Question

Differentiate between traditional cost allocation methods and activity-based costing.

Answer 1

There are two common methods for allocating the indirect costs to the products manufactured. Both of the methods assess overhead costs and then allocate these costs to products based on certain cost drivers. Cost driver is any factor that is related to a cost occurring, such as the volume produced or the number of labor hours.

The first method is Activity-Based costing, which is sometimes called as “ABC.” It determines all activities associated with production, allocate a cost to those activities and then determines the cost of the product.

The other method is Traditional Costing, which assigns costs to products based on an average overhead rate. It totals all the indirect costs incurred in production & applies those costs equally across the board using one appropriate cost driver, such as machine hours.

Activity based costing is more accurate as compared to the Traditional costing method because of the following reasons :-

1. In ABC method the company is able to identify the needs of adding or eliminating certain activities to add value to the products.

2. ABC method provides more accurate costs as compared to Traditional method where the costs are accumulated arbitrarily.

3. ABC method is recommended where the overheads are high.