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Sample Article Review Paper on Activity-Based Costing and Traditional Costing Systems

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Sample Article Review Paper on Activity-Based Costing and Traditional Costing Systems

Introduction

The Activity Based Costing (ABC) system is the process of cost estimation system which focuses on activities performed to generate products. It could be defined as a system, which assumes that the activities are responsible for the incurrence of overheads, and products which create the demand for activities (Kaplann & Atkinson, 2015). In ABC method, costs are charged to products based on individual product’s use of each activity. The key target of ABC system is to identify very many costs possible to be subsequently accounted for as direct costs of production. Thus, by emphasizing cost behaviors, the ABC method tends to determine the causes of the significant cost activities and their relationship with the products produced.

On the other hand, traditional costing method refers to the approach in which all costs are directed towards a single accumulation of costs which cannot be directly identified as a part of the product. It is based on a typical distribution of expenditure such as labor, wages, repairs, and depreciation among other overheads.  It involved the method of allocating costs incurred in production other than direct materials and direct labor costs. The traditional costing technique allocates costs based on a single volume measure such as direct labor hours or machine hours. The traditional costing method is highly recommended by the applied accounting principles. It is simple to implement and doesn’t require a lot of costs to achieve.

 

Table of distinguishing features between ABC and Traditional costing systems

 

Traditional

ABC

Cost pool

one or a limited number

Many to reflect different activities

Applied rate

Volume based cost drivers

Activity based non-financial

Suited for

Labor intensive, low overhead companies

Capital intensive, product diverse, widely diverse set of operating activities, high overhead companies

Benefits

Simple and less expensive

Accurate costing, possible elimination of non-value added activities

Cost assignment

Allocates overhead costs first to departments and second to products and services

Assigns overhead costs first to activity cost pools and second to products and services

Focus

Focuses on managing costs of functional departments

Focuses on managing processes and activities and solutions of cross functional problems

 

 

 

Original purpose and focus

The traditional costing method was discovered around 1890 to 1910 while ABC was rediscovered in 1981 (Kaplan & Atkinson, 2015). Moreover, in traditional costing analyzes the inventory estimation, corresponding, and income. But ABC system deals with more accurate product costs for decision making by the management. Additionally, on the duration orientation, traditional costing method concentrates on short run emphasis with long run implications and primary focus is production and value added by the production departments. Whereas, ABC method focuses on the long run variable costs and mainly focuses on cost tracking to provide accurate costs and profits by cost objects.

Assigning costs

The major difference that is exhibited between these two approaches is outlined well. in the traditional system, the cost depends on the activities in which costs are assigned and the used up assets which were utilized in the production process whereas in ABC costing, the cost depends on upon the activities that have been used up by the items which the costs have been assigned. Also, while the Activity-based costing is considered to be more precise and much more preferred than the traditional system, the traditional costing method is said to be unable to calculate the actual price of goods. It is because; the traditional costing uses a single overhead pool which accumulated random expenses such as depreciation, salaries and wages and other administrative costs while the Activity-based costing system of assigning costs is considered to be more accurate.

Besides, ABC is commonly applied to smaller targeted activity based costs while it is also considered as being of great help in the decision making and clarification of the management concepts because the cost of a product in the ABC approach is determined according to the customer feedback and financial position. Unlike the traditional costing method, this only determines the cost of production only after the manufacturing process and therefore does not serve such a purpose.

 

Overhead cost pool.

The conventional costing method usually uses capacity related measures such as direct labor hours or machine hours to distribute overhead expenditure to the manufactured goods. On the other hand, ABC allocates overheads costs by the resources consumed by each activity involved in the design, production and distribution of a particular product. The conventional system of costing applies indirect costs to products based on a programmed overhead absorption rate (Luu &Vallis, 2011). On the other hand, Activity-based costing system identifies individual activities as fundamental cost objects. Therefore, after assigning a cost to each character activity, the overhead is then reallocated to different products.

The historical cost application

Another difference between the traditional system and activity- based estimate is the past point of reference. It is not unusual for an organization to use the actual past overheads the basis for developing manufacturing rate principles (Tsapaki, Kottou, Kollaros, Dafnomili, Koutelou, & Neofotistou, 2014). In a competitive situation where competitors have been proactive in eliminating waste and improving activities, an organization can go out of business while meeting its standards. While in activity-based costs is also calculated using historical resource cost (Kaplan & Atkinson, 2015).

The two-stage allocation

In the traditional system of costing, overhead costs allocation to the production departments is carried out in the first stage. But in activity based system of charging overhead cost allocation is assigned to each significant activity instead of the departments. In the traditional costing system, overheads are shared department wise. But in ABC, many activities- based expenditure centers are created. Also, in traditional costing, overhead costs of different service departments are reallocated to manufacturing sections and therefore in this costing system finally only fewer groups of individual cost exist (Hoozée & Bruggeman, 2010). But the ABC creates separate groups of different overheads for service activities as well, and overhead costs of these service activities are assigned directly to specific products through applying relevant cost rates. Therefore, in the activity-based system, reapportionment of overheads of different departments is not necessary. There is no need to reapportion overheads of various departments.

Accuracy and complexity

Traditional method costing is simpler to apply, and the results are less accurate as compared to activity based method, and typically assign overhead costs to products based on an arbitrary average rate. ABC system is more complicated and more reliable than the traditional costing system of costing. The activity based costing method starts by assigning indirect costs to activities and then assigning the costs to products based on the products’ usage of the activities.

