Question

What are the reasons that cause the difference in products costs by using activity-based costing and traditional methods?  And why product/services will be under-cost or over-cost?

Answer 1

Traditional cost systems (single department rate) came to origin when manufacturing processes were labor intensive. A single company-wide overhead rate based on basis of volume such as the number of units produced, direct labor hours or the production machine hours may be used to allocate overhead to products in these labor intensive processes. A single department overhead rate based on direct labor hours, or the production machine hours may be used to allocate overhead to products in these labor intensive processes.

Traditionally, this approach have been reasonable or at least sufficient to understand the company's external financial statements, however, in recent decades manufacturer also wants to know the true cost to produce specific products for specific customers, wherein traditional method of cost accounting provides inadequate information.

Activity based costing (ABC) was developed to overcome the shortcomings of the traditional method. Instead of just one cost driver such as machine hours, Activity based costing will use multiple cost drivers to allocate a manufacturer's indirect costs. A few of the cost drivers that is used by ABC include the cost of material purchased or used, the number of machine setups involved, counting the number of engineering change orders, and the number of machine hours. Thus causes difference in products costs.

Under Activity based costing the inventory costs will be lower than under traditional costing; and traditional costing will usually show higher net operating income than activity based costing