Question

In what fundamental ways does activity-based costing differ from a traditional method of absorbing overhead costs. (400 words)

Management Accounting

Answer 1

First of all let's understand what activity-based costing and traditional method of absorbing overhead costs mean:

-Traditional Method: The traditional method of absorbing overhead costs is the simplest method out there. It simply considers an average overhead rate such as the labour hours or machine hours for all types of activities/overheads and allocates all the overheads basis such pre-determined overhead rate.

-Activity-based costing: Activity based costing refers to that method where overhead rates are determined on what we call "cost drivers". Here overhead rates are determined for each activity using the appropriate cost driver such as "no. of orders" for delivery costs or "no. of machine hours" for machine running costs.

The major difference between activity based costing and traditional costing is that activity based costing is much more accurate and depicts a better and true picture as to which product performs better because cost drivers are identified for each type of activity and costs are allocated to products accordingly. On the other hand, traditional costing despite being very easy and inexpensive to implement, might not show a true picture of the profitability of the products. A simple example to explain this is consider a cost of "customer care costs against customer complaints" in an airline company and their being 2 products, products A and B. Now suppose the number of customer complaints in case of product A is 100 and product B is 0. Now if the airline company follows traditional costing by considering say number of tickets sold as a base, then even the customer care costs will be divided amongst both the products even though the customer care costs should ideally be allocated only to product A since the number of customer complaints in case of product B is 0. Hence this shows better profitability of product A by allocating lower costs than what should have been allocated.

This disadvantage/limitation of traditional costing is overcome by activity based costing since if the airline company follows ABC, then it will use "number of customer complaints" as the cost driver for allocating the total customer care costs in which case whole of the costs will be allocated to product A since the number of customer complaints in case of product B is zero which shows a true picture.

Hence the most fundamental way in which traditional costing and ABC costing differ is in terms of their cost and accruacy of allocating the costs among products.