Activity-based Costing (ABC) vs Traditional Costing

See Also:
Activity Based Costing
Standard Costing System
Cost Driver
Value Chain
Implementing Activity Based Costing
Absorption vs Variable Costing
Activity Based Management
Process Costing
Overhead
Job Costing

A product can appear profitable under one costing method and less profitable under another. For manufacturers, the difference often comes down to how overhead is assigned. Here’s how activity-based costing and traditional costing work, and when the distinction is useful.

Activity-Based Costing vs. Traditional Costing

Traditional costing and activity-based costing (ABC) both assign indirect, or overhead, costs to products. Traditional costing typically uses one rate based on direct labor hours, machine hours, or another measure of production activity.

ABC separates overhead into activities, such as machine setups or inspections. It then assigns those costs to products based on how much of each activity they use. This can give management a different view of product costs when some products require substantially more support work than others.

What is the 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, including the following:
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

Use the following formula to calculate predetermined overhead rate:

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

When is Activity-Based Costing More Useful?

Activity based costing systems are more accurate than traditional costing systems. This is 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.

For example, two products might require the same number of labor hours, but one needs more machine setups and inspections. Traditional costing could assign them the same overhead based on labor hours. ABC assigns the setup and inspection costs according to each product’s use of those activities.

Traditional Costing vs. Activity-Based Costing: Which Should You Use?

If reported product margins do not match what your team sees in production, compare the two methods for a few products. A difference may affect pricing, product mix, or production decisions. If the results are similar, the simpler traditional costing system may be sufficient. If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

Get a Clearer View of Your Product Costs

If your costing method makes it hard to assess product margins, Strategic CFO can help review your cost data and improve your financial and operational reporting. Contact our team to discuss what your current reports may be missing.

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