22.3 Compare and Contrast Traditional and Activity-Based Costing Systems

Traditional Costing System

Characteristics:

• Single overhead rate
• Single allocation base (usually direct labor)
• Simple to implement
• Less accurate for diverse products
• Volume-based allocation

Structure:

Total Overhead
    ÷
Single Allocation Base (e.g., direct labor hours)
    =
Single Overhead Rate
    ×
Product's Allocation Base Usage
    =
Overhead Allocated to Product

Example:

• Total overhead: €30,000
• Total direct labor hours: 2,000
• Overhead rate: €15 per hour
• Product uses 2 hours: 2 × €15 = €30 overhead

Activity-Based Costing System

Characteristics:

• Multiple overhead rates
• Multiple allocation bases (cost drivers)
• More complex to implement
• More accurate for diverse products
• Activity-based allocation

Structure:

Activity 1 Cost ÷ Activity 1 Driver = Activity 1 Rate
Activity 2 Cost ÷ Activity 2 Driver = Activity 2 Rate
Activity 3 Cost ÷ Activity 3 Driver = Activity 3 Rate
    ...
    ×
Product's Activity Consumption
    =
Overhead Allocated to Product

Example:

• Setup activity: €5,000 ÷ 100 setups = €50 per setup
• Processing: €15,000 ÷ 3,000 hours = €5 per hour
• Inspection: €3,000 ÷ 200 inspections = €15 per inspection
• Product uses: 2 setups, 10 hours, 1 inspection
• Overhead: (2 × €50) + (10 × €5) + (1 × €15) = €165

Key Differences

Aspect	Traditional Costing	Activity-Based Costing
Overhead Rates	Single rate	Multiple rates
Allocation Base	Usually direct labor	Multiple cost drivers
Complexity	Simple	Complex
Accuracy	May distort costs	More accurate
Cost	Low	Higher
Time	Quick	Time-consuming
Best For	Simple, similar products	Diverse, complex products

Cost Distortion Example

Scenario:

• Product A: High volume, simple (1,000 units, 1 hour each)
• Product B: Low volume, complex (100 units, 2 hours each, 5 setups each)

Total:

• Units: 1,100
• Hours: 1,000 + 200 = 1,200
• Setups: 0 + 500 = 500
• Overhead: €30,000

Traditional Costing:

• Overhead rate: €30,000 ÷ 1,200 = €25 per hour
• Product A: 1,000 × 1 × €25 = €25,000 overhead
• Product B: 100 × 2 × €25 = €5,000 overhead

Activity-Based Costing:

• Setup activity: €15,000, 500 setups = €30 per setup
• Processing: €15,000, 1,200 hours = €12.50 per hour
• Product A: (0 × €30) + (1,000 × €12.50) = €12,500
• Product B: (500 × €30) + (200 × €12.50) = €17,500

Comparison:

• Product A: Traditional €25,000 vs. ABC €12,500 (overcosted by traditional)
• Product B: Traditional €5,000 vs. ABC €17,500 (undercosted by traditional)

When Each Is Appropriate

Use Traditional Costing When:

• Overhead is small
• Products are similar
• Simple operations
• Cost of ABC exceeds benefits
• Single allocation base is reasonable

Use ABC When:

• Overhead is significant
• Products are diverse
• Complex operations
• Need accurate costs
• Multiple cost drivers exist

Luxembourg Compliance Note

In Luxembourg:

• Both systems are acceptable
• Choose based on business needs
• Traditional may be sufficient for simple businesses
• ABC may be valuable for complex businesses
• Consider cost vs. benefit
• PCN accounts support both

Think It Through

What are the trade-offs between traditional costing and activity-based costing? When would the additional complexity of ABC be justified?

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