Traditional Costing Systems and

Activity Based Costing System

Prepared By:

Blal Badr

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 Abstract1
One of the long-standing difficulties in cost accounting has been the allocation of “indirect costs”
to various objects such as products, departments, divisions, etc. Activity-based costing (ABC)
which has become an important aspect of manufacturing/service organizations can be defined as
a methodology that measures the cost and performance of activities, resources and cost objects. It
can be considered as an alternative paradigm to traditional cost-based accounting systems.

Keywords—Activity-based costing, cost drivers, overheads, Traditional costing.

Introduction2
Costing systems are information systems. They require a specific type of information such as
direct labor 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.
Costing systems are information systems. They require a specific type of information such as
direct labor 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.

1 Armstrong, Peter. "The costs of activity-based management." Accounting, Organizations and Society
27.1 (2002): 99-120.
2 "Activity Based Costing (ABC) And Traditional Costing Systems." 2009. 15 Nov. 2014
<http://financialsupport.weebly.com/activity-based-costing-abc-and-traditional-costing-systems.html>

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 1. Traditional Costing System (Peanut-butter costing),
Historically, manufacturing and cost accounting became so linked because of the
necessity to determine profit on goods produced, sold and shipped. Early decisions made within
this relationship fostered a certain benchmark or standard upon which most of the manufacturers
in the earlier times will use as method. In the past, using direct labor as basis for the computation
of overhead costs to be charged on the products manufactured would make sense, since it has
contributed to the largest percentage of the cost that was expended in manufacturing products
such as, automobiles, trains, garments, etc. This procedure of allocating costs incurred in
production, other than direct materials and direct labor costs was known as the traditional costing
method.3
A traditional cost system assigns overhead with a single plant-wide overhead application
rate or rates for operating departments. These rates are volume-based using an application
basis such as direct labor hours or machine hours. All overhead costs, however, do not fluctuate
with volume.4
Assigning these costs with a volume basis will distort the amount of costs assigned to various
product lines. Activity-based costing attempts to correct this by emphasizing long-term product
analysis.
Dual allocation is a cost allocation method that separates fixed and variable costs and
traces variable service department costs to the user departments; fixed costs are allocated based
on either equal shares among departments or a predetermined budgeted proportion.5
Dual-rate method, is an allocation method that classifies costs in each cost pool into two pools (a
variable-cost pool and a fixed cost pool) with each pool using a different cost-allocation base.
Dual Allocation means separate fixed and variable costs:
1. Variable costs:
Charge to user departments at a budgeted rate times the actual usage of the allocation
base.
2. Fixed costs:
Allocate budgeted amounts to user departments in proportion to the capacity demanded
by the user department

3 "Modern Product Costing Technique in the Age of Competition." 15 Nov. 2014

<http://books.google.com/books?id=qRDHKKRh9wMC&pg=PT28&lpg=PT28&dq=Historically,
+manufacturing+and+cost+accounting+became+so+linked+because+of+the+necessity+to+determine&so
urce=bl&ots=cLzqfilsWz&sig=zPpGI6_DyIp62VscPZO_8aQUP20>
4 "chapter 3 systems design: activity-based costing - Harper ..." 2012. 15 Nov. 2014
<http://dept.harpercollege.edu/tutoring/documents/ACC102-Chapter3new.pdf>
5 "Chapter 6--Support Department Cost Allocation." 2008. 15 Nov. 2014
<http://www.csun.edu/~hcbus012/acct380/guides/chapter06.doc>

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 2. Activity Based Costing
Activity based costing is a refinement of the traditional costing systems of allocating
manufacturing overhead to the units produced. As mentioned earlier, traditional costing systems
always use volume-related measures, e.g., direct labor hours or machine hours to allocate
overhead costs to products manufactured. On the other hand, ABC allocates overhead costs to
products on the basis of the resources consumed by each activity involved in the design,
production, and distribution of a particular product. This is accomplished by assigning costs to
cost pools that represent specific activities and allocating these costs using appropriate cost
drivers to the product. Cost drivers are those activities, which have a direct cause and effect
relationship to the occurrence of a particular cost. (Carter, Usry, 2002).
An important function of ABC is to define the activities of a company as value adding or non-
value adding activities. ABC enables managers to see whether the resources are being used
effectively and which activities contribute value to the product or service.
CIMA (Chartered Institute of Management Accountants) defines ABC as an approach to the
costing and monitoring of activities, which involves tracing resource consumption and costing
final outputs. Resources are assigned to activities, and activities to cost objects based on
consumption estimates. The latter utilize cost drivers to attach activity costs to outputs.6

Characteristics of ABC7:
1. ABC applies a more focused and detailed approach than using a department or plant as
the level for gathering costs.
2. ABC can be part of a job order system or a process cost system.
3. ABC can be use d for manufacturing or service businesses.
4. ABC takes a long-term viewpoint and treats production costs as variable.
5. The cost driver is often a non-financial variable.
6. ABC may be used for internal and external purposes (as can job order costing and
process costing).

