Activity Based Costing vs Traditional Costing – Difference and Comparison

What is Activity Based Costing?

Activity-based costing can be defined as allocating additional charges which can be direct and Indirect. These charges may include utilities and salaries related to several products and services.

Activity-Based Costing or simply ABC has its accounting-based system based on certain types of activities. For instance any work, unit, task, or event with a particular goal.

 This specific task derives the fundamental cost for the ABC system. The cost can include setting up of machines or purchase of orders. It can also allocate the cost of miscellaneous pieces of equipment required for the completion of the activity.

This is also called the driving cost. Which eventually decides the overheads or additional charges that are going to be allocated in Activity-based costing. The core advantage of Activity Based Costing was better strategic planning. 

This system of pricing allows companies to have a better pricing plan. Since it is absolutely precise, the organization does not have to double-check its cost evaluation

Activity-Based Costing also derives profit for both the company and the customer. In the longer run, the customer gets better services and the company receives appropriate pricing for that service.

The formula for calculating Activity Based Costing is the total pool of cost upon cost driver. This gives the net cost driver rate.

What is Traditional Based Costing?

Traditional-based costing can be defined as the method of generating a profit by accounting for product manufacturing. This works by adding indirect(or overheads) to the total manufacturing cost.

This type of system depends on applying rates that are based on metrics, by computing the total overhead cost rate. These driving rates are approximate or estimated.

Traditional costing is a faster mode of implying charges. Mainly because it includes very few variables compared to Activity-based costing. However, this also makes it an imprecise process, because it carries significantly less information.

Traditional Based Costing also requires zero additional software for its computation. The process of calculation is simple and can easily be done normally. Hence expensive software is not required in this form of accounting.

Most companies or organizations that are inclined to optimize their profits, prefer this system of accounting. Especially in the field of imports and exports.

The formula for calculating traditional-based costing is dividing the total cost by the driving rate of overhead charges. This will give the per unit charge that will incur in the amount. Based on the number of units, this overhead can be added to calculate the final value of Traditional Based Costing.

Difference Between Activity Based Costing and Traditional Costing

  1. Activity Based Costing is precise, while Traditional Costing is not so precise.
  2. Activity Based Costing is calculated after the completion of activities, whereas Traditional Costing is calculated in advance.
  3. Activity Based Costing has a budget computation rate, whereas Traditional Costing is much more expensive to compute.
  4. Activity Based Costing accounts for only two activities, while Traditional Costing can account for up to four activities.
  5. Activity Based costing is preferred by firm owners, whereas Batch owners prefer traditional costing.

Comparison Between Activity Based Costing and Traditional Costing

Parameters of ComparisonActivity Based Costing Traditional Costing
MeaningThis method evaluates the indirect costThis method evaluates the cost before the due date
Cost This method has less expensive computing costThis method has a more expensive computing cost
AdvantageIt produces a precise outputIt produces a net profit
DisadvantageThe profit made will not be exponentialThe cost of general overheads is not included
SignificanceFacilities, UnitsProduct manufacturing, batches