Difference Between Activity Based Costing and Traditional Costing Methods

Over the recent past, most companies have extensively adopted the use of cost management in their operations. This is because of the need to track and minimize costs while maximizing the output. As such the use of activity-based costing has gained popularity among many cost accountants. This paper discusses the use of activity-based costing and the difference from the traditional costing method.

Activity Based Costing deals with allocating the unidentifiable costs to the activities of the organization and seeks to improve the reliability of the costs allocation activity of the organizations (Harvey, 2000). There are many differences between ABC and the traditional costing systems. First ABC is considered a more reflective method of cost allocation since it provides a precise breakdown of the indirect costs that the organization incurs. The traditional costing system allocates the indirect costs through the setting of a predetermined overhead amount and this makes the major difference between ABC and the traditional costing method (Harvey, 2000).

Activity based costing may be resisted by management because of several reasons. One, the method is more complex than the traditional costing method. This is because the allocation involves the activity of assigning costs of the organization to the activities carried by the organization and then allocates the costs to products based on the usage of that particular product. It is therefore a cumbersome process and as such most of the top management may be opposed to it because of the fear of accountability (Horngren, Foster, & Datar, 1999).

When using ABC, activity rate is important to management since it provides a basis for allocation of the indirect costs to the particular product concerning their usage of the resources. Without the activity rate, ascertainment of the costs per activity may be a hard task and as such, the use of Activity Based Costing may be frustrated or may offer inaccurate information.

Activity Based costing is usually unacceptable for external financial reporting. This is because of the complexity of the system as well as the need to allocate the different costs to different products. This is not always the norm when doing financial reporting since other costs are not associated with the products and therefore using the activity-based costing method in external financial reports may not be recommended.

While allocating the indirect costs by the Chicago company manager, there are various other considerations that the manager ought to take. First, it should be noted that the Activity Based Costing system considers the costs incurred per product per department. This means that although some departments tend to get fewer costs allocated to them, it may not be a mistake since these departments could be playing a rather minor role in the very activity whose costs are being allocated.

However, there are other considerations that the manager should have before deciding on the allocation base. First, the manager ought to know of the inter-departmental services such that while an activity’s costs could be allocated to different departments, there is a portion of the costs that cannot be allocated to another department since that particular activity could be carried out exclusively by one department but affecting the other departments (Horngren, Foster, & Datar, 1999).

The other consideration that the management ought to take into account is the interrelationship between the cost departments and the whole indirect costs. This is because a case may be where these indirect costs are not incurred by the whole organization but just the different departments that are there in the company. this would help the manager remove the departments which do not in actual sense incur overhead costs.

References

Harvey, R. K. (2000). Throw Out Fixed And Variable Cost Thinking— Bring In Activity-Based Costing To Business Decisions. Graceland-Carbondale: Value Associates, Ltd.

Horngren, C., Foster, G., & Datar, S. (1999). Cost Accounting – A Managerial Emphasis. New York: Prentice Hall.