Consequently, full cost accounting allows managers to give an appropriate cost to the company's products and services to include a fair share of overheads to each unit produced.
This paper will take a look at the presently used costing methods in business organizations namely traditional and activity based costing. The next section will discuss how cost accounting was traditionally conducted. Next, it will focus on the recently recognized activity based costing and how it is utilized. Lastly, this report will compare the two methods and apply them to real world examples to asses their relative efficiency.
Traditionally, all costs were orinally fixed. In fact, cost comes from a Latin word which means "to stand." However, developments were made as managers recognized the efficiency of categorizing costs into either fixed or variable. As we now know, fixed costs refer to administrative expenses which remain "fixed" in either busy or slack seasons. On the other hand, variable costs are those which significantly varies with the number of output produced and are dependent on business productivity. Variable costs are those which naturally "rise" or "fall" with business activity (Cost Accounting 2006).
Traditional costing is one of the simplest way of costing products and services. In this system, it is assumed that costs are directly associated with the volume of production as a single cost is given to all products and services. Hence, this costing method presupposes that as the level of production goes up, so does cost. Traditional costing essentially uses unit-based costing which alloates manufacturing overhead based on the unit of products manufactured (ABC Concepts 2000).
Accordingly, the traditional approach to cost-allocation consists of three basic steps: "accumulate costs within a production or nonproduction department; allocate nonproduction department costs to production departments; and allocate the resulting (revised) production department costs to various products, services, or customers (Activity Based Costing 2000)."
In order to fully understand the concept of traditional costing, we will apply it in a real world situation. Suppose that a business organization has an overhead cost of $2,000 monthly in producing 100 a commodity. The company also incurs $10 for materials for each unit and 2 hours of hour at $20 an hour.
Using traditional costing, we will compute for the variable cost which is the sum of the materials and two hours of labor. Thus,
Labour (2 hours, $20/hour) $40.00
Total Variable Cost: $50.00
Allocation of overhead is done by simply dividing the monthly fixed cost by the total number of units produced. In this case, fixed cost is $20 per unit yeilding total product cost under traditional costing of $72.00.
Activity Based Costing
Activity Based Costing (ABC) in the simplest sense is costing by activity, where activities refer to the regular actions performed inside the company (Cost Accounting 200). ABC was originally developed for the utilization of manufacturing companies but is now also used by the services and public sector.
There are basically six steps in ABC