Activity-based costing and traditional costing

Activity Based Costing (ABC) refers to a methodology which recognizes organizational activities and allocates the expense/cost of every project with resources to all goods and services in accordance to the actual usage by each. Consequently, the methodology assigns more of overhead costs (overheads) into direct costs as compared to convectional costing. In addition, the Chartered Institute of Management (CIMA) describes ABC as an approach of costing and monitoring various business tasks that comprise of resource tracing, usage and final outputs costing. Project resources are issued to tasks and tasks assigned to cost objects on consumption estimate basis. Moreover, the consumption estimate applies cost drivers to match activity costs to outputs.

Furthermore, the method aims at estimating elements of costs for the whole product, service or activity. The estimation assists a company in decision making to either recognize and cancel unprofitable goods and services and reduce prices of overpriced products or identify and remove ineffective activities and services and assign processing aspects which contribute to the very same product at a better output. Similarly, the approach focuses on the allocation of costs in operational management thus helps in segregating variable costs, fixed costs and overhead costs. Therefore, the process plays different roles such as looking for unnecessary expenses that might be cancelled from a project, fixing price to a service or product via analytical resolution and identifying products that are inefficient, activities and departments.

On the other hand traditional costing refers to the assignment of factory overheads to goods and services based on the number of production resources consumed. According to the method overhead is normally utilized based on either the volume of direct labor hours used or machine time consumed. The problem with the method is that factory overhead might be higher than the allocation basis. Therefore, a small change in the quantity of resources utilized strikes a massive change in the volume of overheads applied. The phenomenon is common particularly in places with highly automated environments of production whereby the factory overhead is big but the direct labor is almost nonexistent. For example you may realize that factory overhead is supposed to be charged to services and products at the rate of $500 per every direct hour of labor. Therefore, in case of a small change in production process which increases direct labor by an hour it means that the product cost has just rose by $500 of overhead.

In such a situation does not make sense because not every time a direct relationship exists between production resources and the overheads. Therefore, Activity-based costing was formulated to circumvent the issue with traditional costing. The analysis is more comprehensive displaying the relationship between cost drivers and overhead costs such that majority of driver costs can be applied to form a well-founded overhead costs allocation. Consequently, in estimating the costs involved with the production of new products of the ConceptErgo Company both activity-based costing and traditional costing will be worked upon effectively to influence an appropriate decision.