Difference between traditional costing and activity based costing – Which is better?

Activity-based costing (ABC) is a costing method that emphasizes on activities. It treats activities as fundamental cost objects and uses the cost of these activities for compiling the costs of products and other cost objects. The cost of a product is built up from the cost of specific activities that are undertaken to manufacture it. ABC is developed due to many deficiencies of traditional cost systems. In this blog, you shall know the difference between traditional costing and activity based costing, and also the factors that led to the discovery of the ABC system.

First, let us see how costs are assigned under each of these systems.

Cost allocation under traditional costing and activity based costing

Cost allocation under traditional costing and activity-based costing

In ABC, overheads are first related to activities or grouped into cost pools and then they are related to the cost objects, e.g., products. Under activity-based cost allocation, overheads are attributed to products using some activity base rate. But traditionally, overheads are grouped together under cost centres (such as production and service centres) and then absorbed into product costs on some basis such as direct labour hours.

Activity based costing identifies the activities which cause costs to be incurred and searches for fundamental cost drivers of these activities. Once the activity cost pools and their cost drivers have been established, this information is used to assign overheads to cost objects (i.e., products) in proportion to the actual consumption of such overheads.

Some examples of cost drivers for different activity pools in a production department can be as shown below:

Activity Cost PoolsRelated Cost Drivers
Ordering and Receiving Materials costNumber of purchase orders
Setting up machines costsNumber of set-ups
Machining costsMachine hours
Assembling costsNumber of parts
Inspecting and testing costsNumber of tests
Painting costsNumber of parts
Supervising CostsDirect labour hours

The main difference between traditional costing and activity based costing can be summarized by the following picture:

Traditional costing and activity-based costing

In traditional costing, costs are first apportioned to departments and then to products. Whereas, in ABC, costs are first apportioned to activities and then to products. The two processes are, hence, very similar, but the first stage is different, as ABC uses activities instead of functional departments (cost centres) to compute the overhead allocation rate.

How is ABC better than the traditional costing system?

The cost of a product arrived in a traditional costing system is not so accurate. ABC system overcomes the limitations present under traditional costing.

1. Under a traditional costing system, overheads, i.e. indirect costs, are allocated, apportioned, and ultimately absorbed in the cost units. Because of the basis selected for absorption, there can be distortions in computing costs. The situation will be clarified by the following example.

A manufacturing company is making two products, A and B. The direct material cost for these products is Rs. 10,00,000 and Rs. 20,00,000 respectively. Total overheads amount to Rs. 15,00,000 and the company adopts “direct material cost” as the basis for absorption of overheads. Thus, the absorption ratio of overheads will be 10/30 for A and 20/30 for B. The amount of overheads absorbed on product A will be Rs. 5,00,000 and for B, they will be Rs. 10,00,000.

Here, Product B has a larger share of the overhead costs as its material costs are higher than that of A. However, actually it might be possible product B may be requiring lesser efforts in support & indirect activities than A, but only because it has higher material costs, it will be charged with a larger amount of overheads. Hence, this gives rise to a distortion in the determination of total product cost. Such distortion in costs may lead to wrong decisions in several areas like make or buy, pricing decisions, acceptance of export offer, etc.

2. Another limitation of the traditional costing system is that the division between fixed and variable costs may not be realistic due to the complexities of modern businesses. As a business grows, this segregation somewhat becomes complex.

3. It is easy to determine the accurate costs of products or services when a company has only a few products to offer. But when companies expand their product range and these products utilize different amounts of resources such as supervision, quality control, it becomes more difficult to ascertain accurate costs of products. This situation is one of the main reasons why companies adopt ABC.

4. Traditional costing fails to capture the cause and effect relationships of costs incurred.

Therefore, the ABC system has been devised to overcome these inadequacies of traditional costing.

Example to see how costs are allocated under both systems

Let us take an example to understand how Activity based costing turns out to be more precise than traditional absorption costing.

Suppose an organization makes gadgets and its administration dept. chooses to introduce an ABC framework. The administration dept. concludes that all overhead costs will have just three expense drivers viz. direct labour hours, machine hours, and the number of procurement orders. The overall record of the organization shows the following overhead expenses –

General LedgerFigures in Rs.
Payroll taxes2,000
Machine maintenance1,000
Purchasing Dept. labour8,000
Fringe benefits4,000
Purchasing Dept. Supplies500
Equipment depreciation1,500
Electricity2,500
Unemployment insurance3,000
Total overheads22,500

So, which overheads do you think are driven by direct labour hours?

