Question

Respond to the following in a minimum of 175 words:

What is activity-based costing? What are some of the key elements of activity-based costing? How does this method differ from a more traditional costing method?

Answer 1

Solution. An organization deciding to do business in competitive global market needs to plan, record and analyze its activities beforehand in order to sustain and gain competitive advantage over others. Activity-based costing is a tool of allocation of cost pools across various product lines, service areas and departments and widely used in product costing, service pricing, make-or-buy decision etcetera by organizations and stands as a detailed, expensive method of costing. This process involves recording of indirect cost allocation to activity under question thereby moving to assigning cost based on activity usage.

The key elements in activity-based costing process starts by identifying costs which are required to be allocated, determining cost pools which are not directly incurred in production activities such as administrative expenses during the period along with directly involved cost pool followed by determining activity drivers, measuring cost driver rate by dividing cost pool by cost driver to allocate to the number of cost drivers and disclosing the analyzed reports to facilitate in decision making activities of an organization.

Traditional costing also known as conventional method encompasses allocation of predetermined average overhead rate to the manufactured products of an organization based on volume whereas, activity-based costing encompasses process of first allocation of indirect costs to activities and then assigns costs to products based on usage of activities. Traditional costing method is easy to formulate and use than activity based costing which involves detailed breakdown of indirect costs and stands as a expensive process to implement. Traditional method of costing includes single rate of overhead allocation whereas, activity-based costing method includes multiple cost pools which facilitates in decision making activities of organization by analyzing/determining cost causing activities. Traditional method is less expensive process as compared to activity-based costing method and can be employed when indirect cost are low. Traditional method comes second to activity-based costing in terms of accuracy. Traditional method may lead to under and over costing and will come second to activity based costing method which provides organization with better classification and true costs data during an accounting period. Traditional costing method is used in instances of service projects etcetera  whereas, activity based costing method is used in target costing, service pricing, product line profitability, make-or-buy decision etcetera.