Running Head: COMPARISON OF COSTING TECHNIQUES
Comparison of Costing Techniques:
Activity-Based and Traditional Costing Systems
Jesse W Pickerill
Bellevue University
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COMPARISON OF COSTING TECHNIQUES
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Abstract
Determining the pricing of a manufactured good is one of the most critical decisions a
manufacturer will make. Pricing too low may increase the number of goods sold, but may be
insufficient to cover the cost of goods sold. Pricing too high may make the products produced
uncompetitive, thus reducing the number of goods sold, decreasing potential revenue. Effective
pricing strategies depends on accurate costing data. By accurately determining the manufacturing
or production costs, a company will be able to price their goods in line with corporate guidelines.
We will be comparing and contrasting two ways in which a company may calculate the cost to
produce an item, activity-based costing and traditional costing. These costing strategies are
similar in many aspects, but differ when discussing the allocation of overhead or indirect
expenses.
COMPARISON OF COSTING TECHNIQUES
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Comparison of Costing Techniques:
Activity-Based and Traditional Costing Systems
Determining the pricing of a manufactured good is one of the most critical decisions a
manufacturer will make. Pricing too low may increase the number of goods sold, but may be
insufficient to cover the cost of goods sold. Pricing too high may make the products produced
uncompetitive, thus reducing the number of goods sold, decreasing potential revenue. Effective
pricing strategies depends on accurate costing data. By accurately determining the manufacturing
or production costs, a company will be able to price their goods in line with corporate guidelines.
We will be comparing two ways in which a company may calculate the cost to produce an item,
activity-based costing and traditional costing.
When producing a product, a manufacturer must purchase materials, raw or otherwise,
and utilize labor to transform those materials into finished goods to sell. The materials utilized to
produce a product are known as direct materials. The labor is referred to as direct labor. Direct
infers that the labor and materials are directly associated with the production of the goods. There
are other costs that must be considered when calculating the manufacturing costs. These are
known as indirect or overhead costs and the allocation of these costs is where the two methods of
costing differ. Overhead costs are those that cannot be directly attributed to the production of
goods. These can include costs such as rent, electricity, and even legal or human resources
personnel salaries. While these costs are not directly related to the production of goods, without
them, the production could not take place. (Periasamy, 2010)
Traditional costing takes a more generic or blanketing approach to allocating the indirect
costs. All indirect costs are pooled and allocated to goods or services sold based off a single
overarching factor. This could be revenue produced, direct labor hours, or any other driving
factor. This approach simplifies the costing process, but does not always provide the detailed
COMPARISON OF COSTING TECHNIQUES
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approach necessary to provide accurate costing data. This is especially true in companies that
produce vastly differing product lines or have overhead costs that contribute a substantial amount
to the product price. To calculate the production costs using traditional costing, one simply adds
the direct labor and direct material costs to the overhead rate multiplied by the driving factor for
the product. For example, if a product requires 10 hours of direct labor at a cost of $10/hour and
$100 in direct materials and had a direct labor driven overhead rate of $5/hour, the cost would be
calculated as: (10hrs*$10/hr) + $100 +($5*10hrs) for a total of $250. (Arora, 2010)
Activity-based costing is a more detailed method of allocating overhead costs onto
manufactured goods or provided services. Instead of lumping all overhead costs together, a great
deal of effort is placed into separating the overhead costs into activities. The overhead costs
allocated are determined by the rate of usage of the activities during the production of each
product line. For example, electricity usage can be determined by the number of machine hours
required to produce a specific product. Electricity usage would be the activity, and machine
hours would be the driving factor, or the factor considered in order to calculate allocation of this
overhead cost. By allocating as many overhead costs as possible based on activities, the
manufacturing costs much more accurately represent the true costs associated with producing
goods. This allows the management team to more accurately price the goods to be sold. It also
assists the management by providing additional data about existing business systems. This data
often allows managers to focus efforts on key areas to improve efficiency. (Periasamy, 2010)
While offering many benefits, activity-based costing does not come without limitations or
restricting factors. One of the most challenging is the initial implementation of utilizing activitybased costing. Due to the effort required to determine the different cost pools, activities, and
driving factors in addition to the level of analysis that is required to complete the allocation of
COMPARISON OF COSTING TECHNIQUES
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overhead expenses, ABC can be quite costly to implement. Additionally, there are certain
overhead costs that will continue to be allocated in a method similar to traditional costing. Prior
to adopting ABC, a company must determine whether or not the advantages outweigh the costs
and additional labor required to implement the system. (Periasamy, 2010)
In order to better understand the impact of choosing ABC over traditional costing, we
will be examining a problem posed by the scenario presented in Component 4, Phase 4 of FBUS
465.
Case History
You work for a manufacturing company that produces specialty tools. One of your
company’s customers has asked for price quotes on two of these tools: a portable
flammable-gas sensing tool (SKU A1) and a self-contained radon measuring device (SKU
B1). There are at least two other manufacturers that are competing for this customer’s
orders for these products.