6 "Activity-based costing - Wikipedia, the free encyclopedia." 2005. 15 Nov. 2014

<http://en.wikipedia.org/wiki/Activity-based_costing>
7 "An Introduction to Activity Based Costing and Activity Based ..." 2011. 15 Nov. 2014
<http://www.usask.ca/tabbs/documents/An%20Introduction%20to%20Activity%20Based%20Costing
%20and%20Activity%20Budgeting>

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 Benefits and Limitations of an Activity Based Costing System8

Benefits
1. ABC provides more accurate and informative product costs, which lead to more accurate
product profitability measurements and to better-informed strategic decisions about pricing, pr
oduct line, customer market, and capital expenditure.
2. ABC provides more accurate measurements of activity-driving costs, which helps managers
improve product and process value by making better product design decisions, controlling costs
better, and fost ering various value-enhancement projects.
3. ABC provides managers easier access to relevant costs for making business decisions,
enabling them to take a more competitive position

Limitations
1. Allocations. Even if activity data are available, some costs probably require allocations to
departments and products based on arbitrary volume measures because finding a specific activity
that causes the incurrence of the costs might not be practical. Examples are some of the facility-
sustaining costs, such as cleaning the factory and managing the production process
2. ABC reports do not conform to GAAP, so restating financial data adds an expense and causes
confusion (unsure whether to rely on the ABC or external data).
3. Expense and time. An ABC system is very expensive to develop a~t and is very time
consuming. Like most innovative management or accounting systems,
4. ABC usually requires more than a year for successful development and implementation.
5. ABC generates vast amounts of information. Too much information can mislead managers
into concentrating on the wrong data.

8 Kaplan, Robert S, and Steven R Anderson. "Time-driven activity-based costing." Harvard business
review 82.11 (2004): 131-140.

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 Traditional Costing Systems vs. ABC System

The traditional costing is used commonly by manufacturing companies to assign

manufacturing overheads to the units they produce. U sing this, only the products are
assigned an overhead cost by the accountant. The downside of this method of costing is
that it neglects to consider the non-manufacturing costs like administration expenses,
which are associated with production. Today, such method is considered outdated
because a lot of the manufacturing companies already use computers and machines for
their production. Also business accounting software is already being used widely. On the
brighter side, the traditional costing is easy to use especially for those companies that
have one product.

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The following are the basic differences of the two methods of costing 9:
1. The traditional costing method focuses on structure rather than on processes while
the ABC is more on the activities than on structure.
2. Traditional costing method is already obsolete especially with the changing
technology trends such as the introduction of the business accounting software.
3. The ABC provides more accurate costs of products.
4. Whereas the traditional costing method has increasingly become obsolete, the
ABC became a rising method since 1981.

9 "Activity-Based vs Traditional Costing - CliffsNotes." 2013. 15 Nov. 2014

<http://www.cliffsnotes.com/more-subjects/accounting/accounting-principles-ii/activity-based-
costing/activity-based-vs-traditional-costing>

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 REFERENCES

1. Armstrong, Peter. "The costs of activity-based management." Accounting, Organizations and

Society 27.1 (2002): 99-120.
2. "Activity Based Costing (ABC) And Traditional Costing Systems." 2009. 15 Nov. 2014 <
<http://financialsupport.weebly.com/activity-based-costing-abc-and-traditional-costing-
systems.html >
3. "Modern Product Costing Technique in the Age of Competition." 15 Nov. 2014
<http://books.google.com/books?
id=qRDHKKRh9wMC&pg=PT28&lpg=PT28&dq=Historically,
+manufacturing+and+cost+accounting+became+so+linked+because+of+the+necessity+to+deter
mine&source=bl&ots=cLzqfilsWz&sig=zPpGI6_DyIp62VscPZO_8aQUP20
4. "chapter 3 systems design: activity-based costing - Harper ..." 2012. 15 Nov. 2014
<http://dept.harpercollege.edu/tutoring/documents/ACC102-Chapter3new.pdf>
5. "Chapter 6--Support Department Cost Allocation." 2008. 15 Nov. 2014
<http://www.csun.edu/~hcbus012/acct380/guides/chapter06.doc >
6. "Activity-based costing - Wikipedia, the free encyclopedia." 2005. 15 Nov. 2014
<http://en.wikipedia.org/wiki/Activity-based_costing >
7. "An Introduction to Activity Based Costing and Activity Based ..." 2011. 15 Nov. 2014 <
http://www.usask.ca/tabbs/documents/An%20Introduction%20to%20Activity%20Based
%20Costing%20and%20Activity%20Budgeting >
8. Kaplan, Robert S, and Steven R Anderson. "Time-driven activity-based costing." Harvard
business review 82.11 (2004): 131-140.
9. "Activity-Based vs Traditional Costing - CliffsNotes." 2013. 15 Nov. 2014 <
http://www.cliffsnotes.com/more-subjects/accounting/accounting-principles-ii/activity-based-
costing/activity-based-vs-traditional-costing >