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The student described the differences between ABC and traditional costing systems. ABC systems involve four stages: 1) identifying activities, 2) assigning costs to activity cost centers, 3) selecting appropriate cost drivers, and 4) assigning activity costs to products. Traditional systems allocate costs to departments first and use fewer cost drivers like direct labor hours. ABC systems focus on activities, have more cost centers, and use multiple cost drivers based on cause-and-effect relationships.

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50 views5 pages

Student Name: Zain Student ID: 10111453 Course Name/Code: Assignment Question

The student described the differences between ABC and traditional costing systems. ABC systems involve four stages: 1) identifying activities, 2) assigning costs to activity cost centers, 3) selecting appropriate cost drivers, and 4) assigning activity costs to products. Traditional systems allocate costs to departments first and use fewer cost drivers like direct labor hours. ABC systems focus on activities, have more cost centers, and use multiple cost drivers based on cause-and-effect relationships.

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Abass Gbla
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© © All Rights Reserved
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Student Name: Zain

Asim
Student ID: 10111453
Course Name/Code:
ECM 201
Assignment Question:
2. Describe the difference between ABC
and traditional costing systems and explain
each of the four stages involved in
designing ABC systems.

Attempt Count: 1
INTRODUCTION:
A cost accounting system or a costing system is a set of processes, forms or controls used by
firms to estimate the cost of their products for inventory valuation, profitability analysis and
cost control. There are three common cost accounting systems namely; direct costing,
traditional costing, and ABC systems. Direct costing systems only assign direct costs to cost
objects. It require that indirect costs are incorporated at the special study stage. Traditional
costing systems and ABC system use two-stage; four steps allocation systems while they differ
each other in sophistication of the methods of allocation of indirect costs to cost objects.

A BRIEF INTRODUCTION TO COST


SYSTEMS:
Typically cost systems are classified as follows:

1. Direct costing systems;


2. Traditional absorption costing systems;
3. Activity-based costing systems.

DIRECT COSTING SYSTEM:


Direct costing systems only assign variable/direct costs to cost objects. An estimate of those
indirect costs that are relevant to the decision should be incorporated within the analysis at the
special study stage.

TRADITIONAL ABSORPTION COSTING SYSTEMS:


In traditional costing system, overhead costs are allocated to departments (cost centers) and then
to the products based on the volume of production resources consumed with the help of
allocation bases. Traditional costing systems mostly use either direct labor hours or machine
hours as the allocation bases.

ACTIVITY-BASED COSTING SYSTEMS:


In Activity based accounting method, the overhead cost are allocated to activities as cost centers
and then to the products using only cause and effect cost drivers.

DIFFERENCE BETWEEN ABC AND


TRADITIONAL COSTING SYSTEMS:
The differences between ABC and traditional costing systems are briefly explained below:
TRADITIONAL COSTING
ABC SYSTEM
SYSTEM
COST ALLOCATION
In traditional costing system, costs are In activity based costing system, costs are
allocated to departments. allocated to activities.
FOCUS
Traditional costing methods focus on the Activity based costing system's focus is on the
structure. activities or processes.
NUMBER OF PROCESSES
Traditional costing system uses the two-stage Activity based costing system also uses two-
allocation process. stage allocation process.
NUMBER OF COST CENTERS
Traditional costing system tends to have less Activity based costing systems tend to have
cost centers. more cost centers.
COST DRIVER RATES FOR SUPPORT DEPARTMENTS
Traditional costing system normally allocate Activity based costing systems tend to
service/support costs to production centers. establish separate cost driver rates for support
centers.
SECOND STAGE COST DRIVERS
In Traditional costing system, reliance is on a Activity based costing systems use many
small number of volume-based cost drivers second stage cost drivers.
(typically direct labor or machine hours).
COST DRIVERS
Traditional costing systems often rely on Activity based costing systems seek to use
arbitrary allocation bases. only cause-and-effect cost drivers.

DESIGNING ABC SYSTEMS:


Designing ABC systems consists of two stages. The first stage consists of two steps, and the
second stage consists of final two steps.
Let us now consider each of the steps in detail.

STEP 1: IDENTIFYING ACTIVITIES


Identifying activities is the identification of major verbs associated with tasks which take place in
an organization. For example, machine setup might be identified as a separate activity. Activity
analysis is required to carry out the identification of activities. The activities chosen should be at
a reasonable level of aggregation based on costs versus benefits criteria. E.g. For example, rather
than classifying machine setup as an activity, each of its constituent tasks could be classified as
separate activities. Activities with the same product consumption ratios can use the same driver
to assign costs to products and thus be merged to form a single activity cost center. The final
choice of activities is a factor of judgment and is influenced by factors such as total cost of the
activity centers and the ability of the single driver to provide a satisfactory determinant of the
cost of the activity.

STEP 2: ASSIGNING COSTS TO ACTIVITY COST CENTRES


After the activities have been identified, the next step is the assignment of the cost of resources
consumed over a specified period to each activity. Through this assignment, it is determined that
how much the organization is spending on each of its activity. Many of the resources such as
labor and lighting and heating costs) may be indirect and jointly shared by several activities. In
the assignment of these costs, arbitrary allocations should be avoided and should be bases on
cause and effect cost drivers. The greater the amount of costs traced to activity centers, the more
arbitrary and less reliable will be the product cost information generated by the ABC system.
Cause-and-effect cost drivers used at this stage to allocate shared resources to individual
activities are called resource cost drivers.

STEP 3: SELECTING APPROPRIATE COST DRIVERS FOR


ASSIGNING THE COST OF ACTIVITIES TO COST OBJECTS
The cost drivers used at this stage are called activity cost drivers. The assignment of the costs
attached to each activity cost center to products requires a cost driver selected for each activity
center. The factors that must be borne in mind when selecting a suitable cost driver are: First, it
should provide a good explanation of costs in each activity cost pool. Second, a cost driver
should be easily measurable. Third, the data should be relatively easy to obtain and be
identifiable with products. Activity cost drivers consist of transaction and duration drivers.

STEP 4: ASSIGNING THE COST OF THE ACTIVITIES TO


PRODUCTS
The final stage involves application of cost driver rates to products. The cost driver must be
measurable so that it can be identified with individual products. Thus, if labor hours are selected
as a cost driver, there must be a mechanism for measuring the labor hours consumed by each
product.

CONCLUSION:
There are three common classifications of costing systems namely; direct costing, traditional
costing and activity-based costing systems. Both traditional costing and ABC systems consist of
four steps and two stages. Traditional costing system is much less sophisticated than ABC
system. Traditional costing systems use departments for cost allocation in first stage, whereas
ABC system uses activities.
The four steps involved are following:

i. Identifying the major activities that take place in an organization.


ii. Assigning costs to cost pools/cost centers for each activity.
iii. Determining the cost driver for each major activity.
iv. Assigning the cost of activities to products according to the product’s demand for
activities.

Bibliography
Drury, C. (2001). Management Accounting for Business Decisions: 2nd Edition. London: Thomson
learning.

Jan, O. (n.d.). Cost accounting systems. Retrieved from accounting explained:


https://accountingexplained.com/managerial/cost-systems/

Jilani. "Difference Between ABC and Traditional Costing." DifferenceBetween.net. February 5, 2011
http://www.differencebetween.net/business/finance-business-2/difference-between-abc-and-
traditional-costing/

Grade 72.00 / 100.00

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