The current market price ranges for the two products are:
SKU A1
$315–$365 per unit
SKU B1
$700–$800 per unit
Your sales manager believes that quotes of $335 for SKU A1 and $725 for SKU B1 would
get the customer’s orders and lead to significant additional orders in the future. Your
company’s typical profit markup is 25% of total unit cost. Following are the costs and
specifications for the two products:
Requirements per Unit (ABC)
SKUA1
SKUB1
Direct Materials
Raw Material Cost
Purchased Parts Cost
$31.00
$16.00
$66.00
$46.00
Direct Labor
Figure 1.
Manufacturing Labor
$35.00 $77.50
Assembly Labor
$52.20 $138.60
Manufacturing Overhead
Machine Costs
$6.80
$7.10
Other Overhead
Delivery/Transporation
$1.00
$0.25
G&A
$26.40 $52.25
Manufacturing Cost:
$168.40 $387.70
25% Markup
$210.50 $484.63
Requirements per Unit (Activity-Based Costing)
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The data provided by the Sales Manager in regards to the quotes that he believes will get
the quotes accepted drives the following calculations:
Anticipated Unit Demand
Target Selling Price
Target Cost Price
SKU A1 SKU B1
26,500 18,500
$335
$725
$268.00 $580.00
Figure 2. Target Prices and Costs
The calculations given in Figure 2 show that in order to achieve a profit margin of 25%
or greater while providing a quote in line with the Sales Manager’s thoughts, we must keep per
unit manufacturing costs below $268.00 and $580.00 for the SKU A1 and SKU B1 respectively.
The calculations from Figure 1. Show that we are able to stay well below that cost point. SKU
A1 are able to be produced at a cost of $168.40 while SKU B1 are able to be produced for
$387.70. Figure 3 represents the potential profit generated through the production of these
products and the fulfillment of the contract. Given these figures, it is clear that this is an
opportunity that the company should pursue as the level of profit far exceeds the typical 25%
margin seen within the company.
Potential Profits
SKU A1
SKU B1
Selling Price
$335
$725
Mfg. Cost
$168.40
$387.70
Profit/unit
$166.60
$337.30
Units produced
26500
18500
Total Profit
$4,414,900.00 $6,240,050.00
Figure 3. Potential Profits
The use of traditional costing yields the results and potential profits as shown in Figures 4
and 5. With this system, the level of profit is greatly reduced, by nearly 40%. Neither of these
methods included depreciation of mechanical systems. If the SKU A1 production machinery has
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a lifespan of only 250,000 hours, producing 26500 units will utilize over 70% of its lifespan. The
cost of replacing equipment should be factored into activity-based costing analysis through
depreciation of machinery, an additional manufacturing overhead expense. It should also be
considered through the overhead allocations in a traditional costing system. With this exclusion
in mind, utilizing traditional costing, the decreased profits realized through this endeavor may
not have been enough to cover manufacturing equipment depreciation while still maintaining the
typical markup of 25%.
Requirements per Unit (Traditional Costing)
Direct Materials
Raw Material Cost
$31.00 $66.00
Purchased Parts Cost
$16.00 $46.00
Direct Labor
Manufacturing Labor
$35.00 $77.50
Assembly Labor
$52.20 $138.60
General Overhead
$5/hour
$66.00 $209.00
$200.20 $537.10
$250.25 $671.38
Figure 4. Requirement per Unit (Traditional Costing)
Potential Profits
SKU A1
SKU B1
Selling Price
Mfg. Cost
$335
$200.20
$725
$537.10
Profit/unit
Units produced
$134.80
26500
$187.90
18500
Total Profit
$3,572,200.00 $3,476,150.00
Figure 5. Potential Profits (Traditional Costing)
The analysis of the given data using Activity-Based Costing provides a more accurate
manufacturing cost by accurately allocating overhead expenses to the processes and products that
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consume or utilize the materials, labor, or services. While ABC has proven to be an effective tool
for accurate costing and providing managers with information needed to increase efficiency
levels, it also has its own limitations. Cost and complexity of ABC systems must be analyzed
prior to implementation to ensure that the benefits they provide are not overshadowed by the
raise in costs to conduct the costing. The use of traditional costing system, while easier and
cheaper, may result in negative long term trends as a company is not accurately depicting the
cost of manufacture of its goods. This impacts competitiveness and also profit, companywide.
COMPARISON OF COSTING TECHNIQUES
References
Arora, M. N. (2010). Methods and techniques of cost accounting theory, problem and
solutions (Rev. ed.). Mumbai [India: Himalaya Pub. House.
Periasamy, P. (2010). A Textbook of Financial Cost and Management Accounting (2nd ed.).
New Delhi: Himalaya Pub. House.
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