Question

Explain the major differences between the activity-based costing system and the traditional costing system

Answer 1

The major differences between the activity-based costing (ABC) system and the traditional costing system lie in the way they allocate costs to products or services. The traditional costing system uses a single cost driver, while the ABC system identifies multiple cost drivers for more accurate allocation. The ABC system provides a more detailed and accurate allocation of costs.

Step-by-step explanation:

The major differences between the activity-based costing (ABC) system and the traditional costing system lie in the way they allocate costs to products or services. In the traditional costing system, costs are allocated based on a single cost driver, such as direct labor hours or machine hours. On the other hand, the ABC system identifies multiple cost drivers, such as the number of setups or the number of inspections, and allocates costs accordingly.

For example, let's say a manufacturing company produces two products: Product A and Product B. In the traditional costing system, if 80% of the costs are incurred by direct labor and Product A requires 8 hours of direct labor while Product B requires 4 hours of direct labor, Product A would be allocated more costs compared to Product B.

However, in the ABC system, if Product A requires more setups and inspections than Product B, it will be allocated more costs because setups and inspections are the cost drivers in this case. Therefore, the ABC system provides a more accurate and detailed allocation of costs compared to the traditional costing system.

Answer 2

The major difference between activity-based costing (ABC) and traditional costing systems lies in how overhead costs are allocated to products; ABC uses specific activities as cost drivers for more accurate allocation, while traditional costing uses a single, volume-based rate. Understanding explicit and implicit costs is essential in assessing true economic profit versus accounting profit.

Step-by-step explanation:

When it comes to understanding cost structures, it is essential to recognize the major differences between activity-based costing (ABC) and traditional costing systems.

Traditional costing assigns overhead costs to products based on a predetermined overhead rate, which is typically a single, volume-based cost driver such as machine hours or labor hours.

This method can result in somewhat distorted product costs because it does not take into account the actual complexities and variations in the cost-generating activities.

In contrast, activity-based costing allocates overhead more accurately by identifying individual activities as the fundamental cost drivers.

For example, costs like procurement, setup, and quality control are tied to specific activities and products, which allows firms to allocate costs based on the actual consumption of resources.

This can lead to more precise product costing, which is especially useful in complex environments with a wide variety of products and indirect costs.

The decision-making process can also be enhanced by understanding the difference between explicit costs and implicit costs.

Explicit costs are clear, out-of-pocket expenses such as raw materials and wages. Implicit costs represent the opportunity costs of utilizing resources where they are not directly paid for, such as using a piece of equipment you already own.

Understanding both helps to assess the true cost and revenue relationships and measure economic profit, which includes both types of costs, rather than just accounting profit, which only deducts explicit costs from total revenue.