A comparative analysis of activity-based costing and traditional costing

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World Academy of Science, Engineering and Technology 3 2005
A comparative analysis of activity-based costing
and traditional costing
Derya Eren Akyol, Gonca Tuncel, and G. Mirac Bayhan
labor hours, hours of equipment time, number of orders
AbstractActivity-based costing (ABC) which has become an
important aspect of manufacturing/service organizations can be
In traditional cost accounting systems, direct materials and
defined as a methodology that measures the cost and performance of
labor are the only costs that can be traced directly to the
activities, resources and cost objects. It can be considered as an
product. By using the ABC system, activities can be classified
alternative paradigm to traditional cost-based accounting systems. as value-added and non-value-added activities. In order to
The objective of this paper is to illustrate an application of ABC
method and to compare the results of ABC with traditional costing
improve the performance of the system, non-value-added can
methods. The results of the application highlight the weak points of
be eliminated.
traditional costing methods and an S-Curve obtained is used to
Despite the advantages of providing accurate costs, it
identify the undercosted and overcosted products of the firm.
requires additional effort and expense in obtaining the
information needed for the analysis [6]. However, a proper
KeywordsActivity-based costing, cost drivers, overheads, design tool can help to reduce time used for modeling and
traditional costing
overcome the difficulties present in designing a cost model.
The organization of the paper is as follows: In section 2, the
methodology of ABC is explained. A case study is presented
OWADAYS, global competition forced manufacturing in section 3 to illustrate the application of ABC in a company.
Nservices and organizations to become more flexible, The conclusions are given in section 4.
integrated and highly automated in order to increase their
productivity at reduced costs. But it is impossible to sustain
competitiveness without an accurate cost calculation
mechanism [1]. Proposed by [2], as an alternative method to
ABC is an economic model that identifies the cost pools or
traditional cost accounting methods, ABC assigns costs to activity centers in an organization and assigns costs to cost
activities using multiple cost drivers, then allocates costs to
drivers based on the number of each activity used. Since the
products based on each product’s use of these activities [3],
cost drivers are related to the activities, they occur on several
[4]. Using multiple activities as cost drivers, it reduces the risk
of distortion and provides accurate cost information [3].
1) Unit level drivers which assume the increase of the
In an ABC system, the total cost of a product equals the
inputs for every unit that is being produced.
cost of the raw materials plus the sum of the cost of all value
2) Batch level drivers which assume the variation of the
adding activities to produce it [4]. In other words, the ABC
inputs for every batch that is being produced.
method models the usage of the organization resources by the
3) Product level drivers which assume the necessity of the
activities performed and links the cost of these activities to
inputs to support the production of each different type of
outputs, such as products, customers, and services [5]. Each
product requires a number of activities such as design,
4) Facility level drivers are the drivers which are related to
engineering, purchasing, production and quality control. Each
the facility’s manufacturing process. Users of the ABC system
activity consumes resources of different categories such as the
will need to identify the activities which generate cost and
working time of the manager. Cost drivers are often measures
then match the activities to the level bases used to assign costs
of the activities performed such as number of units produced,
to the products.
While using the ABC system, the activities which generate
Manuscript received November 20, 2004.
cost must be determined and then should be matched to the
DERYA EREN AKYOL is with the Department of Industrial Engineering,
level drivers used to assign costs to the products.
University of Dokuz Eylul, Izmir, 35100 TURKEY, (phone: 90-232-3881047;
fax: 90-232-3887864; e-mail: [email protected]).
GONCA TUNCEL is with the Department of Industrial Engineering,
The implementation of the ABC system has the following
University of Dokuz Eylul, Izmir, 35100 TURKEY, (phone: 90-232-3881047;
fax: 90-232-3887864; e-mail: [email protected]).
Step 1) Identifying the activities such as engineering,
G. MIRAC BAYHAN is with the Department of Industrial Engineering,
machining, inspection…etc.
University of Dokuz Eylul, Izmir, 35100 TURKEY, (phone: 90-232-3881047;
fax: 90-232-3887864; e-mail: [email protected]).
Step 2) Determining the activity costs

