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22.4 Compare and Contrast Traditional and Activity-Based Costing Methods

Detailed Comparison​

This section provides a more detailed comparison of the two methods.

Cost Allocation Philosophy​

Traditional:

  • Assumes overhead is driven by volume (direct labor, machine hours)
  • "All products consume overhead proportionally to volume"
  • Simple assumption

ABC:

  • Assumes overhead is driven by activities
  • "Different products consume different activities"
  • More realistic assumption

Accuracy of Cost Assignment​

Traditional:

  • May overcost high-volume, simple products
  • May undercost low-volume, complex products
  • Volume bias

ABC:

  • More accurate cost assignment
  • Reflects actual resource consumption
  • Activity-based, not volume-based

Implementation Complexity​

Traditional:

  • Simple to implement
  • Single overhead rate
  • Easy to understand
  • Low maintenance

ABC:

  • Complex to implement
  • Multiple activities and rates
  • Requires analysis
  • Higher maintenance

Cost Information Quality​

Traditional:

  • Adequate for simple businesses
  • May be misleading for diverse products
  • Less detailed

ABC:

  • More detailed information
  • Better for decision-making
  • More accurate profitability

Decision-Making Support​

Traditional:

  • May lead to wrong decisions
  • Cost distortions affect decisions
  • Less useful for complex decisions

ABC:

  • Supports better decisions
  • More accurate cost information
  • Better pricing and product mix decisions

Example: Product Mix Decision​

Scenario: Company produces two products using traditional costing:

  • Product A: Shows 30% profit margin
  • Product B: Shows 20% profit margin
  • Decision: Focus on Product A

Using ABC:

  • Product A: Actually 15% profit margin (was overcosted)
  • Product B: Actually 25% profit margin (was undercosted)
  • Decision: Should focus on Product B

Impact:

  • Wrong decision with traditional costing
  • Better decision with ABC

Cost Management​

Traditional:

  • Focuses on controlling direct costs
  • Overhead is "lumped together"
  • Hard to identify overhead issues

ABC:

  • Identifies activities that drive costs
  • Can manage activities
  • Better cost control

Luxembourg Compliance Note​

In Luxembourg:

  • Both methods provide cost information
  • ABC may provide better insights
  • Consider business complexity
  • Use method that provides useful information
  • Can improve profitability with better costing

Think It Through​

How can inaccurate costing lead to poor business decisions? What are the consequences of using traditional costing when ABC would be more appropriate?