Question

How does Activity Based Costing differ from the traditional overhead allocation system ?

Answer 1

Companies need accounting system to know cost of their operations. Two common costing systems are traditional costing and activity based costing. One is easy to use and inexpensive, while the other gives more accuracy.

Traditional costing adds an average overhead costs to the direct costs of production and is used when overhead costs is lower than the direct costs of production. Activity based costing identifies all of the specific overhead operations related to the manufacture of each product.

Traditional costing - Traditional costing methods are not expensive to implement. Companies use traditional costing for external reports because it is easy to use and understand for outsiders. Overhead costs are not allocated to the products that are actually consumed by the overhead costs. The traditional costing method is best for companies manufacturing few different products.

Activity based costing - Activity based costing is the most accurate but also difficult to implement. With activity based costing, it is easier to locate areas where expenses are being wasted on non profitable products. This system is costly but it helps in better long term decision making. Accountants use ABC system to overcome inaccuracy caused by traditional costing system.