Activity-based costing and traditional costing are two distinct approaches used in the field of accounting to assign indirect (overhead) costs to products. Both approaches calculate production-related overhead costs and then allocate these costs to products using a cost-driver rate. The two techniques differ in terms of accuracy and complexity. Traditional costing, which typically allocates overhead costs to products based on an arbitrary average rate, is more simplistic and inaccurate than ABC. ABC is more complex and more accurate than traditional costing. This approach first allocates indirect costs to activities, and then, based on how the products use the activities, allocates the costs to products.
Using conventional costing methods, indirect costs are added to products at a predetermined overhead rate. Traditional costing systems, in contrast to ABC, treat overhead costs as a single group of indirect costs. When indirect costs are small in comparison to direct costs, traditional costing is ideal. The conventional costing procedure includes the following steps, among others: Identify indirect costs. 2. Estimate indirect costs for the appropriate period (month, quarter, year). 3. Select a cost-driver (labor hours, machine hours) that has a causal connection to the cost. 4. Estimate the cost-driver’s value for the relevant time period (labor hours per quarter, etc.). ). 5. Compute the predetermined overhead rate (see below). 6. Apply overhead to products using the predetermined overhead rate.
Activity Based Costing vs. Traditional Costing
How to use the traditional costing method with a worked example
To calculate costs using the conventional costing method, follow these steps:
1. Identify overhead costs
Overhead costs are production expenses that don’t directly affect the final product. They can include manufacturing and non-manufacturing expenses.
Take the small business Fresh for Fido, which sells organic dog food, as an illustration. The company has a modest factory space. The factory’s utilities, as well as the wages of the cleaning and maintenance staff, are among the company’s overhead expenses.
2. Estimate the overhead costs for a specific time period
These costs could be projected for a month, a quarter, or an entire year.
The owners of Fresh for Fido estimate their annual overhead expenses to be $30,000 using the same example.
3. Choose a cost driver to use in your calculations
The cost driver should be closely related to production, such as machine hours for production that is highly automated.
Given that Fresh for Fido makes all of its dog food by hand, the business chooses labor hours as a key cost driver.
4. Estimate the figure for the cost driver
Your estimated period for the cost driver should coincide with the time frame you select for your estimate of the overhead costs.
Referring back to the earlier illustration, Fresh for Fido has eight staff members who each work 40 hours per week for 40 weeks a year. This adds up to 12,800 labor hours per year.
5. Calculate the predetermined overhead rate
The predetermined overhead rate is based on your estimates. Divide the estimated overhead costs by the estimated cost driver amount or quantity to determine the rate.
In our illustration, Fresh for Fido determines the predetermined overhead rate using the calculation shown below:
Predetermined overhead rate = estimated overhead cost/cost driver amount
Predetermined overhead rate = $30,000. divided by 12,800 hours of labor, equals 2. 34.
6. Apply the overhead rate to your product
In order to calculate the estimated overhead costs for the product, multiply your chosen metric by the predetermined overhead rate.
Fresh for Fido can use the 2. 34 predetermined overhead rate to calculate its estimated overhead costs. For instance, we can calculate total overhead costs for each pound of dog food if each pound of dog food requires two hours of labor.
2 hours of labor per pound of dog food multiplied by $2 is what constitutes overhead costs. 34 per hour = $4. 68.
This number estimates an average overhead expense of $4. For the specified time period, 68 cents per pound of dog food.
Let’s assume there are no direct costs associated with producing each pound of dog food. 80. You can add $0 to your estimate of production costs for one pound of dog food. 80 to $4. 68 to get $5. 48. If Fresh for Fido charges $54 for a bag of dog food weighing 10 pounds, 80 in total expenses.
Fresh for Fido makes an estimated $5 profit when it sells its 10-pound bag for $60. 20 on each bag. The business will make $26,000 in profit if it sells 5,000 bags of dog food annually.
What is a traditional costing system?
The traditional costing system, which is based on allocating overhead (or indirect) manufacturing costs, is an accounting technique used to calculate the cost of producing goods to make a profit. This system works by figuring out predetermined overhead rates and applying them to a specific metric.
For a particular cost driver, traditional costing systems use estimated overhead rates. An aspect of the manufacturing process known as a cost driver includes:
What are the differences between traditional costing and activity-based costing?
Both activity-based costing (ABC) and conventional costing establish how much overhead should be devoted to a single product. However, each method has distinct advantages and disadvantages. Here are the differences between traditional costing and ABC:
What factors you take into account when allocating overhead to products is the primary distinction between activity-based costing and traditional costing. The predetermined overhead rate and a single cost driver are used in traditional costing to determine estimated overhead costs. You aggregate all administrative expenses into a single estimated sum and evenly distribute it across all products.
All cost drivers involved in creating a product or products are taken into account using activity-based costing. This includes non-manufacturing costs, such as facility maintenance. Activity-based costing also allocates overhead costs more precisely between products. For instance, it makes a distinction between goods made in one machine hour and goods made in three machine hours. By doing so, you can divide the costs into proportionate amounts for each product.
The traditional costing method calls for one cost driver in the Fresh for Fido example: labor hours. Instead, the business will use all of the uncovered cost drivers if it opts to use activity-based costing.
Because traditional costing has fewer variables than activity-based costing, it is a faster method for estimating costs. ABC is frequently complicated and time-consuming, requiring input from multiple departments to obtain the required estimates.
Traditional costing is less accurate than activity-based costing because it uses less detailed information. Managers can find areas for cost reduction by using the more thorough ABC approach to costing, which offers greater insight into business expenses like facility expenses.
Some activity-based costing calculations might become so complicated that using specialized software, which might be pricey, is necessary. Additionally, ABC involves a lot of work for managers or accountants. Traditional costing is less complicated than other methods, so it costs less because it requires less effort and input.
When to use traditional costing vs. activity-based costing
Meeting company objectives and deadlines requires careful planning, including selecting the appropriate costing method. Traditional costing systems are best in the following situations:
Activity-based costing may be best suited for the following situations:
What are advantages of traditional costing system?
Costs are first traced to activities, then to products, in the ABC method of costing. The traditional costing system groups costs by department or by facilities. Each cost pool has a variety of costs that are incurred as a result of various important processes and are typically not due to a single cause.
Why ABC is better than traditional costing?
1. It offers accurate cost figures with large production volumes. When an organization has low overhead costs relative to its direct production costs, the traditional costing system is most effective.
What is ABC method?
A more precise method of estimating the cost of goods and services is offered by activity-based costing, which results in more precise pricing decisions. By making expensive and non-value-adding activities more visible, it improves understanding of overheads and cost drivers and enables managers to reduce or eliminate them.