. Activity based pricing establish a base price for standard quantity for a standard product. In addition company provides menu options with different prices for any services which allow the customer to choose on the features S/he needs. Therefore, prices order not the products! (Atkinson et al, 2007, p. 156). Thereby both suppliers and customers benefit.

In conclusion, I would suggest to implement ABC in your company since significant problem indications given above has alarmed you.