Pricing decisions are among the most important decisions business owners, or their financial teams, make. Cost accounting methods help business leaders make wise pricing decisions. There are two basic costing systems that help you identify all direct and indirect expenses so you can make well-informed pricing decisions: the traditional costing system and the activity-based costing system. While both methods are valuable accounting tools, each one has a unique set of benefits and drawbacks.
Review the terminology section below before you read this short comparison of the two costing methods to determine which method is best suited to your business.
Activity-based costing (ABC)
The ABC method utilizes an in-depth view of the cost drivers associated with overhead to establish prices. This system provides a way to trace costs to individual products and services, which is a very accurate, effective way to manage production costs. The ABC system uses both activity-based drivers and transaction-based drivers to calculate production costs rather than considering volume as the primary basis for estimating overhead.
The cost driver is the root cause of any expense incurred by an activity or transaction. For example, a maintenance department may incur costs associated with repair supplies. In this instance, the number of purchase orders for parts and/or supplies could be applied as a main cost driver for the department.
Direct costs can be allocated to a specific item or process during the production of goods or service delivery plans. Sometimes it is difficult to determine if an expense should be classified as an indirect cost or a direct cost. Consider legal services. When a staff attorney in a large firm works on a particular project for a client, his salary (which would be paid whether the attorney was on a dedicated project or working with several legal teams simultaneously) is typically an indirect expense. However, any legal briefs prepared and printed for a particular client or lawsuit would be considered direct costs.
Indirect costs are expenses necessary to operate an organization or business as a whole. These cost items cannot be singularly assigned to any one service, product, distribution channel, or department. Examples of indirect costs include the costs of heating and cooling a building, electricity for the administration offices, and security systems.
The overhead rate is an allocation of expenses that are not directly associated with the cost of making a product or offering a service. In a manufacturing setting, the overhead rate may be an hourly rate associated with product production.
Traditional costing method
The traditional costing method uses an allocation of expenses based on the volume of resources used during the production of goods. This method typically uses machine hours or man-hours consumed as the basis for estimating costs of production. This is a common costing method used in situations where the processes are highly automated, and where direct labor costs are very low and/or tightly controlled.
Calculating Overhead Rates with A Traditional Costing System
A traditional costing system depends on calculating overhead rates and applying the rates to a specific variable. Traditional costing methods use estimated overhead rates against a cost driver. Calculating costs using the traditional costing method involves six steps.
These steps are:
Identifying indirect overhead costs, such as payroll for maintenance personnel and building rent.
Estimating overhead cost for a specific tracking period, for example a calendar month or semi-annually.
Select a cost driver that is linked to production of your product or service.
Estimate a defined number for the cost of driver. For example, if you are using man hours (labor hours) for a single month, you would multiply the number of hours worked per week by the number of employees. Then multiply that total by 52 (the number of weeks per year) and divide by 12 (the number of months in a year).
Calculate the overhead rate using the following formula:
Overhead Costs / Estimated Cost Driver = Overhead Rate
Apply overhead rate to your product.
Activity-based costing VS Traditional Costing Method
The main difference between the two costing systems discussed here is that traditional costing methods use a single cost driver to predict costs, while activity-based costing methods are more precise and may use several cost drivers to estimate the cost of production.
The traditional costing system is also simpler, which means your accounting team invests fewer man-hours estimating cost-based pricing tiers. However, the ABC method is more accurate than traditional costing.
Deciding when to use traditional costing methods and when activity-based costing systems may be better suited to an organization depends on the business type and operational structure. Companies with a hard deadline for reporting may choose traditional costing to save preparation time. Another scenario would be a company that only produces one product, such as a custom hat business that offers hand-made hats rather than an assembly-line product.
When accuracy is critical, such as when preparing internal reports for stakeholders or corporate leaders, many companies choose the ABC system.
Determining prices does not always rely on a costing method. Companies may use a variety of formulas to determine their price schedules. However, cost accounting systems provide business decision-makers insight into their operational and production costs, which helps them estimate revenue potential and return on investment.