The answer is

Payroll taxes2,000
Fringe benefits4,000
Unemployment insurance3,000
Total9,000

Essentially, overheads driven by machine hours incorporate Machine maintenance, depreciation, and Electricity totalling Rs. 5,000 and lastly overheads driven by the number of procurement orders incorporate purchasing department labour and purchasing department supplies totalling Rs. 8,500.

Now, the overhead rate will be calculated by the formula:

Total cost in the activity pool ÷ Base

In the given case, the base shall be the total number of labour hours, machine hours, and the total number of purchase orders. Assuming the total number of labour hours to be 2,000, machine hours to be 500, and total purchase orders to be 200, the cost driver rate would be:

Cost Driver RateFigures in Rs.
Rs. 9,000 ÷ 2,0004.50 per labour hour
Rs. 5,000 ÷ 50010 per machine hour
Rs. 8,500 ÷ 20042.50 per purchase order

Now, let us allocate the overheads between two gadgets A and B, the details of which are:

ParticularsGadget AGadget B
Labour hours8001,200
Machine Hours200300
Purchase orders100100

So, the total overhead costs allocated to Gadget A = (800×4.50) + (200×10) + (100×42.50) = Rs. 9,850. Similarly, the total overhead costs allocated to Gadget B = (1,200×4.50) + (300×10) + (100×42.50) = Rs. 12,650.

Total overheads cost = Rs. 12,650 + Rs. 9,850 = Rs. 22,500.

But, generally, under the traditional costing method, overheads are apportioned on the basis of direct labour hours (total 2,000 labour hours in the given case). So, in that case, the overhead absorption rate would be – Rs. 22,500/ 2,000 = Rs. 11.25 per hour and the total overheads applied to Gadget A would have been = 800 × 11.25 = Rs. 9,000 and to Gadget B = 1,200 ×11.25 = Rs. 13,500.

Hence, when using traditional absorption costing, Gadget A would have been undervalued and Gadget B would have been overvalued by Rs. 850.

The difference in total costs of products under the two systems arrives because of the difference in overheads borne by each product. ABC system provides more accurate costs since it takes into account proportional overheads borne by each product based on the consumption level of different activities.

The main cause of inaccuracy in traditional costing is in the computation of the overhead rate itself, which is generally based on direct labour hours or machine hours. These rates assume that products that take longer to make, generate more overheads, and so on. But this may not hold true in very instance.

A comparison table showing the difference between traditional costing and activity based costing

Traditional CostingActivity-based costing
Overheads are related to cost centres/ departments (Production and Service Cost Centres).Overheads are related to activities and grouped into activity cost pools.
Since costs are related to cost centres, they don’t showcase realistic cost behaviour.Since costs are related to activities, they are more realistic. Overheads are related to the casual factor, i.e., driver.
Time (labour hours) is considered to be the only cost driver governing costs across all departments.Different cost drivers (activity–wise) are determined.
Usually, a single overhead recovery rate may be determined for absorbing overheads.Activity–wise recovery rates are calculated and there is no concept of a single overhead recovery rate.
Cost Centres/ departments cannot be eliminated. Hence, this method is not suitable for cost control.Essential activities can be simplified and unnecessary activities can be eliminated too. Hence, the corresponding costs are also reduced or minimized. Thus, ABC aids in cost control.
Overhead rates may be applied to ascertain the cost of products only.Activity cost driver rates may be used to determine the cost of products and also the cost of other cost objects such as customer segments, distribution channels, etc.

Takeaway

ABC system gives a more realistic picture of the way in which costs behave.

Organizations that do not want to know how much it costs to precisely manufacture a product may be satisfied with the conventional costing method. Others, however, set their prices on the basis of cost and need to assess it with fair precision. The latter organizations have benefited greatly from the implementation of activity based costing, which is considered as a modern form of absorption costing and is designed to provide more accurate product costs.

Read more: What is activity-based costing? – Meaning and suitability

Ruchi Gandhi

The author enjoys to write informational content in the domain of company law and allied laws. She takes interest in doing thorough and analytical research on legal topics. She is a CA along with MBA (Fin) and M. Com.

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