Friday, 20 January 2012

ABC Costing vs Traditional Costing

Activity-based costing :
Activity-based costing is a system that attempts to accurately trace indirect costs to products by allocating indirect costs to activities and then to products based on their usage of the activities. ABC is optimal when accuracy is very important and when indirect costs comprise a large proportion of total costs compared to direct costs. ABC is commonly used in the manufacturing sector. A reason why it is so useful for the manufacturing sector is fairly obvious, by allocating indirect costs to products based on usage, a company can more accurately see where the resources and energy is going in their company. By figuring out where the money and energy is going, efforts can be focused upon those products that are eating up the most time and energy. This will eventually lead to a drop in cost, in theory, as efforts will be made to reduce the costs on the bulk of the products. Activity based costing is all about efficiency. Efficiency is paramount to success and growth within a company and that is why activity based costing is an effective way to allocate indirect costs within a company to products.

Activity-Based Costing Steps:There are four steps in the activity based costing process.

1. Identify and classify all of the activities in the value chain related to the production of the product.

2. Estimate a total cost for each of the activities identified.

3. Compute a cost-driver rate for each activity based on a cost allocation base that has a causal link to the cost of the activity.

4. Apply activity costs to products using the appropriate cost-driver rate.

Activity-Based Costing Example:
For example, a company identifies and classifies machine maintenance as an indirect cost activity. Based on historical data, the company estimates machine maintenance costs to be $1,000 per month. The company determines that batches of product produced on the machine are an appropriate cost-driver allocation base for machine maintenance costs. The machine typically produces 500 batches per month. Thus, the cost-driver rate would be $1,000/500 batches, or $2/batch. So, for each batch of product produced, the company would apply $2 of indirect cost for machine maintenance.

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.

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