Abc costing v traditional costing

Last Updated: 26 Jan 2021
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There are different stages that a firm must go through to implement ABC into their business, these are defined in appendix one. Under Traditional Cost Accounting (TCA) there is a simple method by which to implement allocation of overhead for the purpose of arbitrarily assigning indirect costs (overhead) to cost objects (products or services). When using TCA, the sum of a company’s overhead is allocated among products based on some sort of volume measure (Proctor, 2006). In TCA it is assumed that there is a direct relationship between overhead and the volume of output based on the volume measure. The different stages of implementing a TCA method are demonstrated in appendix two. TCA is now outsourced in most organizations. This is due to the effect that product costing serves an important function in an organization and also helps in achieving goals and to implement some principles like setting targets for competitors, growth and improvement, coordination between units and processes and measurement and control. ABC has become an increasingly popular process for which many organizations are replacing traditional methods that no longer meet their demands. As Reinstein and Bayou (1997), argue the switch from the traditional system to an activity-based costing (ABC) system opens new avenues for eliminating waste and reducing costs. Implementation of ABC provides management with a different point of view on the profitability of products and services, providing insight into pricing. Middle management and technical performing organizations are involved in the line item reporting provided within the ABC system, enabling management to achieve more responsibility of reported information throughout all levels of the organization. By understanding how resources are transformed into products or services, and by focusing on the cost of activities, ABC helps an organization and its managers to obtain a greater understanding of how costs behave and which activities create significant amounts of cost. Firms can then begin to control their costs based on tangible activities rather than relatively uninformative general ledger or cost centre reports. Stevenson & Barnes (1996) stated that ABC can more realistically model the cost structure facing businesses today. As agreed by many other authors, ABC is highly accredited to business’ in society today than the TCA due to competitive environment and advances in technology (Proctor, 2006). The improved accuracy within ABC is accomplished by tracing costs to products through activities. Essentially, an attempt is made to treat all costs as variable, recognizing that all costs vary with something, whether it is production volume or some non-production volume related factor. Both manufacturing costs and selling are traced to products in an ABC system. In traditional full absorption costing indirect manufacturing costs are allocated to products on the basis of a production volume related measurement such as direct labour hours. Furthermore the significant differences between traditional systems and activity based systems are: How the indirect costs are assigned and which costs are assigned to products. The main differences are also demonstrated in the diagram in appendix three. Most traditional costing systems utilize a single basis, (e.g. direct labour) to distribute the indirect costs to all products and services. This method of allocating indirect costs commonly results in erroneous cost data. Often products which have high volume are over costed. Likewise, the cost of lower volume products are often understated, and many of the indirect costs of these products are overlooked. Rather than relying on a single basis to distribute costs, ABC assigns costs to activities and products based on how the costs (resources) are actually consumed by the process or product. By moving away from traditional cost allocation methods and using improved ABC methods of tracing and assignment, ABC provides managers with a clearer picture of cost of processes and the profitability of customers and products. As Helberg et al. (1994) states ABC provides answers that can be crucial to the survival of the company, so it is imperative to make sure the right decisions are made. ABC differs from TCA and is advantageous as overhead costs are broken down into activities that cause the costs. The determined results can help management implement a more thorough understanding of product costs and they should be able to see the relationship between product complexity, product volume and product cost. This would be vital information for pricing decisions and profitability strategies. Traditional methods would not be able to give a firm this data which could give a sustainable competitive advantage. Activity Based Costing accurately predicts costs, profits, and resource requirements associated with changes in production volumes, organizational structure, and resource costs for the present and the future. Where in Traditional Cost Accounting, although future costs are somewhat predicted based on the current allocation of costs, the accuracy of those predictions is dependent upon the strength of the correlation between the selected cost driver as it relates to the actual usage of overhead. If a company is to rely on such predictions for future product costing it could hinder business performance rapidly. This is also stated by Glynn et al. (2003) as he denotes the total cost figures can understate the ‘real’ cost and these costs will not be sufficiently accurate or reliable for use in forward decision making. Activity-based costing requires a much more detailed breakdown of costs into activities that cause costs. Under TCA the drawback of assigning costs based on a predetermined overhead rate is the assumption that the selected cost driver is what drives a large percentage of the costs in an organization. In most organizations, there is no one single cost driver, rather a multitude of cost drivers. A company should implement ABC only if it thinks the benefit from improved management decisions will outweigh the cost of establishing and maintaining the new cost system. Furthermore, Activity Based Costing is not appropriate for every company.