World Academy of Science, Engineering and Technology 3 2005
Step 3) Determining the cost drivers such as machining
firm called final packaging. It includes packaging and
hours, number of setups, engineering hours…,etc.
shrinking of the products.
Step 4) Collecting the activity data
iv) Overheads: This is also common cost pool for all the
Step 5) Computing the product cost
stages in the firm. It includes depreciation, rents, indirect
labor, materials, and miscellaneous costs.
In order to perform ABC calculations, process costing
sheets are used. Because process costing aggregates the cost in
the case of more than one product, it is difficult to obtain the
The implementation study presented here took place in one
correct results. The correct results with process costing can
of the leading sanitaryware companies in Turkey [7]. It has a
only be achieved when there is a single homogenous product.
production capacity of 6.8 thousand tones. Like many After analyzing the output of bulk preparement department, it
sanitaryware manufacturers, the company includes some is seen that bulk prepared for the two departments are the
common processes. First stage of the processes is done in the
same which brings an opportunity for the analysis.
bulk-preparement department which is in charge of preparing
Firstly, time sheets are prepared to learn how much of the
the essential quantities of bulk bearing. Recipes are prepared
labor time is used to perform the relevant activities. Workers
for each production run and according to these ingredient filled the time sheet and as a result, the activity knowledge of
recipes, the bulks are prepared by the electronically controlled
the processes and related percentage times are obtained. The
tanks. After the bulk is ready, it can be sent to two different
time sheets are edited and necessary corrections are made.
departments, pressured and classical casting departments.
While some of the activities are merged, some of them are
In pressured casting department, the bulk is given shape by
discarded. After this stage, the wage data is requested from the
the pressured casting process. The process uses automated
accounting department and labor cost of the activities are
machines and has shorter cycle times when compared to determined.
classical casting department. However, the bulk used in this
If the amount of the activities that each product consumes
department must have the characteristics of strength and can be learnt, the product costing can be calculated by taking
endurance. The output of this department is sent to glazing
the sum of the costs of the activities consumed by these
products. Observations and necessary examinations are done
Classical casting is the second alternative to produce to reach this knowledge and the conversion costs are loaded
sanitaryware products. In this department, most of the onto the activities. Cost of rent is loaded according to the
operations are performed by direct labor. The cycle times of
space required for each activity and similarly, the power,
the products are longer than the pressured casting department.
depreciation and other conversion costs are loaded on the
The output of this department is “shaped and casted” bulk and
activities according to the activities’ consumption of the
sent to the glazing department, too.
resources. If activity a uses 2/5 and activity b covers 1/5,
In glazing department, shaped bulk is glazed. This stage can
while activity c covers 2/5 of the department space, then
be defined as polishing the products with a protective material
activity a is given 2/5, b is given 1/5 and c is given 2/5 of rent.
from external effects. The output of this department is sent to
All the conversion costs are distributed by using the same
tunnel oven.
In tunnel oven, the products are heated over 1200 degrees
The activities performed during classical casting are:
Celsius. After staying in theses ovens for a period of time, the
molding, drilling assembly holes, rework, equipment clean-up,
products are inspected by the workers. However, some of the
drilling function holes and carrying. The activity driver for
output may have some undesired characteristics like the molding is the processing time, for drilling assembly holes is
scratches, etc. In this case, these products are sent to the
the number of holes, for rework is the number of outputs, for
second heat treatment where they are reworked and heated
equipment clean-up is the total processing time, for drilling
again. The proper output is sent to packaging while the function holes is the total number of function holes and for
defected ones are sent to waste.
carrying are the number of processed units in this department,
Finally, in packaging department, products are packaged
unit area the product allocates on the carrier and the total area
and shrunken.
of carried goods.
Company has been using a process costing logic for
The activities performed during pressured casting are:
obtaining the proper costing of its products. Process costing is
molding, drilling lateral holes, setup, cutting excess materials
also a widely used costing tool for many companies. This
from the products, general rework, carrying WIP, drilling
method recognizes the following cost pools:
assembly holes, ring preparation, drilling some sub-
i) Direct Labor: All workers taking place in the production
components washbasins, washbasin drilling, rework of back
are recognized as direct labor and this pool is the most of the products, X-patch control, bringing the WIP, helping to
common pool used in every stage.
other departments, filling forms, mold check-up, WIP control,
ii) LPG-Electricity hot water: These items are important
equipment and personnel control, drilling water holes. The
costing element in casting departments.
activity driver for molding is the number molds used, for
iii) Packaging: This cost is observed in the final stage of the
drilling lateral holes is the number of output, for setup are the

