Activity-Based Costing

Thus far in these sections on cost accounting, we’ve been addressing the traditional method of cost accounting, meaning the method that we must use for our external reports (i.e., our financial statements). This is the method that follows U.S. GAAP. Traditional cost accounting implies we have period costs and product costs, and we don’t expense the product costs until we sell the items while we expense the period costs when incurred.

Traditional cost accounting also influences how we allocate overhead. To find the allocation rate, we select one cost driver (e.g., direct labor hours). Then we compute our total estimated overhead costs divided by our total estimated cost driver to find the allocation rate.

Limitations to the Traditional Method

Consider two examples of why traditional cost accounting may not offer the best snapshot of our costs. Allocating overhead is one limitation of the traditional method of cost accounting.

For the first example, imagine we’re using machine hours as our cost driver, and then let’s say that one of our products is highly customized, meaning that before we even use the machine, we have to set it up, calibrate it, and test it. We incur all these costs just setting up the machine. Yet, we haven’t even started using the machine. Since machine hours are our cost driver, but we haven’t used any machine hours, we can’t allocate any overhead yet, despite incurring all these costs setting up the machine. 

Also, with traditional cost accounting, everything is either a product cost or a period cost. Yet sometimes we need to combine both costs to determine how much our product is genuinely costing us. Let’s say that we have a customer complaint call center. We’re paying an entire floor of employees just to answer customer complaint calls about our products. This expense would be considered a period cost, so it doesn’t even factor into our product costs.

Now imagine that you’re producing two different products. One is well-made, customers love it, and they’re never complaining about it. The second one is poorly made. Customers hate it and they’re always calling about it. Think about all the costs that you’re incurring on the poorly made product due to all the employee wages that you’re paying.

With traditional cost accounting, we’re not permitted to report these customer service costs as product costs. Even though the second product is costing us much more, we’re not permitted to report it that way. Now we’ve examined two examples, the machine hours, and then the customer call center, to demonstrate why maybe the traditional method of cost accounting is not always the most helpful.

We have to use the traditional method for external reporting, but there is an alternative method for internal reporting called activity-based costing.

Differences Between Activity-Based Costing and the Traditional Method

There are two major differences between activity-based costing and the traditional method of cost accounting, and then there are a few subtle differences.

First, in activity-based costing, there’s no distinction between product costs and period costs. We just add up all the costs together, then decide how to spread them out. Second, since we don’t have product costs, then we don’t have to allocate overhead.

Study Tip 😀 

In activity-based costing, there’s no distinction between product costs and period costs. Second, since we don’t have product costs, then we don’t

have to allocate overhead.

Instead, take all of our costs and allocate them to our product. How do we figure out how much our product actually costs with activity-based costing?

There are three steps to activity-based costing:

1. Take your total costs and then allocate them into individual cost pools

2. Choose a cost driver for each cost pool

3. Divide your cost pool by the cost driver

Step one is you take your total cost and then allocate them into individual cost pools. There are many activities that we perform as a company. We are producing products, packaging them, shipping them, and advertising.

Since we’re doing so many activities, we need to estimate our total costs for each activity.

If we spent $1 million total, we need to figure how much of the $1 million we spent on each activity.