1. Introduction – Traditional Costing and Activity Based Costing

Traditional Costing and Activity Based Costing are two costing methods that have been developed towards the same objective.  This encompasses the apportionment of manufacturing overheads to specific products and production processes (Drury 1996, p 295).  Despite such similarities the application of these two methods on the same company and manufacturing overheads may lead the different results.  This is due to the fact that such techniques hold different methods in which manufacturing overheads are apportioned to product costs.  Such distinction will be further examined in the forthcoming section.

1.1  Differences between Traditional Costing and Activity Based Costing

As already hinted in the previous section the main difference between these method stems in the way overheads are apportioned.  Under the traditional costing approach a single overhead absorption rate is used to serve as an apportionment basis.  Such overhead rate is normally either direct labour hours or machine hours.  The application of a blanket overhead rate, as it is normally called, holds its advantages, because it is easy to operate and understand (Drury 1996, pp 85-86).  However, there is an important weakness that hinders management should meticulously consider before applying such technique.  Such weakness will be further discussed in section 1.2 of this paper.

The activity based costing approach is much different than the aforesaid traditional system.  Rather than applying a blanket overhead rate, in activity based costing the main activities that take place in an organisation are identified firstly.  This is followed by a determination of the cost pool of each activity.  A cost pool, also know as cost centre is the classification of all pertinent overhead expenditure under one activity.  For example, all set-ups occurring the in the production process are classified under a cost pool known as set-up related costs.  Once the cost pools are established the cost drivers for each cost pool identified should be determined.  A cost driver as its name entails is the main driving force that is leading to the creation of such overhead expense.  For instance, a cost driver for set-up related costs is the number of set-ups carried out.  These cost drivers will lead to the final stage of activity based costing, which comprises the assignment of cost drivers to products or production processes (Drury 1996, pp 296-297).  As one can note there are more steps in activity based costing leading to greater complexity.  However, the benefits derived from such a technique as will be explained in the proceeding section are worth the effort.

1.2 Utility of Activity Based Costing for Decision-Making Purposes

The main benefit of activity based costing, which enhances the decision-making process stems from the salient weakness of the tradition system as stated in the previous section of this paper.  This basically rests upon the accuracy provided by the method.  Critics of the traditional method state that under such method the overheads are not apportioned properly, because this system presumes that products consume resources in proportion to their production volumes.  The traditional method was developed a long time ago, in a period where manufacturing of narrow products took place and the dominant expenditure in the manufacturing process entailed direct material cost and direct labour cost.  Overheads held a low proportion of the total manufacturing costs and therefore the development of a more elaborate approach like activity based costing was not financially justified (Drury 1996, p 294).

Nowadays, organisations produce a much wider range of products in line with the importance of diversification strategies.  The proportion of overhead costs also commenced increasing rapidly at the expense of lower direct labour costs during the years. Such higher overhead expenditure started diminishing the justification of a single overhead rate especially when information processing costs have diminished due to more technologically advanced costing systems.  As pinpointed by Holzer and Norreklit (1991), over the years the increasing opportunity cost of having poor cost information and the decreasing cost of administering more complex costing systems led to the a higher demand for more accurate information on product cost, leading to the inception of activity based costing (Cited In: Drury 1996, p 294).

As a result the traditional system is condemned of providing high distortions in overhead allocation especially in organisations that hold a vast range of products.  Critics contend that manufacturing overheads are overstated in products that utilise high proportions of machine hours and/or labour hours, while manufacturing overheads are understated in products that utilise low proportions of machine hours and/or labour hours, which depends on the item used in the blanket overhead rate (Drury 1996, pp 294-295).

Therefore as outlined by the developers of activity based costing, Cooper and Kaplan (1988), activity based costing is more useful for decision-making purposes because it provides more accurate and reliable information.  Thus the decision-maker holds better financial information, which is a key ingredient for the decision outcome.

1.4 Critical Evaluation of the Usefulness of Activity Based Costing

Activity Based Costing is frequently acclaimed to aid in the decision-making process for a number of reasons.  It can provide information to cost a product as is frequently implemented in the sections above.  However, activity based costing is also useful to provide information for cost control purposes.  As already stated in the previous section manufacturing overheads are rising and therefore cost control should take into account overheads too.  Activity based costing is not the only method used for such purposes.  A company can also adopt the theory of constraints.  However, scholars contend that the application of both approaches in the company can lead to conflicting product-mix decisions, which will thus lead to confusion in the decision-making process.  Further research revealed that the theory of constraint method is more applicable for the short term, while the activity based costing method is more fruitful for the long term (Kee et al. 2000).

1.5 Illustration of Differences between Traditional Costing and Activity Based Costing

As stated in section 1.3, the traditional method leads to overstatement of manufacturing overheads on products that use high proportions of machine hours and/or labour hours and the reversal on products that use low proportions of machine hours and/or labour hours.  Therefore the total cost per case under the two methods will differ.  Likewise, different manufacturing overheads will lead to different break-even points and different level of volumes to reach the desired profit.

1.6 Concluding Remark – Recommendation on Costing Approach to be Used

In line to the benefits noted under the activity based costing approach in section 1.3 it is plausible to state that an activity based costing method is more desirable than the traditional method.  Aiding in the decision-making process is very important, because decision-making is central for the survival of the organisation.  However, it is pertinent to say that the change from the traditional system to activity based costing should be done gradually in a collaborative way with operational management and employees.  Changes should always be conducted in a meticulous manner in order to ensure that resistance to change is mitigated and implementation is enhanced across all the levels of the organisation.

References:

Drury C. (1996).

Kee R. and Schmidt C. (2000).  A Comparative Analysis of Utilizing Activity-Based Costing and the Theory of Constraints for making Product-Mix Decisions.  International Journal of Production Economics, Vol. 63, No. 1, pp 1-17.