Lesson 36 - Intermediate Accounting Course 

36. Activity-Based Costing (ABC) vs. Traditional Costing

Costing methods are crucial in determining how companies allocate expenses to products or services. Two common methods used are Traditional Costing and Activity-Based Costing (ABC). While traditional costing assigns overhead based on a single volume-based metric (such as labor hours or machine hours), ABC provides a more accurate allocation by linking costs to specific activities.

1️⃣ What Is Traditional Costing?

Traditional costing is a simpler method that assigns overhead costs based on a single driver, such as direct labor hours, machine hours, or production volume. This method works well for companies with homogeneous products and straightforward production processes.

✔ How It Works:

1. Total overhead costs are collected.
   
   

2. A single allocation base (e.g., labor hours) is chosen.
   
   

3. Overhead costs are divided among products based on the allocation base.
   
   

✔ Example:
A factory produces two types of chairs: Basic and Premium. The company uses labor hours as the allocation base.

• Total overhead costs = $500,000
  
  

• Total labor hours = 10,000
  
  

• Overhead rate per labor hour = $50
  
  

If the Basic Chair requires 2 labor hours → Overhead = $100
If the Premium Chair requires 5 labor hours → Overhead = $250

📌 Limitations:

• Assumes all products consume overhead at the same rate.
  
  

• Can distort product costs if some products require more indirect resources.
  
  

2️⃣ What Is Activity-Based Costing (ABC)?

ABC is a more detailed costing method that assigns overhead costs based on activities rather than a single volume-based driver. It provides a more accurate cost allocation, especially in complex production environments.

✔ How It Works:

1. Identify activities that drive overhead costs.
   
   

2. Assign costs to each activity (e.g., machine setup, quality control).
   
   

3. Determine cost drivers for each activity (e.g., number of setups, inspections).
   
   

4. Allocate costs based on actual resource consumption.
   
   

✔ Example:
Instead of using only labor hours, the company identifies:

• Machine Setup Costs → $100,000 (allocated based on number of setups)
  
  

• Quality Control Costs → $200,000 (allocated based on number of inspections)
  
  

• General Overhead → $200,000 (allocated based on labor hours)
  
  

If the Basic Chair requires fewer setups but more inspections, its costs will reflect its true resource usage, rather than being arbitrarily assigned based on labor hours alone.

📌 Advantages:
✔ More accurate cost allocation
✔ Helps identify high-cost activities
✔ Improves pricing and profitability analysis

📌 Challenges:
✖ More complex to implement
✖ Requires detailed activity tracking

3️⃣ Key Differences Between ABC and Traditional Costing 

4️⃣ When to Use ABC vs. Traditional Costing?

✔ Use Traditional Costing If:

• Overhead costs are relatively low.
  
  

• Products require similar resources.
  
  

• Simplicity and quick calculations are preferred.
  
  

✔ Use ABC If:

• Overhead is a significant portion of costs.
  
  

• Products vary in complexity and resource usage.
  
  

• Precise cost data is needed for pricing and decision-making.
  
  

📌 Example:
A factory making identical plastic bottles may use traditional costing, while a custom furniture manufacturer benefits more from ABC due to varying labor, materials, and design costs.

5️⃣ Conclusion: Why ABC Matters

ABC provides a clearer picture of where a company’s money is going. While it is more complex, it helps managers:
✔ Identify costly activities
✔ Set better pricing strategies
✔ Improve cost control and efficiency

Understanding these two methods helps businesses optimize profitability and decision-making, ensuring that resources are allocated efficiently.