This report aims to compare the differences between Traditional costing system and Activities Based Costing (ABC) system. The advantages and disadvantages of both concepts determine which method is more superior for the business.
Traditional costing concepts
Traditional costing is to consider how much will cost to produce a product. It plays an important role in the business to predicting the profitability of a product. Traditional costing is also well known as the conversional method costing, which refers to the allocation of manufacturing overhead costs to the product manufactured (Harold, n.d.). Traditional costing assigns manufacturing overhead on the basis of volume of a cost driver, such as direct labor hours, production machine hours or direct material hours, all of which are needed to produce an item and the number of units produced.
Different from activity- based costing, traditional costing is emphasis on costing information of external financial report in the business, because it provides the value of cost of goods sold. Many manufacturing companies use traditional costing system in order to divide the total cost of a product by the direct labor cost. Generally, the traditional costing method users make the assumption that the volume metric is the underlying driver of manufacturing overhead cost. Hence, under traditional costing method, accountants regard manufacturing costs only to product. Whereas, some cost such as administrative expenses are allocated as non-manufacturing cost and they are also associated with product of an item, which still cannot be assigned into traditional costing method.
ABC system is used for the internal decision making in the business. It helps managers with decisions which may have possibly impacts on the fixed costs and the variable costs. It is an approach that identifying costs based on activities, including direct and indirect costs accruing from the different levels of activity that all related to producing an item and allocating the cost. Then these costs are related to the products that require the activities.
By comparing ABC with the traditional cost accounting, there are three main differences. Firstly, ABC approach is in relation to all overhead costs which contain both manufacturing overhead as well as selling and administrative overhead. Secondly, all the manufacturing costs are allocated to the product in traditional costing accounting while ABC costing only assigns some of the manufacturing costs to the products. The costs such as organization-sustaining costs and unused costs are not included in the ABC. (Garrison, Noreen & Brewer, 2012). For example the cost such as the wages for the factory security guard which does not have impact on the product, ABC recognizes this kind of cost as expense thus is not included in the ABC method. The third difference is ABC uses more cost pools. According to Garrison, Noreen and Brewer (2012), activity cost pool is defined as accumulated cost that is related to a specific activity measured in the ABC approach. When there are too many activities in the business, it is hard to manage the system. Therefore the activities can be treated at five different levels. Unit-level activities have one to one correspondence with unit output, such as the calibration activity for final metering of the product. Batch-level activities must be performed; however they can be related to more than one units output. For example shipping activity, the activity incurred once as the order has been placed by the customer. Product level activities are carried out only at the level of the product, such as designing a product, advertising a product and so on. Next there are customer level activities; these activities can be incurred in various forms, which maybe included is technical support help lines, sales calls, catalog mailings and many other activities. The last, but not least, is organization sustaining