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Activity-Based Costing vs. Product Costing

Small Business | Types of Businesses to Start | Starting a Production Company

By Elliott Taylor

Product-based costing is a relatively simple form of allocating direct

and indirect costs to individual units of product. Activity-based costing
is a more intricate system that assigns costs to activity centers rather
than the products produced by those activities. As manufacturing
processes become more technical and demanding, more robust costing
methods such as activity-based costing are being widely adopted by
both small and large businesses.

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Activity-Based Management Vs. Functional-Based
Product Costing Management

Product costing is also known as traditional costing. This method seeks

to allocate all costs down to individual units of finished product. The rationale behind product-based costing is that each
unit produced caused a certain percentage of both the fixed and variable expenses the company incurred. Direct costs
such as raw materials are allocated per unit and overhead costs are allocated either equally across all units produced or
on a weighted basis derived from a variable such as direct labor hours.

Weakness of Product-Based Costing

Product-based costing provides little flexibility in the way that overhead costs are allocated to finished goods. Even if
costs are allocated to products in a weighted fashion based on a variable-like cycle time or direct labor, the system is not
robust enough to accurately reflect the complicated flow of product in a plant that produces multiple products of different
complexity. This can lead to either over-costing or under-costing -- allocating too much or too little overhead to an
individual product -- and can also mask inefficiencies in the production system due to its broad application.

Activity-Based Costing
Activity-based costing approaches costs from the perspective that products do not cause costs; they require activities, and
the activities themselves are the causes of all costs incurred. This method is better suited to the increasingly complex flow
of today's manufacturing processes. Shifting the focus from products to activities highlights the existence of non-value-
add, or NVA, activity. If activity is occurring that does not contribute efficiently to the production of the finished good or
service, it can be targeted for reduction or elimination, thereby reducing costs.

Activity-Based Cost Considerations

The primary benefit of activity-based costing is that it brings a much higher level of focus and understanding to bear on
fixed cost categories. However, there is a significant up-front time investment required to develop a system of accounting
that accurately addresses each category of activity involved in a business. This process will usually involve some form of
value-stream or process-flow analysis, which, while time-consuming, will provide invaluable insights into the true drivers of
a company's costs.

REFERENCES RESOURCES WRITER BIO

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What Are the Issues Associated With Cost Tracing &

Cost Allocation?
By Melanie J. Martin

MOST POPULAR
Activity-Based Costing vs. Product
Cost accounting systems identify and measure cost objects, which 1 Costing
include anything to which costs are assigned. Tracing costs accurately
How to Determine the Amount of
helps firms to ensure they are making wise choices. In other words, 2 Overhead to Be Allocated to Finished
past performance informs future success. However, determining cost Goods Inventory

tracing and allocation is more art than science, as it's difficult to trace
3 Sequential Method in Accounting
costs with 100 percent accuracy.
What Is Linearity Assumption in
4 Accounting?

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Direct costs are directly associated with a cost object. The two have an
immediately apparent relationship: A worker is paid to produce goods,
or materials used to create the product are purchased. However, business also involves indirect costs, which contribute
less directly to the cost object, leading to a complex array of costs to estimate. For example, utilities used to power the
facility where workers produce the good are an indirect cost. Likewise, if a company produces all components of a
product, the costs associated with producing them must be traced to the end product. Determining all of the indirect costs
involved with production can pose a challenge because they're not always immediately apparent.

Difficulty Estimating
Tracing costs becomes even more difficult when a cost goes toward producing multiple goods or services. Estimating
which percentage of a given utility goes toward producing a particular product poses a challenge, according to Don R.
Hansen and his coauthors in "Cost Management." To further complicate the matter, such costs can be shared by different
companies, making accurate cost tracing particularly important to ensure each firm pays a fair percentage of the total
cost. In such scenarios, firms use driver tracing, meaning they look for clues that show what percentage of a given service
is going toward each cost object. For example, if Company A uses a facility to produce its product for 10 more hours per
week than Company B, Company A may pay a larger portion of the electric bill. Factors such as machine hours used must
be considered, as well.

Time
Tracing and assigning costs efficiently is crucial. If an accountant spends countless hours attempting to track every cost,
he isn't benefiting the firm financially. However, the task of record keeping may require him to assign all costs to cost
objects. Thus, accountants sometimes allocate costs rather than trace them to their origins. Allocating means assigning
costs to a cost object by making an educated guess when accuracy would be impossible without spending considerable
time or funds on studying the cost/cost object relationship.

Inaccuracies
Inaccurate estimations of the costs associated with cost objects can cause a firm to make an incorrect determination
about whether the cost object is profitable. If the firm incorrectly allocates a higher percentage of material costs to
Product A, it might conclude that Product A isn't profitable and stop selling it. Thus, a firm must balance between spending
too much and too little effort on tracing and allocating costs.

REFERENCES WRITER BIO

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