Traditional Costing Method vs. Activity Based Costing Method
Allocation of indirect cost is a typical allocation as the costs cannot be directly allocated to products and services produced/provided by the company. Hence, an allocation method or basis is required. For such allocation of indirect overheads, two methods are provided by the cost accounting. These methods are traditional costing method and activity based costing method. (Martin, 2018)
Under traditional method, the costs are allocated using either direct labour hours or machine hours, or in other words using a single cost driver. Whereas under activity based costing, the costs are allocated on the basis of production resources consumed by the various activities involved in the production. Hence, activity based costing allocates the resources in a practical and meaningful way which is far more realistic than traditional costing.
However, we do not agree with the view of Kerry that the activity based costing is useful for manufacturing companies only and has no benefit for service industries. Since, the challenges faced by both the industries are common, i.e. appropriate allocation of overhead cost and since, both the industries have indirect overheads which needs to be allocated to the products produced or services consumed, hence, activity based costing can be applied by both the industries. Further, the purpose of activity based costing is to allocate indirect overheads to the products or services.
It not only allocates the overheads, but also helps in fixing the correct price of the product. And appropriate pricing of the products or services is the most important factor for any business. Moreover, ABC is an important analysing tool for the management as it helps in analysing the profitability and the costs of the company. It is a simple method to adopt and provides the insight of the costs allocated to the products. It breaks down the costs in to the activity level costing, and then finds out the relevant cost drivers of the activities. Then the costs are allocated on the basis of these cost drivers consumed by the products or services. Further, application of ABC will not just help in appropriate allocation of overheads instead it also helps in taking informed decisions by the management. As well managed service firms with the good understanding of their profitability, markets and customers, can become more profitable and successful. (“Role of ABC in Service Industry”, 2018) (2018)
However, ABC has some limitations as well. ABC is useful if it is implemented in the company having more than one products and services, as if the company has only one product or service, then the question for allocation of costs does not arises, as the entire costs belong to that single product or service.
Moving to our firm costing scenario, if the costs are allocated using the traditional method, i.e. the current method, the total overheads of $410,000 are allocated as $162,491 in Tax, $53,100 to bookkeeping services and $194,409 to Advisory services. Whereas, when we allocate the costs of $410,000 using activity based costing, then the allocation comes at $133,555 to Tax, $44,651 to bookkeeping services and $231,794 to Advisory services. Hence, we can see that the overheads are over allocated by $28,936 to Tax division and similarly, the overheads are over allocated by $8,449 to bookkeeping services and the overheads are under allocated by $37,385 to advisory services.
Due to this inappropriate allocation of costs, the loss from bookkeeping services division has been increased. If the costs are properly allocated, then it may mislead the management to take correct decisions. As due to incorrect allocation, an profitable division may seem to be loss making and loss making division may seem to be profit making.
As in service industry, the main cost is the cost of professional labour employed for providing the services and further, the cost of each assignment or service differs from other as the services are personalized and vary upon needs of the customers, hence appropriate costing of the service provided is yet another important challenge in the service firm, in which ABC proves to be very helpful.
Hence, considering the above stated positive impacts of ABC, it is proved that the ABC can be used by the service industries also and it is highly recommended for the firm to use activity based costing system.
References:
Martin, J. (2018). Activity-Based Costing in the Service Sector.
Role of ABC in Service Industry. (2018).
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