Accounting and Finance: Traditional Costing vs Absorption Costing vs Activity Based Costing

Running head: ACCOUNTING AND FINANCE
Accounting and finance
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Table of Contents
Introduction................................................................................................................................2
Traditional method of costing....................................................................................................2
Absorption costing.....................................................................................................................2
Example..................................................................................................................................3
Limitation of absorption costing............................................................................................4
Decision making.....................................................................................................................5
Activity based costing (ABC)....................................................................................................5
Example..................................................................................................................................5
Limitations.............................................................................................................................7
Decision making.....................................................................................................................7
Conclusion..................................................................................................................................8
Reference....................................................................................................................................9

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Introduction
The main objective of the report is to suggest other cost models as against the
traditional costing methods as the traditional method uses the labour hour rate or machine
hour rate for allocating the overheads. Therefore, the traditional costing method is regarded
as outdated systems and is receiving various criticisms in recent times. The report will focus
on other cost allocation system that is more systematic and use systematic approach to
allocate the costs. Other costing systems that can be used against the traditional method of
costing are absorption costing and activity based costing to calculate cost of individual
product, activity or service (Ruiz-de-Arbulo-Lopez, Fortuny-Santos and Cuatrecasas-Arbós
2013. Pp. 647-668).
Traditional method of costing
Under the traditional costing method, the manufacturing overheads are allocated on
the basis of cost driver volume that is requirement of direct labour hours for producing the
product. Cost diver is the factor that causes incurring of the costs like direct material, direct
labour and machine hours. However the traditional accounting fails to assign the non-
manufacturing costs associated with the product like the administrative costs (Subramaniam
and Watson 2016. Pp. 275-305). Traditional costing method is outdated systems and
receiving various criticisms in recent times. The reason behind this is that this system does
not assign the cost appropriately as direct labour hour is not the best and most appropriate
method. Further, it does not take into consideration other cost drivers associated with the
product. Therefore, it can lead to inefficient management decision as it fails to take into
consideration various non-manufacturing costs.
Absorption costing
The absorption costing or full product costing is the method of calculating the cost of
a product or service by taking into consideration all the indirect expenses and direct expenses.
It considers all the costs incurred by business for manufacturing the product (Fullerton,
Kennedy and Widener 2013. Pp 50-71). The accountant gathers all the costs like overhead,

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labour and materials costs throughout the company. Under absorption costing the overhead
must be allocated to each product that is being manufactured (Salah and Zaki 2013).
Example
XYZ Plc manufactures product “P”. Following are other information associated with
the production of “P” –
Selling price - £ 50.00 per unit
Direct materials - £ 8.00 per unit
Direct labour - £ 5.00 per unit
Variable production overheads - £ 3.00 per unit
Production for the month of January – 500 units
Sales for the month of January – 300 units
Fixed production overheads - £ 4,000 per month and absorbed on the basis of units. Normal
production level is 400 units
Other costs are as follows –
Fixed selling cost - £ 4,000 per month
Fixed administrative cost - £ 2,000 per month
Variable sales commission - 5% of revenue from sales
No opening inventory was there. (Hoare 2018).
Solution –
Computation of full production cost
Direct material £ 8.00
Direct labour £ 5.00
Variable manufacturing overhead £ 3.00
Fixed manufacturing overhead (£ 4000 / 400 units) £ 10.00
Full production cost £ 26.00