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Activity Based Costing is an alternative to the traditional way of accounting. ABC is a costing model that assigns costs to products and services (cost drivers), based on the number of events or transactions that are taking place in the process of providing a product or service. As a result, Activity Based Management (ABM) can support managers to see how shareholder value can be maximized and how corporate performance can be improved. Proctor (2006) defines ABM as a collection of actions performed by managers based on the information produced by an ABC system. In order to manage costs, a manager should focus on the activities that give rise to such costs. Accordingly, given the activity focus of ABC, managers should implement ABC systems in order to facilitate financial management. The goal of ABM is to improve the value received by customers and, in doing so, to improve profits which will be advantageous for the organization in the long run. The key to ABM success is distinguishing between value-added costs and non-value-added costs. A value-added cost is the cost of an activity that cannot be eliminated without affecting a product’s value to the customer. In contrast, a non-value-added cost is the cost of an activity that can be eliminated without diminishing value. Some value-added costs are always necessary, as long as the activity that drives such costs is performed efficiently. However, non-value-added costs should always be minimized because they are assumed to be unnecessary. Oftentimes, such non-value activities can be reduced or eliminated by careful redesign of the plant layout and the production process. This will help benefit the organization for the future as costs can be reduced in one area of the firm and placed into another area with the general objective to help boost sales levels. Using a cost management system has helped enterprises in answering the market need for better quality products at competitive prices. Analyzing the customer and product profitability, the ABC method has continued effectively for the top management’s decision making process. With ABM firms are able to improve their efficiency and reduce the cost without sacrificing the value for the customer. This has also enabled firms to model the impact of cost reduction and subsequently confirm the savings achieved. Beheshti (2004) denotes that ABM should not be viewed as the exclusive property of any particular department but should be integrated into the corporate strategy and culture. This will help any particular department operate fully with the rest of the business to help achieve goals and objectives set. ABM is a dynamic method for continuous improvement and firms can have a built in competitive cost advantage so it can continuously add value to both its stakeholders and customers. Major (2007) states that changes within the last couple of decades have led to a new competitive business environment. It is these different changes that have led to many firms implementing the use of ABM to acquire and maintain a competitive advantage within the market. The successful implementation of a cost management system will allow a firm to identify its most profitable customers, products and channels. In turn, this will allow them to acquire the necessary measures to attain and secure a competitive advantage from its most productive lines of the business. It will also enable a firm to identify the least profitable in which the managers will be able to direct their decisions towards reversing the outcome to a profitable one. Activity Based management can be superior in how a business performs within the competitive environment as it can have a predominant effect on how a business facilitates their marketing mix. With a successful mix containing Place, Promotion, Product and Price the executives of any business can expedite the different elements in accordance with how the business is performing. By offering the product with the right combination of the four Ps marketers can improve their results and marketing effectiveness.

Allocation of overhead costs to a product or job is an important part of the accounting process in an organization. It also plays into multiple decisions outside of the accounting department, including work flow design, allocation of resources, and product and marketing mixes. It is important to take into consideration the benefits offered by Activity Based Costing as well as the potential drawbacks. Although Activity Based Costing is not meant for every organization, the overall benefit of the system should be considered. The implementation of activity based management within any organization is generally perceived to be advantageous but care must be placed to notice any potential limitations. The managers of any business must be effective with applying an activity based costing system as it can be timely and costing so it is imperative to ensure applying ABC will be beneficial for the firm in the future.


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