In this essay we will discuss the traditional costing method and consider the alternative method offered by Activity Based Costing (ABC) technique. We will discuss how the two methods differ from each other and also from the direct costing systems. The essay will also evaluate the value added by each costing system within a company’s decision making process, in terms of the accuracy of information they provide.
Cost systems differ in terms of which costs are allocated to the cost objects i.e. product, service etc and also in terms of their levels of allocation ingenuity. There are three main cost systems in existence, namely, the direct costing system, the traditional absorption costing system and the activity based costing system.
The direct costing system as suggested by its name, only allocates direct costs to the products or services; it does not attempt to allocate indirect costs. Therefore, it reports only the contribution attributable from the product or service towards indirect costs incurred by the business. It is often referred to as a partial costing system. The direct costing method is only pertinent for decision making process where the indirect costs are small part of the overall organisational costs or does not fluctuate greatly to changes in demand.
Both the traditional and ABC system assign indirect costs to the product or service to give full costing information to the organisation in its decision making process.
As illustrated in figure 1.0 above, there are two systems of assigning indirect costs to cost objects, namely, traditional costing system and ABC system. The traditional costing system has been in use since early 1900 and is still being used today. The traditional costing method relies to a large extent on the use of arbitrary cost allocation, commonly the use of either labour or material absorption rate.
In order for companies to make viable decisions, they require accurate product costs. Without sufficient allocation of indirect costs it would be difficult for companies to differentiate between profitable and loss-making products and services. Therefore cost systems needs to accurately reflect the consumption of resources by products, otherwise, product costs will be distorted and profitable products will be discontinued or rejected by the company and loss-making ones will be continued.
Traditional costing system varies greatly in the level of sophistication to that of ABC in allocating indirect costs to the cost object. There is a general consensus that the traditional system is simplistic whereas ABC is more complex in its allocation technique. Therefore, traditional cost systems are inexpensive to operate, as it extensively uses an arbitrary cost allocation and results in low levels of accuracy. This in turn leads to higher cost of errors in product decisions being undertaken by organisations. ABC on the other hand, is more expensive to operate as it makes extensive use of cause and effect cost allocations (use of cost drivers), but results in greater levels of accuracy and leads to less errors in decision making process.
Traditional vs. ABC
The ABC system devises a number of activity based cost centres, whereas with traditional systems, overheads tend to be pooled by departments (cost centres).
Traditional costing method like ABC system use a two-stage process to allocate indirect costs, with the first stage comprising of overhead being allocated to departments both production and service, the service departmental costs are subsequently reallocated to production departments. ABC, however, assigns overheads to individual activity instead of departments. The second stage of the allocation process involves allocating costs from individual departments under traditional method and activity cost centres under the ABC system, into the cost objects. The traditional system uses only a small number of second stage allocation bases, which are linked to volume produced. ABC system on the other hand uses a large number of second stage cost drivers; including non-volume based drivers i.e. number of production runs, number of purchase orders etc.
In summary, the major distinguishing features of ABC system to that of the traditional method is that, a greater number of cost centres together with a variety of second stage cost drivers exist. This result in the ABC system delivering more accurate measurement of resources being consumed by a cost object, ensuring that management undertakes correct decisions.
ABC came to prominent during the 80’s as a result of the limitations of traditional costing method and its value to decision making process of large blue chip organisations. In today’s volatile market place where blue chip organisations are involved in the production and delivery of complex products and services, the traditional costing system and its use of volume based cost drivers like direct labour hours represent only a small fraction of total object costs.
Volume based cost drivers assume that product’s consumption of overhead resources is directly connected to units produced. The use of volume based drivers to allocate indirect costs, which are considerably larger, results in inaccurate product costs and provides management with information which is of minute or no value. In fact the organisation runs the risk of making incorrect decisions about its profitable and unprofitable products and services which could result in financial ruin for the organisation and threaten its long term survival.
Therefore, unsophisticated volume based overhead allocations using a declining direct labour cannot be warranted, principally when information processing costs are no longer a barrier to introducing more sophisticated cost systems like ABC. Furthermore, the intense global competitiveness within the market place had made decision errors due to poor cost information more probable and more costly.
Therefore, with use of traditional costing system, misleading information is reported. However, ABC system recognises that overheads are caused by other factors, beside volume, and it allocates overheads based on cause and effects, resulting in more accuracy in organisational decision making.
However, surveys of management accounting practices continue to present evidence of organisation’s still using traditional costing. Hughes, S.B. and Paulson Gjerde, K.A. (2003) carried out a survey of US manufacturing companies and reported 35 per cent of respondent using traditional costing and a further 30 per cent using a combination of traditional with ABC. Therefore, it is evident that traditional costing still provides information which is useful for blue chip Company’s decision making process, but they must use the information only with the knowledge of its drawbacks.
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References & Bibliography
- Drury, C. (2005) Management Accounting for Business – 3rd Edition, Thomson
- Drury, C. (2008) Management and Cost Accounting – 7th Edition, South-Western
- Gowthorpe, C. (2008) Management Accounting, South-Western
- Hughes, S.B. and Paulson Gjerde, K.A. (2003) ‘Do different cost system make a difference?’, Management Accounting Quarterly, Fall, Vol. 5, No. 1, pp.22-30