Comparing traditional and activity based costing: Advantages and disadvantage


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Comparing costing results from two approaches

Table 7 below shows the per-unit profitability estimates for each product from the examples above.

Product Profitability (Gross Profit Margin)

Product A Product B
Traditional cost allocation
(Production volume based allocation)
42.5% 26.3%
Activity based costing approach 26.1% 36.8%
Table7. Comparison of profitability estimates from two different costing methods. Traditional costing shows product A more profitable than product B. ABC based costing shows the reverse. These differences result from the different treatment of overhead costs.

Key differences between Costing methods

The tables and examples above illustrate some key differences between the costing methods:

Data and analysis

  • Activity based costing requires detailed knowledge of the activities and resources that go into overhead (or “indirect”) support work.
  •  Traditional cost accounting (production volume based allocation) requires only a total overhead cost and a simple allocation rule.

Overhead components and products: Differentiation vs. aggregation

  • ABC recognizes that individual overhead components can be distributed differently for different products. One product may consume relatively more maintenance resources, for instance, while another product may consume relatively less maintenance resources but relatively more machine set up resources.
  • Traditional cost accounting typically puts overhead components into fewer categories, or even a single category, and uses a single allocation rate for all products.

Direct vs. indirect measurement

  • Activity based costing treats overhead costs essentially as direct costs, in that cost estimates reflect actual cost driver usage for each product. These costs, in turn can be reasonably be apportioned to individual product units.
  • In traditional cost accounting (production volume based allocation), the total overhead cost is known accurately. However, in traditional costing the distribution of that total to individual products is based on an indirect measure of that cost.

Costing accurs. the cost of costing

For the profitability figures shown in Table 7 above, the activity based costing results may be taken as the more accurate results. That is, ABC results reflect the “true production costs of products A and B more closely than the profitability figures from the traditional costing approach. Whether or not the improved accuracy justifies the higher cost of applying this costing method,

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