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Discuss traditional costing and why a better approach is/was needed. Activity based costing (ABC) is the solution since it will enhance the accuracy and effectiveness of costing products by applying overhead costs where they belong. Explain how is this helpful to managers?

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Answer 1

In traditional costing we allocate the factory overhead on the basis of the amount of production resources used, generally in this method overhead is applied on the basis of amount of direct labor hours or the amount of machine hours. The major drawback of this method is that a small change in the amount of production resources used leads to drastic changes in the amount of overheads.this method shows the direct relationship between volume of production resources used and factory overhead which is not true. for example in highly automated production environment if direct labour hour increses by 1 or 2 hours and the rate is 1000 usd per hour this will leads the cost of product to be increases by 1000 or 2000 usd of overhead. To overcome these problems we have ABC (activity based costing) unlike traditional method which just focuses on one driver for factory overhead which is machine hour(or D. Labour hours) the ABC method focuses on numbers of drivers for factory overhead e.g setup of machinery, storage, handling, inspection, demand of consumers, types of products and so on. In traditional method we get an average amount because of the fact that it pool all the drivers in just one cost and divides the result by number of machine hours and this is applied to every product regardless the nature of process so this basically provides us a misleading image but in the ABC method their are different sets of costs and we allocate according to the root cause.

ABC method is most prefered method of costing among managers because it emphasis on the improvement of quality and reduction in costs. Management is a set of n numbers of activities and if we use traditional method which just focuses on one driver will not be suitable for managerial purpose and will also not improve the efficiency. For managers it is very much needed to know the cost of different activities differently so when managers have a detailed information about each and every subhead they will have a better control on activities and their costs this can help them to obtain efficiency.