Comparing Traditional Costing & Activity-Based Costing

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  • 0:02 Costs of Production
  • 1:07 Traditional Costing Systems
  • 2:12 Activity-Based Costing Systems
  • 4:22 Lesson Summary
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Lesson Transcript
Instructor: Christian George

Christian has a PhD in Business Management and an MA in Accounting & Financial Management

In this lesson, we'll compare traditional costing with activity-based costing in order to help students determine the advantages of one particular method of costing over another.

Cost of Production

'Sonny, let me tell you about a simpler time, back when I worked at the local auto plant.'

If you've ever had a relative, like Uncle Chuck, start a conversation with this line, you probably rolled your eyes and sighed as you knew that the story would last forever and be completely boring and irrelevant. Who cares how things used to be at the auto plant?

Fast forward a few years and you're studying accounting at the state university. You're sitting in your parent's living room, when Uncle Chuck sits down beside you and takes you by surprise with his infamous line. You can't escape! As you barely listen to him barrel on about unions and better wages, your ears perk up when you hear 'cost of production.' You decide to pay attention in case the information can come in handy later in school.

'We used a good old traditional costing system to determine the cost of the parts we made,' he continues. 'Nowadays, they have this complicated method that makes you think harder, but supposedly saves you more money in the long run.'

And with this conversation, your next accounting class just became that much easier.

Traditional Costing Systems

Manufacturing companies assign costs to products based upon many factors. The more accurate the costs are for a product, the more accurately a company can charge customers for that product. The true cost allows companies to know the exact amount of money being used to make a product so there are no loose ends.

In older days, businesses used what's now known as the traditional costing system, which assigns manufacturing costs to a product based on the volume of materials, direct labor, and direct machine hours needed to manufacture that product.

The auto plant that your Uncle Chuck works at produces spark plugs used in automobiles. The volume of spark plugs being produced is directly related to the cost needed at each part of the production process. The types of cost assigned to spark plugs under the traditional costing system are:

  • Machine hours
  • Direct labor hours
  • Direct material cost

Let's look at an example using the spark plugs being manufactured at the auto plant. The auto plant produces 5,000 spark plugs in an 8-hour day. It takes 3 workers to operate 3 machines to produce the spark plugs. Each worker makes $50/hour. Each machine costs the company $40 to run for 1 hour.

Type of Cost Cost per unit/hour Total
Machine Hours: $40/hour x 3 machines running x 8 hours/work day $960
Direct Labor Hours: $50/hour/1 worker x 3 workers needed x 8 hours/work day $1,200
Direct Material Costs: $0.80/spark plug x 5,000 spark plugs produced $4,000

Total Cost to Produce 5,000 Spark Plugs = $6,160

Cost per Spark Plug = $1.23

Activity-Based Costing Systems

But what if your product needs more than just a machine and someone to run it? Due to advances in technology and the need to more accurately assign costs to a process, most companies now use activity-based costing, which sees anything that has to do with making the product as an activity with a cost, not just the machinery.

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