Activity Based Costing vs. Traditional Costing

Summary

This video explains the key differences between activity-based costing (ABC) and traditional costing methods. Traditional costing uses a single plantwide overhead rate based on machine or labor hours, making it simple but less accurate. ABC, on the other hand, assigns multiple activity rates by categorizing costs into pools, resulting in more accurate product costing. Although ABC provides detailed insights, it is more complex to implement, requiring additional resources and employee involvement. The video emphasizes the importance of balancing accuracy with cost-effectiveness when choosing between these costing methods for better decision-making in business operations.

Takeaways

• 😀 Traditional costing uses one plantwide overhead rate based on machine or labor hours.
• 😀 Activity-Based Costing (ABC) uses multiple activity rates, each tied to a specific cost pool.
• 😀 ABC is more complex to implement than traditional costing, requiring detailed employee input and cost estimations.
• 😀 Traditional costing is easier to implement and less resource-intensive, making it suitable for less complex firms.
• 😀 Traditional costing only allocates product costs, while ABC can allocate both product and period costs (e.g., SG&A).
• 😀 Traditional costing is acceptable for external reporting, such as calculating cost of goods sold, while ABC is not.
• 😀 ABC is superior in accuracy because it assigns overhead costs more precisely, reflecting actual usage of resources by products.
• 😀 Traditional costing often leads to over or under-costing products, especially when different products use resources at different rates.
• 😀 ABC allows for more informed decision-making by providing a clearer picture of the true costs of products and services.
• 😀 Implementing ABC may face employee resistance due to the increased tracking of activities and departure from traditional methods.
• 😀 Companies that adopt ABC may need to maintain two separate sets of books: one for external reporting using traditional costing and another for internal management using ABC.

Q & A

What is the main difference between activity-based costing (ABC) and traditional costing methods?

The main difference is that traditional costing uses a single plantwide overhead rate, typically based on machine hours or labor hours, to allocate costs. In contrast, ABC uses multiple rates derived from activity cost pools, allowing for a more precise allocation of costs to products based on specific activities.

Why is traditional costing easier to implement than activity-based costing?

Traditional costing is simpler because it involves calculating just one overhead rate, typically based on machine or labor hours. ABC, on the other hand, requires identifying and interviewing employees about which activities should be included in cost pools, making it more complex and time-consuming.

How does activity-based costing (ABC) allocate costs compared to traditional costing?

ABC allocates costs using multiple activity rates, where each cost pool has its own rate. Traditional costing allocates overhead using a single rate, either based on labor hours or machine hours, across all products, regardless of their actual consumption of activities.

What are the disadvantages of implementing ABC within a firm?

ABC is more complex and harder to implement because it involves detailed analysis of activities and cost pools, interviews with employees, and the tracking of specific activities. Additionally, employees may resist the change, especially if they are accustomed to traditional costing systems.

Can activity-based costing be used for external reporting?

No, activity-based costing is primarily for internal use, such as decision-making and cost analysis. It cannot be used for external reporting like calculating the cost of goods sold for financial accounting, which requires traditional costing methods.

Why might a company still need to use traditional costing if they implement activity-based costing (ABC)?

A company would need to continue using traditional costing to calculate the cost of goods sold for external reporting purposes. This means a firm using ABC would essentially need two systems—one for internal decision-making (ABC) and one for external financial reporting (traditional costing).

What are period costs, and how are they treated in traditional costing versus ABC?

Period costs are expenses like selling, general, and administrative (SG&A) costs. In traditional costing, these are treated as expenses and not allocated to products. However, in ABC, firms may choose to allocate some period costs to products, depending on their relevance to the costing system.

Why is activity-based costing considered more accurate than traditional costing?

ABC is more accurate because it takes into account various activities and their associated costs, rather than just using a single allocation rate. This helps to more accurately reflect the true cost of a product, especially if certain products require more support activities than others.

What is the potential impact of using traditional costing on decision-making in a firm?

Traditional costing may lead to inaccurate product costing because it allocates overhead costs uniformly, regardless of how much activity a product actually requires. This can result in under- or over-costing certain products, leading to suboptimal business decisions.

What factors should a company consider when deciding whether to implement ABC or stick with traditional costing?

A company should conduct a cost-benefit analysis, weighing the accuracy and decision-making benefits of ABC against the higher implementation complexity and potential resistance from employees. The number of cost pools to use and the trade-offs between accuracy and ease of implementation are also crucial factors to consider.