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Traditional versus Activity Based Costing

   

Added on  2021-04-21

7 Pages1239 Words82 Views
1Traditional versus Activity Based Costing

2IntroductionIn business there is occurrence of multiple costs in manufacturing of goods or renderingof services. The manufacturing organizations have to distribute the cost occurred for rawmaterial,, labour, and overhead to the goods produced in order to determine the overall cost ofthe manufactured goods. In costing there are various methods for allocating the all the costs tothe goods and services. Some of important cost allocation methods are traditional costing methodand activity based costing method. In this essay, there will discussion on both of these costingmethods and difference between them will also be explained. The traditional costing method andactivity based costing method both are used to allocate the indirect cost incurred during themanufacturing of goods or providing the services. The main role of both these costing methods isto calculate the overhead costs and allocate them to the products using the certain cost drivers.Comparison of Traditional costing method and activity based costing methodThe traditional costing method of cost allocation is most easy and frequently used methodfor allocating the factory overhead to the products. The main reason why the traditional costingmethod is frequently used is because of its simplicity and easy to apply characteristics. Underthis costing method, all the overhead cost (factory overhead) are allocated to the differentproducts using the single cost driver such as direct labour hour method or machine hour methodor direct material used method (Cooper and Kaplan,1991). There are many potential problemsassociated under this method like use of single recovery cost driver to allocate all the overheadirrespective of overhead consumed under respective product or not. This problem give rise tocritical cost issues that can harm the company’s performance. Under traditional costing method,the cost allocation takes place in two stages. In first stage, all the overheads are calculated by

3reporting all the overhead cost to the cost centers. In second stage, all the overheads cost aredistributed form the cost center to the different products in the proportion of cost driver used byeach of the product in the respective period (Hayden, 2017). The traditional costing method of cost allocation does not help in effective operatingmanagement performance system that will help managers to obtain the relevant informationabout the products to help in improvement of business performance. The users of the traditionalcosting method make unrealistic assumption that volume metric is the most common underlyingdriver of the manufacturing overhead cost. Under the traditional costing assigns all types ofoverheads using the single recovery rate among the products manufactured by the company. Thetraditional costing method of cost allocation has failed after company has started using themachines and other different tools for manufacturing of products. The modern manufacturingprocess involves many activities to produce any product and it is completely wrong to allocatethe overhead costs using the allocation base that has no relation with the activities used in themanufacturing of products. To solve all these problems, the new costing method has beenintroduced known as activity based costing system (Bromwich and Bhimani, 2005).The activity based costing method is very unique and most accurate method of costallocation as this method completely based on the actual consumption basis. As per this methodthe complete manufacturing process has been divided into many stages and each stage consumessome costs. The certain activities can differ depending upon the products manufactured by thecompany. Every activity used in the manufacturing process critically based on some cost driversuch as if product is processed through certain machine than the cost driver will be machinehours. The activity based costing system identifies the activities that are performed to make theproduct fit for the consumption and then allocate overhead cost linked with particular activity to

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