Is Activity-Based Costing Better?

Generally speaking, I agree with the statement, “Activity-based costing does a better job of allocating both direct and indirect costs than traditional methods do.” Both methods use the same costing procedures for direct costs, as accountants measure a product’s unit cost for each direct cost individually (Noreen, et al., 2017). As such, I cannot say that either is better or worse in its allocation of direct costs. The differential advantage, rather, lies in the way they allocate indirect costs.

Traditional costing is a simpler method of costing that assigns overhead costs to products based on an average rate (Wilkinson, 2013). Activity-based costing (ABC), on the other hand, assigns indirect costs to activity pools, then assigns costs to the products based on the products’ share in the usage of the activity pools (Wilkinson, 2013). For this reason, ABC is more detailed and accurate, and so it is a better tool for decision-making, especially when it comes to profitability analysis, product differentiation, product pricing, and cost refining (Business Encyclopedia, 2020).

The main drawback to ABC is that it usually requires more resources and costs more to administer (Business Encyclopedia, 2020). Accordingly, ABC is less common than traditional costing with usage at about 20-50% for manufacturing companies, 15-25% for companies in the financial services industry, 12-18% for public sector businesses, and 6-12% for communications companies (Business Encyclopedia, 2020).

References

Business Encyclopedia (2020). Activity-based costing, ABC management. Retrieved from https://www.business-case-analysis.com/activity-based-costing.html

Noreen, E., Brewer, P., Garrison, R. (2017). Managerial accounting for managers. Retrieved from McGraw Hill Connect

Wilkinson, J. (2013). Activity-based costing (ABC) vs traditional costing. Retrieved from https://strategiccfo.com/activity-based-costing-abc-vs-traditional-costing/