Traditional Costing and Activity-Based Costing - Essay Example

Management Accounting Introduction Traditional costing and Activity-Based Costing (ABC) techniques are the commoncosting methods used in management accounting. While the traditional costing technique uses driver costs such as direct machine hours and direct material hours to determine cost per unit of commodities, ABC technique allocates costs to production activities and then to the individual products that require these activities in order to determine costs. The essay details a comparison between various products to show the differences between the two methods in determining costs and profits. In particular, the essay illustrates how the ABC and the traditional costing techniques are used to determine the costs and profits of products YZT, ABW and XYI. Both techniques are said to provide important cost and profit data essential in decision making, but, the essay tries to explain why managers find it fashionable to use the ABC technique rather the traditional costing method. Types of Costing Techniques The tables below shows the difference between the Activity-Based Costing (ABC) and the traditional costing techniques by comparing the costs and profits of products XYI, YZT and ABW. Comparison of total cost per unit for each costing techniques: Costing Method XYI YZT ABW Traditional 40.18 92.48 71.45 ABC 39.25 92.03 73.58 Difference -0.92 -0.45 2.13 Comparison of profit by product line for each costing technique:   XYI YZT ABW Traditional £241,250 £101,000 £46,500 ABC £287,500 £119,000 -£17,500 Difference -46,250 -18,000 64,000 The tables above indicate that the cost per unit of products YZT and XYI, using the ABC technique is lower the cost per unit of similar products under the traditional costing technique. From the second table shown above, you can observe that the profit levels of product XYI and YZT are higher in ABC method than the profits of similar products in the traditional costing technique. However, product ABW has a lower profit level under the ABC technique that in the traditional costing method. The difference in costs per unit in both methods arises because the ABC method does not include all the production costs considered irrelevant in the required activities. Instead, the method captures only the adequate costs needed for executing the required tasks and activities. As a result, the costs become lower since the overhead costs of the products meant for these activities are not included. On the other hand, the traditional costing technique includes all the production costs such as the direct labour hours and machine hours on the volume of products generated. However, the methods fails to include the relevant cost drivers that contribute to the actual total cost of products and thus, not capturing the overhead costs. The higher cost per unit of product ABW under the ABC method results from the accounting of all the production costs necessary to facilitate product generation. On the other hand, the cost per unit of product ABW turns out to be lower because it fails to include the relevant cost that contribute to product formation such as administration expense. In determining the profits, the ABC method tends to ignore the unrelated costs to the volume of products generated and, therefore, give a higher margin of profit. Products XYI and YZT produce lower profits under the traditional costing method due to the fact the method includes the production cost associated with the volume of products generated. The profit levels in product ABW reveals that after accounting for the overhead costs, add or drive costs, production and non-manufacturing costs associated with producing a product, there will be losses in product ABW and profit while using the traditional method. Discussion From the analysis above, it is evident that ABC method focuses on the actual cost of required activities that lead to production of a product. The traditional costing method includes all the production costs, for example, the direct man hours, machine hours in determining the cost per unit for products. However, when the driver or add costs are included in determining the cost per unit for product using the ABC method, the cost per unit goes high, for example, the costs of products XYI and YZT. Costs and profits data obtained from the ABC method can, therefore, be used to inform the decision making process by the top management executives (Baxter 2003, p. 98). Based from the scenario of Riptide PLC, the Managing Director could have a valid argument when he states that the Activity Based Costing (ABC) is usually implemented because it is fashionable. It does not provide extra information to the management because it is a supplemental costing technique to traditional costing. As indicated in the earlier discussions, the ABC method involves allocation of costs to the identified activity that leads to production of an item. The costs assigned to the selected activities are those products that require the activities for production (Banker, Chang and Pizzini 2004, p. 100). In other words, the ABC method offers a benchmark for understanding the overhead costs, but, do not include them in the costing. The ABC technique only offers easy interpretation of costs by the internal business management but do not add valuable data, which can be referred in decision making. The method is used in the notion that it excludes all the irrelevant costs, which are hard to determine. However, these irrelevant costs are necessary for determining the cost incurred in producing a product like in the traditional method. Additionally, the ABC method tends to assume the manufacturing costs of a product included in the traditional method and just gives an overview of the costs of activities (Chapman, Hopwood and Shields 2007, p. 123). Across the management accounting, it has been argued that the Activity Based Costing is quick and accurate method of determining the costs associated with producing a product in exclusion of irrelevant costs (Hansen, Mowen and Guan 2009, p. 70). Managers find it easy and fashionable to use this costing method other than relying on the old method of costing. As a matter of fact, they prefer the ABC method to the traditional method because the old fashioned method requires the determination of direct man hours, which is a tedious process (Baker 1998, p. 76). With the large influx of machines and computers in manufacturing companies, the directors adopt this method so as to see a change. Of course, the traditional method would provide the more details that the ABC method, but, ABC technique is “descent.” As stated earlier, the traditional costing method accounts for the drive costs and manufacturing costs. Cost drivers usually cause a cost to incur, for example, the machine hours, direct material hours and direct labour hours. However, the method has been out-dated due to the introduction of computers