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Activity-Based Costing (ABC)

Activity-Based Costing versus Traditional Costing

Activity-based costing can help managers make better decisions when they use it as a supplement to traditional costing.

At its core, activity-based costing differs from traditional costing in the way it assigns indirect costs. Indirect costs include rent, spoilage, and officers' salaries. Under traditional costing, these indirect costs are lumped together as overhead costs. In activity-based costing, overhead is teased apart and applied to the activity. Costs may be assigned to production activity pools. These costs may include salaries of those directly involved in the orders and scheduling.

The process of traditional costing does not apply the costs exclusively to product development and to the activity of generating the product. For example, the overhead costs may be applied to products but based on an average rate for producing the product. Activity-based costing, on the other hand, is more specific and more accurate than traditional costing. For this reason, activity-based costing can help improve the accuracy of costing products for inventory pricing. Costs that occur for a specific activity in activity-based costing can be applied to a specific product where costing is more accurate.

The disadvantage of activity-based costing is that it may require a team specifically allocated to evaluate costs for specific activities, and it may take time and expertise to collect this data. Because of this, companies often blend traditional costing with activity-based costing. An organization needs to determine how specifically it wants to place cost on production activities and how challenging it will be to collect the data.

Activity-based management is an approach to overseeing costs that focuses on the assignment of costs to production activities. When applying activity-based management, a company will decide which cost drivers give direct unit-level information and which do not.

At the extreme, a single-owner, single-employee company would be wasting its time if it used reporting cost to make a small number of custom-made products. Reporting cost means using expenses from analysis to determine overhead and activity-based costing. For this one-person company, traditional costing would work fine because the owner's overhead costs would be divided between administration and direct manufacturing of the product. Activity-based costing would give managers better information in cases where costs for resources are complex and do not readily show a direct link to unit production.

Comparing traditional costing and activity-based costing allows managers to look at costs from two different perspectives. By using both methods, managers can see where certain costs may be overstated or understated.

For instance, if Megalith Manufacturing produces only one product, then activity-based costing is unlikely to help managers as they analyze data. However, if Megalith Manufacturing produces two or more products, then overhead will be varied and complex enough that activity-based costing will likely give managers greater insight into how to control costs. The allocation of overhead under traditional costing uses a predetermined overhead rate that managers use across all overhead expenses. Activity-based costing applies the activity rates to individual drivers within the overhead, making it a more accurate costing method. In some situations, the direct costs between the two systems may be the same, but the overhead allocation may be different, requiring additional analysis.

Direct materials and labor for each product will be the same whether traditional costing and activity-based costing are used, but the application of overhead will be different. If Megalith used traditional overhead calculations and just one, plantwide predetermined overhead rate, they would apply $864 of total overhead cost per unit to both Product A and Product B. This result is different than the rates calculated under activity-based costing. Product A had $998.16 of overhead per unit under activity-based costing. If Megalith were to use the plantwide predetermined rate, the overhead cost per unit would be understated by $134.16. Product B had $729.84 of overhead per unit under activity-based costing. If Meglith were to use the plantwide predetermined rate, the overhead cost per unit would be overstated by $134.16 per unit.

Product A Product B
Activity-based overhead per unit $998.16 $729.84
Plantwide traditional rate per unit ($8,640,000 total overhead costs/10,000 units) $864 $864
Under/overstatement $134.16 overstated ($134.16) understated

If the complexity of the products differs, the resulting overhead per unit can be significantly different when using a traditional plantwide overhead rate versus activity-based costing.