Traditional versus Activity Based Costing Systems

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.

The Traditional Costing System

Traditional costing systems utilize a single, volume-based cost driver which distorts the cost of products. This type of costing system assigns the overhead costs to products on the basis of their relative usage of direct labor which leads to reporting inaccurate product costs. The assumption under this costing is that each time a product is manufactured, it incurs cost. This is not true for activities that are not performed directly on the products units. Products are produced by a combination of manpower and technology, a specific product cannot be attributed to a single cost driver.
The typical cost report gives information on what is spent, but not why it is spent. 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, since traceable fixed costs are booked to departments while common fixed costs are pooled in the traditional costing system approach. 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)

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. It is a different approach and improves control of overheads by a cost/cause relationship that is activity and cost. The system is flexible enough to relate costs to customers, processors, management responsibility and not just products. This helps develop a way to analyze and justify manufacturing cycle-time improvements. Over years, activity based costing has evolved as follows,

• Activity based costing
• Activity based cost management
• Activity-based budgeting
• Activity reporting
• Performance measurement and benchmarking
• Continuous improvement
• Product/customer and sector profitability
• Business process re-engineering

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 approach is to start with activity analysis, then activity based costing which then create performance improvement ideas. This is 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. 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.

Overhead costs are assigned to a large number of cost pools that represent the most significant activities involved in the production process.  Then, cost drivers are identified that are suitable for each cost pool and 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. When using this 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 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.
While 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 aspects 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, focuses on product costing, the second on process costing or performance evaluation, and the third, 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.