and machines in the production processes. As a result, cost analysts find it easier to determine the operational costs rather than modifying the old costing system, which is tedious. Therefore, many managers tend to recommend the Activity Based Costing to be the successor of the old costing method (Weygandt, Kieso and Kimmel 2010, p. 345). Why the Activity Based Costing Method? Some of the reasons as to why managers find it a fashionable in using the ABC method is because it promotes understanding of costs, accurate computation of the costs, as well as, the logical representation of the activities’ costs (Rich 2012, p. 200). The traditional method provides similar analysis, but, the ABC technique integrates the entire costing system. First, the ABC method is known for increasing the understanding of the cost drivers and overheads necessary in cost determination. The method recognizes the existences of unique relationship between the products and the activities and as result, assigning indirect costs to the identified products (Du toit 2007, p. 43). It is not that the method adds accounting information, but, it assigns costs less arbitrarily the old costing system. The organizations that tend use the successfully implemented ABC method in pricing and adding or deleting some items from the company’s product portfolio. In addition, the management can decide on whether to in-house or out-source production and even assess the viability of the company’s improvement initiatives already in place. As a result, the understanding of the costs would not be abstract like when using the traditional methods. In other words, the ABC methods clearly identifies the relationships between products and activities in a more fashionable way that the old system. The enhanced understanding of these relationships even quickens the decision making process concerning pricing, outsourcing and product portfolio management (Mathur 2011, p. 89). The traditional method would give similar result but it is complex and indeed an out-dated costing system. Another benefit of using the Activity Based Costing in decision making is that it gets closer to the true production costs. It analyses the overheads and cost drives in terms of resource consumption. In the tradition costing technique, these costs are treated as indirect costs, but, the ABC approach considers them as direct costs (Bhattacharyya 2011, p. 60). In this way, the implementers of the ABC technique improve costing closer to the true/ actual cost and profitability of every product or services. Through analysing how individual products require certain activities, the ABC approach successfully allocates direct costs rather than rough estimates. The managers opt for the ABC technique because it focuses on the product lines, unlike the traditional method, which considers the manufacturing costs of producing a product. Although both methods estimates the costs per unit of certain products, the modern ABC technique is more fashionable that the older one. In addition, it appears easier to analyse the true costs of certain project initiatives using the modern approach than the old costing system. Managers find it interesting by getting the rough estimates of how their initiatives are performing in terms of returns and benefits (Danture and Alawattage 2012, p. 345). The logical nature of determining the costs is another reason why the ABC approach is implemented not because of its additive information, but, its descent fashion. The aspect of allocating costs on the basis of direct man-hours or machine hours may be irritating to modern managers who prefer to go the fashionable. The simplicity of the old system of costing is more or less the same as the modern ABC logical determination of costs and benefits. The Activity Based Costing assigns costs first to the activities associated with the overheads and cost drives. Then, the costs are extended to the individual products and services, which require these activities (Riahi-Belkaoui 2001, p. 125). In this way, the ABC technique provides a more logical approach to the actual costs of the activities. Therefore, the activity based costing can be said to be that approach that allows costing and controlling the activities that contribute to cost consumption. The method is not abstract because it traces the resources consumed by the individual products and services (Baines and Landfield-Smith 2003, p. 67). Thus, the managers would rely more on the ABC technique because it provides the costs of final outputs. The Activities Based Costing does not provide any extra information; it is only that it tends to assign costs to activities while the traditional method attaches costs to the cost drivers. Actually, successful implementation of both methods would most likely give similar costs of the final outputs. However, the notion that the ABC approach is fashionable and gives results faster than the older costing system makes managers rely on the modern method (Steffan 2008, p. 90). Another argument supporting the scenario where managers find it fashionable to use the ABC technique in cost accounting is that it provides the true costs, which can be easily misinterpreted. Misinterpretation of the costs and benefits derived from the activity based costing is a common disadvantage that is experienced in many organizations. Therefore, it is evident that many company directors may as well go for ABC technique and leave the traditional method, which takes time to interpret. They would claim that it is fashionable even when it gives incorrect costs and benefits of individual products and services (Banerjee 2006, p. 101). Conclusion From the discussion, it is evident that the underlying factor that contributes to the implementation of the activity based is the notion of its descent fashion. The method does not provide more information than the traditional cost accounting system. In fact, they are more of similar techniques used to determine the costs and benefits of products. The traditional methods use the cost drivers such as the machine hours, direct materials hours or direct material hours in determining the costs. The Activity Based Costing method, on the other hand, assigns costs to activities and then to the individual products that require the activities. In this way, they provide cost per unit data that is essential in decision making. References List Baines A & Langfield-Smith K 2003, Antecedents to management accounting change: A structural equation-approach. Accounting, Organizations and Society 28, 675-698. Baker J J 1998, Activity-based costing and activity-based management for health care. Md, Aspen, Gaithersburg. Banerjee B 2006, Cost accounting: theory and practice. New Delhi, PHI Learning Private Limited. Banker R D, Chang H & Pizzini M J 2004, The Balanced scorecard: judgemental effects of performance measures linked to strategy. 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