I’m trying to learn for my Accounting class and I’m stuck. Can you help?
STUDENT 1: Rachel
Companies need accounting systems to track the costs of their operations. Two of the most commonly used systems are traditional costing and activity-based costing. One of these is easy to use and inexpensive to implement, while the other costs more to use but gives you greater accuracy. Traditional costing adds an average overhead rate to the direct costs of manufacturing products. The overhead rate gets applied on the basis of a cost driver, such as number of labor hours required to make a product. Traditional costing is best used when the overhead of a company is low compared to the direct costs of production. Activity-based costing identifies all of the specific overhead operations related to the manufacture of each product. Not all products require the support of all overhead costs, so it is not reasonable to apply overhead costs to all products. Accountants created the ABC method to solve the problems of inaccuracy that result from the traditional costing approach. Managers needed more accurate costing methods to determine which profits were actually profitable and which were not. (Horngren, 2014).
Deciding between traditional or activity-based costing is not easy. The choice should depend on the purpose of the reporting and who will see the information. Managers need accurate product costs and prefer to use an activity-based accounting system. Even though this system is more costly, it provides better information that will enable managers to make more profitable decisions in the long-term. For external reporting, companies still use the traditional costing system, but it is becoming obsolete as outsiders demand more accurate information about businesses. (Horngren, 2014).
ABC can be applied to any company that has manufacturing operations, and is commonly used in automobile manufacturers and power companies. In recent years, ABC has also been employed in service companies, government entities, and other non-manufacturing organizations. Essentially all organizations employ processes and activities to convert capital and resources to products or services. ABC attempts to examine each business process or activity and break it down into discrete components. For example, a business school may divide its accounts payable operation into several activities: interacting with purchasing, receiving the invoice, coordinating with the vendor, releasing the check, and handling any return issues. Identifying and quantifying the costs of these processes and activities is the essence of ABC. (Emblemsvåg, 2003).
Emblemsvåg, J. (2003). Life-cycle costing using activity-based costing and Monte Carlo methods to manage future costs and risks. Hoboken, N.J: Wiley.
Horngren, C. T., Datar, S. M., Rajan, M. V. (2014). Cost Accounting. [VitalSource Bookshelf]. Retrieved from https://bookshelf.vitalsource.com/#/books/97813234…
Student 2: Christopher
Traditional costing is best used when a company’s overhead is low, in correlation with the direct costs to produce products. When production volume is high, traditional costing produces accurate cost figures. When it comes to traditional costing, organizations will normally use the method when it is formulating external reports. This is because it is usually easier for outsiders to comprehend. The flip side to that coin is, it lacks an accurate picture of product costs. This is largely due to the overhead rates being applied evenly to the cost of all products.
Activity based costing recognizes all specific overhead operations related to the manufacture of each product. One of the differences between traditional and activity-based costing, is that with activity based, its method grows the amount of indirect cost pools that can be allocated to specific products. With traditional, as mentioned above, it takes one pool of a company’s total overhead costs and allocates it evenly to all products. This method, is the most accurate, but is often difficult to do and is also quite expensive.
Our discussion this week, asked us if we agreed that activity based is better at allocating (in regards to direct and indirect cost), better than traditional. Yes, activity based does better job than traditional, because it is more accurate and traditional is becoming more obsolete, based on companies and its mangers, wanting more accuracy. Activity based also requires a lot of knowledge. The method also alters the nature of several indirect costs, making costs previously considered indirect – such as depreciation, inspection, or power – traceable to certain activities. It also transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.
ORIGNAL QUESTION: Activity based costing does a better job of allocating both direct and indirect cost than traditional methods do. Activity based costing cannot be applied in a business school. Are these statements true, false, or uncertain? Explain the reasoning for your answers.