Costing systems are information systems. They require a specific type of information such as direct labour hours and units produced, to be of value. It is from the input data that product costs and other information are determined according to the specific costing system defined methodology. The results obtained would depend on the costing system used, since the same input data could be used in different ways. In this case the traditional costing system or an activity based costing system.
A costing system should provide information to help minimize waste, but should not be wasteful in itself. In other words, the resources required to design, implement and maintain a costing system should be less than the benefit derived from the use of the system.
In order to compare the two systems it is necessary to understand the working of both system.
The Traditional Costing System
It is a well-known fact that the traditional costing systems utilize a single, volume-based cost driver. This is the reason why the traditional product costing system distorts the cost of products. In most cases this type of costing system assigns the overhead costs to products on the basis of their relative usage of direct labor. For this reason traditional cost systems often report inaccurate product costs.
The problem is in the underlying methodology of the traditional costing systems. They adhere to the assumption that products cause cost. Each time a unit of product is manufactured, it is assumed that cost is incurred. This assumption makes sense for certain direct costs. The assumption does not work for activities that are not performed directly on the product units.
The problem with this approach is that for most overhead activities, the proportions of the activity actually consumed by a specific product, does not universally correspond with a single cost driver. This holds true for most modern companies where products are produced by a combination of manpower and technology. The traditional cost accounting model employs a volume-based driver, such as direct labor hours or machine hours for the assignment of all manufacturing overhead costs. The conventional cost accounting model ends up with a cost of goods sold based on absorption costing and includes only product costs as defined in financial accounting.
Fundamentally, traditional costing systems try to assign cost directly to products, rather than to activities first and then from the activities to product units. The typical cost report gives information on what is spent, but not why it is spent.
When overhead costs are cut in order to reduce total costs it is the symptoms that are treated and not the cause. In many cases the cutting of overheads is more likely to lead to a reduction in the quality of the products than to the long term reduction of the cost.
The separation of traceable and fixed cost is crucial when doing segmented reporting of costs. This is important, since traceable fixed costs are booked to departments while common fixed costs are pooled in the traditional costing system approach. The guidelines suggested for using the traditional approach is to use a broad, general guideline in determining which costs are traceable. This approach has obvious inherent inaccuracies.
The traditional costing systems only have one or a few indirect cost pools for each department or whole plant. The application of costs in the traditional costing system is normally based on an indirect cost driver and that the indirect cost applications are often financially based.
The traditional approach to costing of products fundamentally utilize a system whereby the total costs to produce a number of products are divided amongst the various products. By making use of the traditional costing system, it thus means that all the costs incurred have to be allocated to one or other product.
Activity Based Costing (ABC)
The underlying assumption of activity based costing is entirely different from that of conventional costing systems. The conventional costing system assumes that products cause costs. Activity based costing systems have activities as the fundamental cost objects. Activity based costing systems also assumes that activities cause costs and that cost objects create the demand for activities.
Activity based costing is a different approach and improves control of overheads by a cost/cause relationship, that are activity and cost. The system is flexible enough to relate costs to customers, processors, management responsibility and not just products.
As the name suggests, activity based costing is a system that focuses on activities as the basic cost objects and uses the costs of these activities as building blocks for compiling the costs of other cost objects. The use of an activity based costing system can also help a company to develop a way to analyze and justify manufacturing cycle-time improvements.
The use of activity based costing according evolved over the last few years from a more accurate method of product costing, to a more scientific method of cost reduction, to an all-embracing advanced planning, monitoring and control system, encompassing:
Activity based costing
Activity based cost management
Performance measurement and benchmarking
Product/customer and sector profitability
Business process re-engineering.
It is therefore important to note that in activity based costing, costs are assigned to activities. The assignment is based on the consumption of resources utilized.
In utilizing activity based costing, costs are collected for each activity as an independent cost object. These costs are then applied to commodities as they undergo the different activities. The final product cost is built up from the costs of the specific activities that each product line has undergone. In other words activity based costing assigns activity costs to cost objects based on activity drivers that accurately measures consumption of the activity.
When utilizing the activity based costing system managers attempt to assign the costs of significant activities to the products that causes those costs to be incurred. This results in activity based costing providing sufficient information to allow managers to know which activities cause the use of resources.
The most common approaches to activity based costing start with some kind of activity analysis, followed by activity based costing which is then used to create performance improvement ideas. Activity based costing is thus the tracking of activity costs to cost objects. These cost objects can be products, services, projects, customers or distribution channels.
When applied correctly activity based costing will diminish the issue of cost distortion by forming a cost pool for each activity that can be isolated as a cost driver.
Performance improvement techniques should also include cost driver analysis, activity grouping, performance evaluation and activity based costing. A cost driver is defined as the root cause or reason for an activity to occur. It is important to note that a cost driver should not be misinterpreted as an output measure. An output measure is a magnitude measure measuring how many outputs an activity produces. It is the output measure that should be followed to the cost object.
In an activity based costing system, overhead costs are assigned to a large number of cost pools that represent the most significant activities involved in the production process. It is also true that activity based costing systems utilizes several indirect cost pools because of the many activity areas.
After allocating costs to the activity cost pools, cost drivers are identified that are suitable for each cost pool. Then the overhead costs are assigned from each activity cost pool to each production job in proportion to the amount of activity used up by the job. In other words, activity based costing assigns activity costs to cost objects based on activity drivers that accurately measures consumption of the activity.
The improved product costing accuracy in activity based costing comes from the identification of a large number of activity cost pools and the isolation of a suitable cost driver for each activity.
When using activity based costing the focal point is on resources and the activities that cause them. There should therefore no longer be a division between product and period costs as defined by financial accounting.
The importance of the correct activity classification is underlined in that activity classification should always include some kind of value-added / non value-added analysis and more importantly all staff involved in classifying activities should understand these definitions. The popular definition of a non-value added activity is anything that can be eliminated without detriment to the final product. Although activity classification is subjective, it is only a tool to help with performance improvement.
Whilst activity based costing is not a perfect science it does offer a sense of financial pragmatism to the wider management process. The initial premise that activity analysis can highlight waste (non-value adding) and bureaucracy (secondary or support activities), activity based techniques have been used for straightforward cost reduction, process improvement and re-engineering, benchmarking, performance measurement and a variety of related exercises including activity or priority based budgeting.
The three generations of activity based costing supplement and complement each other and one system should not be considered the replacement of either of the other two. The first generation focuses on product costing, the second generation on process costing or performance evaluation, and the third generation on value chain costing to be used in strategic analysis. All three use the same activities database; differences lie in types of linkage and the extent to which data on activities are to be gathered.
Activity based costing forces the manager to investigate fixed costs very closely. It therefore helps management to identify areas of inefficiency as well as recognize costs which we could have been conceived fixed but, which are in fact, variable or semi-variable to specific products.