Traditional costing system uses arbitrary methods to allocate overheads to products. Generally, this method allocates overheads using a single overhead rate, also known as a blanket overhead rate or predetermined rate.
For example making use of direct labour hours, Machine hours, Production units, floor space etc.
Consider this example of Ms PriceCut clothing store. There are 3 departments, Women, Men and children.
The floor space and floor labour hours is 800m2 and 15 000 hours for Women’s department, 300m2 and 1500 hours for the men’s department and 500m2 and 3500hours for the children’s department.
The company’s only overheads is $2,6 million of rent expenses. These overheads are allocated to the department using floor labour hours.
Based on this information, the blanket overhead allocation rate is $130 per floor hour, that is $2,6 million/20 000hours
The allocations to the departments will be:
Women: 15 000 x $130 = R1 950 000
Men: 1 500 x $130 = R195 000
Children: 3 500 x $130 = R455 500
Activity Based Costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs.
it is a costing system that uses activities to allocate costs
Activity-based costing assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on a volume basis such as machine hours.
Activity-based costing first assigns costs to the activities that are the real cause of the overhead cost. It then assigns the cost of those activities only to the products that are actually demanding the activities.
There are 7 steps to approaching an Activity-based costing question.
Step 1: is to identify the activities – this is usually provided in the question. Activities are tasks, actions or unit of work being done within a company such as for example designing a product, quality control, material procurement.
Step 2: is to identify the cost of each activity or cost centre. This is also usually provided in a question.
Step 3: is to identify the cost driver volumes. Here we can be creative.
Step 4: is to match the cost driver with a specific activity overhead cost. We will also give this to you in a question. For example, the cost driver of the quality control activity is the number of inspections.
Step 5: is to calculate the activity rate. In order to calculate the activity rate, you need to divide the total activity cost by the cost driver volume total.
Then in Step 6, you will allocate the cost associated with the different products using the activity rate that you have allocated and the cost driver volume relating to the specific product.
Step 7: is not always applicable. If the question asks you to calculate the cost of the overheads per unit, remember to divide the total cost with the number of units in the end to get to a cost per unit.
Activity-Based Costing Basic Premise
- Cost objects consume activities.
- Activities consume resources.
- This consumption of resources is what drives costs.
- Understanding this relationship is critical to successful budget management.
Treatment of Costs under Activity Based Costing
In ABC, products are assigned the overhead costs that are supposed to be related to the allocation base.
- Non-manufacturing costs.
- Manufacturing costs.
- Plant wide Overhead Rate.
- Departmental Overhead Rates.
- Costs of idle capacity.
ABC’s Basic Steps
- Analyze activities.
- Gather cost data.
- Trace costs to activities.
- Establish output measures.
- Analyze costs.
Advantages of activity-based costing
- Makes it possible to determine production cost traced to outputs.
- Targets areas needing management attention.
- Encourages the consideration of alternative methods of production.
- Highlights operational efficiency.
- Identifies financial benchmarks for activity performance.
- Generates more information to measure and reward performance, and prioritizes activities for cost reductions.
- Provides a common managerial framework among support activities.
disadvantages or Limitations of Activity Based Costing
- Trade-off between expense and accuracy.
- Need for more precise data.
- Need of full support of top level management, and support of ABC based performance review.
- Cases of overstated costs and under-stated margins and mistakes in pricing and other critical decisions.
Activity based management involves any use of ABC information to support the organization’s strategy, improve operations, or manage activities and their resulting costs.
the following are differences between activity-based costing and traditional costing method
traditional costing method allocate fixed manufacturing overhead cost to products and/or service on an arbitrary ‘one volume’ driven basis while activity-based costing allocates fixed manufacturing overhead cost to products and/or services on the basis of activities
also, the traditional costing method uses a single absorption rate which is calculated based on budgeted operation capacity while activity-based costing use multiple activity rates based on the actual operation capacity
The traditional costing method is inexpensive to implement and maintain while activity-based costing is costly to implement and maintain
ease of use
The traditional costing method is straightforward to use and implement while activity-based costing is complex to use and implement due to a diverse set of activities that must be identified, recorded, and assigned to each product and/or service
traditional costing method product decisions are not independent resulting in often distorted decisions while activity-based costing has improved decision making as a result of a more accurate allocation of overhead costs