Activity Based vs Traditional Costing: Difference and Comparison

Costing is used in accounting. It helps the company and the business in the long run. It comes under the commerce stream. Account people used this method and implemented it based on the kind of product.

Activity-based costing and traditional costing are two such methods used for accounting. 

Key Takeaways

1. Activity-based costing allocates overhead costs based on specific activities, while traditional costing allocates overhead costs using a predetermined rate.
2. Activity-based costing is more accurate and better suited for complex production processes, while traditional costing is simpler and more applicable to businesses with uniform products.
3. Activity-based costing helps identify non-value-added activities, enabling cost reduction, whereas traditional costing doesn’t offer the same level of detail.

Activity Based Costing vs Traditional Costing

The difference between Activity-based costing and traditional costing is the factors that are considered when assigning the price for overhead products. Traditional costing uses a predetermined method to calculate the overhead product rate. It would be good if you use activity-based costing for correct accuracy. 

Activity-based costing is to determine the overhead costs for different methods. The method will not be specific. Here the cost driver will be applied differently based on what kind of product we use.

It is considered the most expensive one as it is very difficult to implement them, and the process will be tedious to understand. 

The traditional costing method is to allocate the overhead products of the factory. It is one of the easiest costing methods as the process will be simple and easier to implement. It is used under accounting. The single cost driver is based on various methods. 

Comparison Table

Parameters of Comparison	Activity Based Costing	Traditional Costing
Definition	This is used for finding the indirect costs.	This method is for finding the cost for the products in advance.
Advantages	It gives the profit of the product accurately.	Workers will be more productive to do the work.
Disadvantages	The benefits will be limited.	It is not helpful when we determine the overhead costs for general purposes.
Activity Types	Unit level and Facility level.	Unit level, facility level, product level, and batch level.
Costing Method	Less expensive costing method.	More expensive costing method

What is Activity Based Costing?

This method is used for maintaining overhead and indirect costs. It is related to products and services. This kind of costing method is used in Manufacturing Industry.

The reason behind this is it is used for enhancing the cost data reliability. This, in turn, will produce reliable costs, which are used for the better production of the company. It is based on activities and specific goals. 

This will help us to get a better grip on costs. So, more companies will be able to follow some strategies for appropriate pricing.

Activity-based costing is mainly used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. There are some steps to be followed for activity-based costing. 

The first thing we have to do is to identify the cost of the objects we are going to invest in. The second step is to identify the direct costs of those products. The third step is to allocate the indirect costs to these products.

The fourth step is to identify the indirect costs which we have allocated to these products. The fifth step is to compare the price per unit. The sixth step is computing those indirect costs.

The seventh step is computing the total cost of all those products. Their main purpose is to provide more accurate costing services. 

What is Traditional Costing?

Traditional Costing is to identify the cost of the products that are needed to make a profit to the products of the organization. This method is done by allocating overhead manufacturing costs.

So, the predetermined overhead method is calculated in order to apply the rates. The costs that are incurred in traditional costing are Managing the expenses, Packaging, Machine Hours, Machine Setups, Quantity of Materials Required, and Cleaning and maintaining the materials.

In order to follow the traditional costing method, we have to follow some predetermined steps. The first step is to identify the cost overhead. The next step is cost estimation. The overhead costs for some time period will be estimated in this step. The third step is Calculation.

In this step, we have to choose the cost driver. Because traditional costing is based on the cost-driving method. The fourth step is estimating the amount that is required for the cost-driving method. The fifth step is to calculate the overhead rate, which is predetermined. 

The sixth and final step is to apply the rate which we have calculated from the estimation to the overhead product. This type of costing is mostly used by manufacturing industries. Because their main purpose is to predetermine the amount for the products they are going to make.

Main Differences Between Activity Based Costing and Traditional Costing

1. Activity-based costing is used to cover only the product cost. On the other hand, traditional costing is used to cover both the product and the period costs.
2. Activity-based costing is very difficult to learn and understand, and at the same time, the implementation process becomes very difficult, while traditional costing is easy to understand, and the implementation process is simple.
3. Activity-based costing is used in external finance, while traditional costing is used in external reporting statements.
4. Activity-based costing uses multiple drivers for its operational requirements, while traditional costing uses an identical cost driver for its operational requirements.
5. Activity-based costing uses only two activities, but traditional costing uses four activities.

References

1. https://onlinelibrary.wiley.com/doi/abs/10.1111/1475-679X.00031
2. https://link.springer.com/content/pdf/10.1007/s12351-009-0049-3.pdf