Costing systems helps companies determine the cost of a product related to the revenue it generates. Two common costing systems used in business are traditional costing and activity-based costing. Traditional costing assigns manufacturing overhead based on the volume of a cost driver, such as the amount of direct labor hours needed to produce an item. A cost driver is a factor that causes cost to incur, such as machine hours, direct labor hours and direct material hours. Activity-based costing allocates the costs of manufacturing a product according to the activities needed to produce the item. Managers should understand the advantages and disadvantages of both systems to meet the needs of their business.
Understanding Traditional Costing
Many manufacturing companies use the traditional costing system to assign manufacturing overhead to units produced. Users of the traditional costing method make the assumption that the volume metric is the underlying driver of manufacturing overhead cost. Under traditional costing, accountants assign manufacturing costs only to products. Traditional accounting fails to allocate nonmanufacturing costs that also are associated with the production of an item, such as administrative expenses. Companies commonly use traditional accounting in external financial reports because it provides a value for the cost of goods sold.
Pros and Cons of Traditional Costing
An advantage of using traditional-based costing is that it aligns with Generally Accepted Accounting Principles, or GAAP. Easy implementation for companies that provide one product also is a plus. However, traditional costing is an outdated costing system in many companies because those manufacturing companies now use machines and computers for much of their production. Computers and machines make the system outdated because it often uses direct labor hours to calculate cost. Cost is not appropriately assigned because direct labor hours is not the best cost driver to use. Traditional costing negates other cost drivers that may contribute to the cost of an item. Another disadvantage of solely using the traditional costing system is that it can lead to bad management decisions because it excludes certain nonmanufacturing costs.
Understanding Activity-Based Costing
Activity-based costing provides a more accurate view of product cost, but companies typically use it as a supplemental costing system. The allocation bases used in activity-based costing differ from those used in traditional costing. Activity-based costing determines every activity associated with producing an item and allocates a cost to the activity. The cost assigned to the activity is then assigned to products that require the activity for production.
Pros and Cons of Activity-Based Costing
Greater costing accuracy is the primary benefit of activity-based costing. Companies assign cost only to the products that require the activity for production. This method eliminates allocating irrelevant costs to a product. Other advantages of activity-based costing include an easy interpretation of cost for internal management, the ability to enable benchmarking and a greater understanding of overhead costs. Implementing an activity-based costing system within a company requires substantial resources. This can prove a disadvantage for companies with limited funds. Another disadvantage of using activity-based costing is that it is easily misinterpreted by some users.