Critically discuss “activity-based costing” vs traditional full costing. Discuss

Question

Critically discuss “activity-based costing” vs traditional full costing. Discuss in detail benefits and limitations and provide example to support your points.

Inventory Historic cost (£/unit) Sales value (£/unit) Replacement cost (£/unit) Component X 10 15 18 Component Y 25 17 20 Component Z 35 40 50 Component X is in constant use in business. We currently have 150 units of Component X. Component Y was bought several years ago and there are 200 units in stock which has no current use in business. It could be sold at sales value of £17 per unit. Component Z is in constant use in business. We currently have 50 units of Component Z. For a New Project 1, we need 100 units of Component X and 600 units of Component Y and 100 units of Component Z.

Explanation / Answer

Costing is used in business accounting strategies as a way of determining the cost of manufacturing a product in relation to the revenue generated by that product. Costing systems determine the overhead of production and then allocate those overhead costs to a business’ products.

There are two common methods for allocating these indirect costs to products. Both of these methods assess overhead costs and then attach these costs to products based on certain cost drivers. A cost driver is any component that costs money or any factor that is related to a cost occurring, such as the volume produced or the number of labor hours.

The first of these methods is activity-based costing, which is sometimes referred to as "ABC." Activity-based costing determines all activities associated with production, assigns a cost to those activities and then determines the cost of the product.

The other method is traditional costing, which assigns costs to products based on an average overhead rate. This method pools all indirect costs in production and applies those costs equally across the board using one appropriate cost driver, such as machine hours.

ABC vs. Traditional

Activity-based costing is more accurate because it takes important factors into account before assigning a cost to a product. However, for this same reason, it is a bit more complicated and time-consuming. It's also more thorough and considers nonmanufacturing expenses as well, such as administrative and managerial costs.

Traditional costing is a much easier way of determining the cost of a product, since it relies solely on assigning average overhead rates. This also means it won’t always be as accurate, because it doesn’t factor in nonmanufacturing expenses or determine which overhead costs actually affect specific products.

A simple example of these costing methods can be demonstrated with the costs of living in an apartment with roommates. Two roommates in an apartment will typically split the costs of rent, utilities and groceries, and they have a couple of options for doing so. They could simply total the cost of all of the bills and divide it exactly in two. This would be similar to traditional costing.

The roommates also have the option of determining who uses specific utilities and paying only for what each one uses. They can then create an itemized bill for each roommate. For example, if one roommate doesn’t use the internet and the other doesn’t use cable, they won’t have to pay those parts of the bill. This method is similar to activity-based costing.

Which Should You Use?

Both forms of costing have various benefits as well as disadvantages. Determine which form of costing will be best suited for your project by considering your specific needs and your timeframe.

Activity-based costing should be used when accuracy is crucial, because it is the most precise. Although it is costly to implement, it should be used for:

Traditional costing should be considered when time is limited or when accuracy won’t be affected much by production activities. Traditional costing is most effective for:

Project 1

For Component X, required is 100 units , so we have 50 units in excess. So the same can be sold @ $15 / unit.

For Component Y current stock is 200 units which has no current use in business, so these 200 can be replaced @ $20/unit and balance 400 units needs to be purchased @ $ 17 per unit.

For component Z current stock is 50 units which is in constant use in business , therefore balance 50 needs to be purchased @ $ 40 per unit

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