Advantages of ABC costing method
  1. ABC system facilitates basis and causes link to practice successful cost control.
  2. It creates accuracy and reliability of the costing data in the determination of the cost of the product (Tsapaki, Kottou, Kollaros, Dafnomili, Koutelou, &Neofotistou, 2014).

iii.    It provides necessary cost information for the management to take decisions on any matter relating to the business.

  1. It also performs a significant role in setting up the cost and selling price of a product.
  2. It facilitates operating cost allocation straight to the particular product.
  3. It enables the organization to control the activities and not costs.

vii.    It provides relevant information to assess on the comparative efficiencies of different capital assets.

viii.    Cost driver rates help in a significant impact on the development of new products or modification of existing products.

  1. It facilitates a better and allows for a better and more wide-ranging understanding of overheads and what causes them to occur.
  2. It makes the non adding value and expensive more visible, this enables the managers to focus on such areas to decrease or do away with them.
  3. It chains other organization techniques such as constant development, scorecards, and routine management.

xii.    It settles the significant disagreements between the operations staff and the secretarial staff about the costs of producing and marketing products and services.

xiii.    It is most beneficial where technical products appear to be gainful and simple products appear to be cost ineffective.

Disadvantages of ABC costing method
  1. ABC systems require management to estimate the costs of activity pools and to identify and measure cost drivers for these individual grouping of costs.
  2. Very comprehensive ABC systems are very expensive to operate and difficult to understand by the management. It may require the management to hire an expert at an extra cost to explain how the system works.

iii.    Activity cost rates also need to be regularly updated. Frequent review of rates may be costly and could as well create confusion among the users or the management.

  1. Activity based system can be challenging and time-consuming to accumulate the data about actions and cost drivers.
  2. In the activity-based system, some overheads are difficult to assign to products and customers. The costs still have to be randomly applied to products and customers.
  3. It is not recommended by the GAAP (generally applied accounting principles) hence making it less applicable when preparing an external report.

vii.    The choice of cost drivers. It is such a simple assumption that a given cost driver is an adequate summary measure of complex activities.

viii.    The supposition of a direct, linear correlation between the usage of various cost drivers and some overheads. Very few costs indeed are truly variable in this sense whether in either the short run or long run.

  1. A full ABC system having numerous cost pools and cost drivers is more complex and consequently more expensive to operate (Kaplan&Atkinson,2015).
  2. Tracing difficulties. It is not always apparent which product should carry the traced overhead. The failure to locate the individual overheads makes it difficult to conduct cost pooling.

 

Advantages of Historical costing method
  1. It is easy to apply. It easy for managers to be able to trace all the direct costs associated with a product including labor and direct material cost. Also, it’s hard to assign overhead costs to different types of products.
  2. In a traditional manufacturing environment, direct labor hours were an easy way to apportion overhead costs. At the time traditional costing methods were developed, direct labor was typically the biggest cost of production. Therefore, it was used as an alternative to allocating overheads too, with managers assigning higher overheads to products with higher direct labor hours (Luu&Vallis, 2011).

iii.    It recognizes the importance of fixed overheads in the production process. It enables the management to evaluate these costs.

  1. The method is important in preparing the financial accounts. When the production remains constant but sales fluctuate, traditional costing will show less fluctuation in the net profit. The traditionally based costing aligns with Generally Accepted Accounting Principles which has boosted the ease in implementation for companies that provide one product is an added advantage.
  2. Traditional costing negates other cost drivers that may contribute to the cost of an item.
Disadvantages of Historical costing method
  1. It affects the competitive position of a company. Firms that have a lot of overhead expenses need a more reliable method to allocate the overhead costs to different products. If a business uses incorrect costing to allocate costs, it could price its products incorrectly.
  2. The method is outdated due to the increasing technological advancements. The technological developments have led to a decreased need for labor in manufacturing processes. It would imply that a system that uses direct labor as an alternative for allocating different overheads is obsolete.

iii.    As traditional costing majorly emphasized on the total cost such as variable and fixed costs, it is not so convenient for management to use in making decisions, planning, and control (Hoozée & Bruggeman, 2010).

  1. In a historical costing method, overheads that are indirect costs are allocated, apportioned and at last absorbed in the cost units.
  2. Another disadvantage of traditional costing is the division among fixed and variable might not be realistic because there are many complications because of the complexity of the modern business. There should be a linkage between the activities and the costs. Likewise, the information should be made presented when the activities are going on. Information presented after the activity is over will not be of much use.
  3. Solely using the traditional costing method can lead to bad management decisions because it excludes certain nonmanufacturing costs.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

References

 

Hoozée, S., &Bruggeman, W. (2010). Identifying operational improvements during the design process of a time-driven ABC system: The role of collective worker participation and leadership style. Management Accounting Research, 21(3), 185-198.

Kaplan, R. S., & Atkinson, A. A. (2015). Advanced management accounting. PHI Learning.

Luu, V. V., &Vallis, M. F. (2011). U.S. Patent No. 6,948,165. Washington, DC: U.S. Patent and Trademark Office.

Tsapaki, V., Kottou, S., Kollaros, N., Dafnomili, P., Koutelou, M., Vano, E., &Neofotistou, V. (2014). Comparison of a conventional and a flat-panel digital system in interventional cardiology procedures. The British journal of radiology.

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