In table 2 the apportionment basis cost drivers for each overhead cost, and the proportion of the cost to go to each part of production was stated.
However, it does not give managers an accurate picture of product costs because the application of overhead burden rates is arbitrary and applied equally to the cost of all products. If the costs of support activities are allocated to products on the basis of a production volume related measurement such as direct labor hours, low volume products will not receive cost allocations in proportion to their demands on these activities.
For external reporting, companies still use the traditional costing system, but it is becoming obsolete as outsiders demand more accurate information about businesses.
Capital Budgeting Techniques Activity-Based vs Traditional Costing Assume the Busy Ball Company makes two types of bouncing balls; one has a hollow center and the other has a solid center. The following example can illustrate the above — Question A used as example: ABC use various cost drivers to allocate the overheads to the products whereas Traditional Absorption costing relies on a single or perhaps two, volume based rates i.
The overhead costs incurred have been allocated to activity pools as follows: Finally, In table 5 you can see a comparison of the two methods. Definition, Features and Limitations! The traditional costing method is best used for manufacturers that only make a few different products.
The number of orders, setups, or tests the product actually uses does not impact the allocation of overhead costs when direct labor dollars are used to allocate overhead. Product Diversity Cost distortions from product differences occur when there are variations in product size and product complexity.
The activity by product is shown in the following table. More and more factory overheads, such as setup cost, materials handling cost, and product design and research and development costs, are unrelated to the number of units produced. For external reporting, companies still use the traditional costing system, but it is becoming obsolete as outsiders demand more accurate information about businesses.
This section covers learning objectives 10 through Deciding between traditional or activity-based costing is not easy. Functional-based volume-based costing system has the following features: To calculate the per unit overhead costs under ABC, the costs assigned to each product are divided by the number of units produced.
That is, Total Overhead costs were divided by the addition of all DLHs, giving us the overhead rate per labour hour? The other major manufacturing cost item, direct materials costs, consists of payments to vendors rather than costs incurred inside the factory.
It is more suited to businesses with high overhead costs that manufacture products, rather than companies that offer services. Thus, companies that apply plant-wide and departmental overhead rates to assign overhead costs to products often do not produce reliable cost data.
The following are the limitations of volume-based costing system: The other major manufacturing cost item, direct materials costs, consists of payments to vendors rather than costs incurred inside the factory.
However, engineering design, marketing, distribution and customer service costs are clearly part of the costs of placing a product in the hands of the customer. Product A is very popular andunits are produced annually.
A fundamental difference between traditional costing and ABC costing is that ABC methods expand the number of indirect cost pools that can be allocated to specific products.
In this costing system, overheads are charged to products on a production volume related basis such as direct labour hours, direct labour cost, and machine hours.
Traditional Absorption methods were used to spread overheads to products when factory overheads were relatively small compared to material and labour costs. Your choice should depend on the purpose of the reporting and who will see the information. Also a cost pool can be problematic if the chosen single cost driver cannot fully explain the cost behavior of all items in the particular cost pool; this would indicate that further brekedown is needed.
Company X produces two types of products: Traditional Costing Traditional costing adds an average overhead rate to the direct costs of manufacturing products. Different products utilize different amount of resources, which is not recognized in traditional costing system. Traditional product costing system is also referred to as functional-based cost accounting system or volume-based costing system.
The primary assumption of ABC is that cost is caused by activities and not by products. Indeed, often traditional costing system indicates higher cost in the presence of known productivity improvement or vice versa.
Accountants created the ABC method to solve the problems of inaccuracy that result from the traditional costing approach. Overhead costs are not allocated to the products that actually consume the overhead activities.
The last section relates the emergence of activity based costing to the dichotomy of capitalism framework discussed in Chapter 1. To keep the illustrations in this chapter fairly simple, we will concentrate on manufacturing costs, but remember that non-manufacturing costs are also traced to products and services using the ABC approach.
Deciding between traditional or activity-based costing is not easy. Product Volume Diversity Cost distortions from product volume differences occur when a company produces one, or more, high volume products i.Activity Based Costing Costing vs Traditional Costing.
In the field of accounting, activity-based costing and traditional costing are two different methods for allocating indirect 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 product costing system is also referred to as functional-based cost accounting system or volume-based costing system. Traditional (or conventional) product costing system determines product cost by way of allocating, in the first stage, direct costs to the products and then subsequently adding a proportion of overheads deemed to be related to the units produced.
Traditional costing is the allocation of factory overhead to products based on the volume of production resources consumed.
Under this method, overhead is usually applied based on either the amount of direct labor hours consumed or machine hours used. Traditional product costing system is also referred to as functional-based cost accounting system or volume-based costing system.
Traditional (or conventional) product costing system determines product cost by way of allocating, in the first stage, direct costs to the products and then subsequently adding a proportion of overheads deemed to be related to the units produced.
These activity volume measurements may represent the frequency, duration or physical volume of an activity.
5 However, the key difference between traditional costing and activity based costing is that ABC uses both production volume and non production volume activity measures to trace costs to products. Some examples of common activities and representative activity measures are presented in Exhibit Jun 29, · A fundamental difference between traditional costing and ABC costing is that ABC methods expand the number of indirect cost pools that can be allocated to specific products.Download