Activity-Based Costing 2

Topics: Costs, Management accounting, Cost accounting Pages: 10 (3535 words) Published: April 29, 2011
Differences between Activity-Based Costing and Traditional Cost Strategy Activity-based costing (ABC) is a costing model that identifies overhead activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption, while traditional costing equally distributes all overhead expenses. Thus, an organization employing ABC, can precisely estimate the cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced. ABC is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has mainly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives. Due to its nature, traditional costing gives less freedom in that respect. In the past, accountants divided all costs into variable costs and fixed costs based on the relationship between the cost and output (business volume) changes, where only the short-term costs that vary with the cost of production were viewed as variable costs. However, although short-term costs do not necessarily change with the yields, they will change in a period of time with the product design, product mix, company’s product range and customer scope. Therefore, ABC provided further visibility and divided costs into short-term and long-term variable costs. The short-term variable costs are consistent with the original definition of the variable costs, such costs are quantity-based, and change in proportion with product output. Long-term costs, however, are based on activity levels, and change with the activity volume. In the ABC system, the fixed costs only refer to those costs that do not change with the amount of any activity in a given period of time. Some studies have shown that the fixed costs are only a small proportion of the entire manufacturing costs. Therefore, ABC would pay more attention to long-term costs that can be variable. In ABC, almost all of the costs include the so-called ‘common costs’ and usually consider indirect and short-term fixed costs as variable, which allows for allocation to the products or product lines. Traditionally, cost accountants have been arbitrarily adding a broad percentage of expenses into the indirect costs. However as the percentages of indirect or overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not driven proportionately by all of the products. For example, two products may use the same amount of direct labor and materials, however, one of the products may have to be produced on a machine that requires more costly and frequent maintenance; since the amount of direct labor and materials are the same, the additional cost for the use of the machine would not be recognized. The traditional costing systems are often unable to accurately determine the actual costs of production and related services. Consequently, managers are not able to make informed decisions because of this deficient data. Instead of using broad arbitrary percentages, ABC seeks to identify cause-and-effect relationships to objectively assign costs. Once costs of all activities have been identified, the cost of each activity is attributed by product to an extent in which this product uses a specified activity. In this way, ABC often identifies areas of high overhead costs per unit and thus directs attention to finding ways to reduce these costs or to charge more for costly products. At first, ABC was focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is...
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