Illustrate the difference between traditional costing and activity-based absorption costing
Managers are always looking for more effective ways to figure out the cost of their products. In the case of the Ultimate Planner, that we have been discussing during this module, getting all of the costs, from direct materials, direct labor and overhead, into the cost of the product will allow managers to appropriately price the product so the company can make a profit on each sale. If we miss allocating one of the indirect costs to our products, we are missing out on a cost, thus lowering our potential profit. So when we look at traditional costing versus activity based costing, how can we decide which one makes the most sense for our business?
Traditional costing will have one rate for allocation of overhead for the entire business operation, while activity-based absorption costing creates multiple cost pools. The ABC system can be extremely complicated and difficult to implement. Traditional costing is easy to implement and is the most common costing method used.
Activity-based costing has pros and cons:
- Activity-based costing provides more detailed measures of costs than traditional allocation methods.
- Activity-based costing can help marketing people by providing more accurate product cost numbers for decisions about pricing and which unprofitable products the company should eliminate.
- Production also benefits because activity-based costing provides better information about the cost of each activity. In practice, ABC helps managers identify cost-causing activities. To manage costs, production managers learn to manage the activities that cause costs.
- Activity-based costing provides more information about product costs than traditional methods but requires more record-keeping. Managers must decide whether the benefits or improved decisions justify the additional record-keeping cost.
- The allocation of indirect costs is at least somewhat arbitrary, even using sophisticated accounting methods.
- Installing activity-based costing requires teamwork among accountants, production managers, marketing managers, and other non-accounting people.
Some organizations with several product lines might believe that the benefits of implementing ABC will outweigh the costs. But management needs to be willing to use the ABC information to benefit the company. Chrysler Group LLC tried ABC, but the managers resisted. It is pointless to incur the costs if the managers refuse to use the information to make improvements in operations.