Question

What is the difference between Activity-Based Costing(ABC) and Traditional Costing?

Answer 1

The main points of difference between activity based costing and traditional costing are given below:

1. Primary Focus:

The primary focus of traditional costing is the apportionment of overhead costs to the activities of production. Irrespective of the specific allocation of resources, traditional costing sets a single metric for every activity involved in production and allocates costs based on the consumption of that metric. Although, activity based costing is also used for cost allocation but it adopts a different approach. Under activity based costing, appropriate cost drivers are determined for every different activity and cost is then allocated according to these cost drivers.

2. Application:

Traditional costing method is easy to implement as a single cost driver is set for all activities and overheads are simply divided into fixed and variable overheads. Activity based costing is difficult to implement because it involves choosing a suitable basis of absorption and absorbing overheads on that same basis is a complicated and time-consuming exercise. Additionally, in some cases it becomes difficult to determine a proper basis for the allocation of an activity.

3. Scope:

Traditional costing can only be used for the absorption of manufacturing overheads but activity based costing can effectively be used to allocate manufacturing as well as non-manufacturing overheads like selling, administration etc. This is because activity based costing considers the actual center of cost for the period cost and then allocates it.

4. Management use:

The figures extracted by traditional costings can be included into cost figure of statement of profit or loss because it only inculcates product costs but activity based costing can only be used for management purposes. The main reason being activity based costing is based on the subjectivity of the user and two users may not find a cost metric suitable for the same activity. However, activity based costing can be actively used by the management of a company to make better cost pools and allocate costs more accurately.

5. Effectiveness of operations:

Activity based costing improves business processes in long term. This is because management of a company needs to investigate deeply into production activities and related costs. This highlights the reasons for certain costs being incurred, which can ultimately help control and manage these costs. Traditional costing does not compel management to look for different cost centers and so it becomes difficult for management to gather incremental data about production activities.

Activity based costing vs traditional costing – tabular comparison

A tabular comparison of activity based costing and traditional costing is given below:

Primary Focus
Uses multiple cost drivers for multiple activities.	Uses identical cost driver for different activities.
Application
Is difficult to implement and requires time and effort.	Is straight forward and easy to implement.
Scope
Cover product cost only.	Can cover both product as well as period costs.
Management Use
The values can be used in external financial statements.	The values cannot be used in reports of external reporting.
Effectiveness of operations
Enhances management knowledge about activities related to production process.	Does not provide opportunity to identify any specific reasons for costs incurred.

Conclusion – activity based costing vs traditional costing:

Traditional costing is a conventional method of costing and is an easily understandable method by the management of a company. Its use is suitable for companies that have low overhead cost. In medium to large size companies where overheads are relatively high, the use of activity based costing may be preferred.

Managers may resist the use of activity based costing because not only it increases the amount of work required to identify all overhead operations but also it needs specialist management costing knowledge and experience.