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In the field of accounting, activity-based costing and traditional
costing are two different methods for allocating indirect (overhead) costs to products. Traditional Costing MethodTraditional costing
systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat
overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to
direct costs. There are several steps in the traditional costing process, including the following: Predetermined Overhead Rate CalculationUse the following formula to calculate predetermined overhead rate: Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount For example: $30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor Activity-Based Costing BenefitsActivity based costing systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. The leap from traditional costing to activity based costing is difficult. Traditional Costing Advantages and DisadvantagesTraditional costing
systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and
over-costing. [box]Strategic CFO Lab Member Extra Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits. Click here to access your Execution Plan. Not a Lab Member? Click here to learn more about SCFO Labs[/box] Companies need accounting systems to track the costs of their operations. Two of the most commonly used systems are traditional costing and activity-based costing. One of these is easy to use and inexpensive to implement, while the other costs more to use but gives you greater accuracy. TipTraditional costing adds an average overhead rate to the direct costs of manufacturing products and is best used when the overhead of a company is low compared to the direct costs of production. Activity-based costing identifies all of the specific overhead operations related to the manufacture of each product. Traditional CostingTraditional costing adds an average overhead rate to the direct costs of manufacturing products. The overhead rate gets applied on the basis of a cost driver, such as number of labor hours required to make a product. Pros and Cons of Traditional CostingTraditional costing is best used when the overhead of a company is low compared to the direct costs of production. It gives reasonably accurate cost figures when the production volume is large, and changes in overhead costs do not create a substantial difference when calculating the costs of production. Traditional costing methods are inexpensive to implement. Companies usually use traditional costing for external reports, because it is simpler and easier for outsiders to understand. However, it does not give managers an accurate picture of product costs because the application of overhead burden rates is arbitrary and applied equally to the cost of all products. Overhead costs are not allocated to the products that actually consume the overhead activities. The traditional costing method is best used for manufacturers that only make a few different products. Activity-Based CostingActivity-based costing identifies all of the specific overhead operations related to the manufacture of each product. Not all products require the support of all overhead costs, so it is not reasonable to apply the same overhead costs to all products. Accountants created the ABC method to solve the problems of inaccuracy that result from the traditional costing approach. Managers needed more accurate costing methods to determine which profits were actually profitable and which were not. A fundamental difference between traditional costing and ABC costing is that ABC methods expand the number of indirect cost pools that can be allocated to specific products. The traditional method takes one pool of a company's total overhead costs to allocate universally to all products. Pros and Cons of Activity-Based CostingActivity-based costing is the most accurate, but it is also the most difficult and costly to implement. It is more suited to businesses with high overhead costs that manufacture products, rather than companies that offer services. Companies that manufacture a large number of different products prefer an activity-based system because it gives more accurate costs of each product. With activity-based allocation of overhead costs, it is easier to identify areas where expenses are being wasted on unprofitable products. Deciding between traditional or activity-based costing is not easy. Your choice should depend on the purpose of the reporting and who will see the information. Managers need accurate product costs and prefer to use an activity-based accounting system. Even though this system is more costly, it provides better information that will enable managers to make more profitable decisions in the long-term. For external reporting, companies still use the traditional costing system, but it is becoming obsolete as outsiders demand more accurate information about businesses. What are the main advantages of volumeWhat are the main advantages of traditional volume-based allocation methods compared to activity-based costing? traditional volume-based methods are easier to use and less costly to implement and maintain. Sales price per unit less total variable cost per unit.
What are 3 advantages of activityWhat are three advantages of activity-based costing over traditional volume-based allocation methods? More accurate product costing, more effective cost control, and better focus on the relevant factors for decision making.
What are the differences between volumeTwo Stage Cost Assignment Procedure
Factory overhead costs to activity cost pools and then to cost objects to determine the amount of resource costs for each of the cost objects. Volume-based costing systems assign factory overhead costs first to plant or departmental cost pools and second to products or services.
What are the advantages of activityActivity-based costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions. It increases understanding of overheads and cost drivers; and makes costly and non-value adding activities more visible, allowing managers to reduce or eliminate them.
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