What is the Difference Between Activity Based Costing and Traditional Costing?
🆚 Go to Comparative Table 🆚Traditional costing and activity-based costing (ABC) are two different methods for allocating indirect costs in accounting. The main differences between them are as follows:
- Accuracy: ABC systems are more accurate than traditional costing systems because they provide a more precise breakdown of indirect costs. Traditional costing assigns overhead costs to products based on an arbitrary average rate, while ABC assigns indirect costs to activities and then assigns the costs to products based on the activities that drive the costs.
- Complexity: ABC systems are more complex and costly to implement than traditional costing systems. Traditional costing is simpler and easier to implement, making it more suitable for companies with low overhead costs compared to direct costs.
- Cost Drivers: Traditional costing typically uses a single cost driver, such as direct labor hours or machine hours, to allocate overhead costs. In contrast, ABC systems use multiple cost drivers, which results in more accurate cost allocations but also makes the system more complicated.
- Suitability for Complex Business Operations: ABC is more suitable for businesses with complex production processes or diverse activities, while traditional costing may not be ideal for such operations.
- Implementation: Implementing ABC requires teamwork among accountants, production managers, marketing managers, and other non-accounting personnel. Traditional costing is easier to implement and more commonly used.
In summary, while ABC provides more accurate and detailed information on costs, it is also more complex and costly to implement. Traditional costing is simpler and easier to use, but it may result in less accurate cost estimates. The choice between the two methods depends on the specific needs and resources of the company.
Comparative Table: Activity Based Costing vs Traditional Costing
Here is a table comparing Activity-Based Costing (ABC) and Traditional Costing:
| Feature | Activity-Based Costing (ABC) | Traditional Costing |
|---|---|---|
| Method | Identifies specific overhead operations related to manufacturing and allocates costs based on multiple cost drivers. | Allocates an average overhead rate to the direct costs of manufacturing products based on a single cost driver, such as labor hours required to make a product. |
| Accuracy | Provides a more precise breakdown of indirect costs, resulting in more accurate cost estimates. | Less accurate than ABC, as it treats overhead costs as a single pool of indirect costs and can result in significant under-costing and over-costing. |
| Complexity | More complex and costly to implement. | Simpler and easier to implement. |
| Suitability | Ideal for businesses with complex production processes or diverse activities. | Best used when overhead is low compared to direct costs and production volume is large. |
| Decision-Making | Enables more profitable decisions by providing accurate product costs. | May lead to inaccuracies in cost estimates, particularly for products that consume different levels of resources. |
| External Reporting | Less commonly used for external reporting. | More commonly used for external reporting. |
In summary, ABC is a more accurate and comprehensive costing method, suitable for businesses with complex operations or diverse activities. Traditional costing, on the other hand, is a simpler and more cost-effective method, best used when overhead is low compared to direct costs and production volume is large.
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