World Academy of Science, Engineering and Technology 3 2005
incoming units, setup hour, setup for other products, setup for
An S-Curve will exist after the comparison of the
basins, setup for other products, for cutting excess materials
traditional and ABC costs [8].
from the products is the incoming units, for general rework is
The following notation is used for the comparison of the two
also the incoming units, for carrying WIP is the number of
product cost values. % Bias of ABC from traditional costing is
output, for drilling assembly hole and for ring preparation is
found for each product.
the number of output, for drilling some sub-components
% bias = (ABC cost/traditional cost)*100
washbasins is the number of subcomponents, for washbasin
Product costs under ABC and traditional costing views can
drilling is the number of washbasins, rework of back of the
be used to design a table (Table 1) which illustrates %bias of
products and X-patch control is the number of output, for
ABC and traditional costs.
bringing the WIP is the incoming WIP, for helping to other
departments is the number of reservoirs, for filling forms,
mold check-up, WIP control, equipment and personnel
control, drilling water holes is the incoming units.
Products %
Bias Products %
The activities performed during glazing are maintenance,
Product 70
Product 28
glazing with hand, WIP transfer, rework, closet shaking,
Product 23
Product 56
planning, routine controls and prism data entry. The activity
Product 64
Product 48
Product 12
Product 4
driver for maintenance is the number of reworked parts, for
Product 59
Product 63
glazing with hand is the weight of parts to be glazed, for WIP
Product 47
Product 53
transfer and rework is the number of reworked parts, for closet
Product 62
Product 46
shaking is the number of closets, for planning, routine controls
Product 31
Product 11
Product 1
Product 54
and prism data entry is the planned units.
Product 37
Product 50
The activities performed in the tunnel oven department are
Product 3
Product 8
tunnel oven activity, transfer to oven, transfer from oven, heat
Product 22
Product 6
Product 30
Product 44
control, oven security control, planning, routine controls,
Product 42
Product 7
prism data entry, taking records, second heat treatment
Product 19
Product 14
activity, WIP feeding to the oven, rework of heat processed
Product 58
Product 29
Product 36
Product 5
units and special treatment. The activity driver for tunnel oven
Product 20
Product 15
activity, transfer to oven, transfer from oven, heat control and
Product 26
Product 39
oven security control is the total area covered by the heated
Product 24
Product 32
Product 55

units, for planning, routine controls, prism data entry and
taking records is the total sum of outputs, for second heat
Note that the table includes only the products that are sold.
treatment activity and WIP feeding to the oven is total area
Products that are not sold but left as semi products are not
covered by all units, for rework of heat processed units and
special treatment is the total area covered by outputs.
The activities performed in the packaging department are
packaging, shrinking, clean-up, organizing the finished
products, maligning, and product function control and
transferring the outputs. The activity driver for packaging, and
shrinking is the packaged volume, for clean-up is the total
number of units cleaned, for organizing the finished products,
maligning, product function control and transferring the
outputs is the total number of outputs.
After finding the product costs of the firm, the costs
obtained by process costing methodology and the ABC results
of the product costs are compared. From the results, it is seen
that there are significant differences between some of the
product costs obtained by the two methods.
Fig 1. S-Curve
The results show 3 significant regions:
ABC utilizes the activity concept and by using the 1- Products undercosted by traditional costing:
activities, ABC can successfully link the product costs to
The costs of these products are higher than the “process-
production knowledge. How a product is produced, how much
costing” and when plotted are greater than the value 100 at y
time is needed to perform an activity and finally how much
axis. Before the ABC study was implemented by [7], firm was
money is absorbed by performing this task are answered by
not aware of this hidden loss of money for each of these
the help of ABC studies.

World Academy of Science, Engineering and Technology 3 2005
products. By the help of the ABC study, people noticed this
D. Ben-Arieh, and L. Qian, “Activity-based cost management for design
“hidden loss” and pricing decisions are examined.
and development stage,” International Journal of Production Economics,
vol.83, pp.169-183, 2003.
2- Products overcosted by the traditional methods:
R. J. Lewis, “Activity-based models for cost management systems,”
These products are the ones which have smaller values
Quorum Books, Westport, CT, 1995.
than the value 100 of y-axis. By the help of the ABC, firm
U. Köker, “Activity-based costing: Implementation in a sanitaryware
realized that, the costs of these products are lower than the
company,” M.Sc. Thesis, Department of Industrial Engineering,
University of Dokuz Eylül, 2003.
costs obtained by process costing. A “hidden profit zone”
G. Cokins, “Activity-based cost management making it works,”
occurs for these products. Without any intention, a hidden
McGraw-Hill. Inc., 1997.
benefit is gained from these products by traditional costing.
But noticing the real ABC costs of these products, the firm
can re-price these outputs and can gain a competitive
3- Products which are costed almost the same:
These are the products whose costs result nearly the same
by using the two methods. A narrow band of ± 20 percentage
(%80-%120) can be accepted for this region.
From the ABC analysis, it is seen that while some of the
products are undercosted, and overcosted, some of them give
nearly the same results.
In the analysis, the cost calculations of the bulk
preparement department are performed using traditional
costing method. When the outputs of the processes are
identical or nearly identical, then ABC must be avoided to
implement. Because ABC consumes lots of time, data and
efforts, implementation of it has also a cost. For identical
outputs, both ABC and traditional give the same results, so it
is not logical to implement ABC.
By the help of this analysis, product-pricing decisions gain
importance. Pricing decisions can be done under the scope of
these hidden losses and profits. According to the ABC results,
the company will probably increase or decrease some of its
product costs to gain more competitive advantage.
The costing process of the company highlighted some
weaknesses of the information system, too. These problems
are also expected to be fixed in the future.
As it is seen in this application, ABC is capable of
monitoring the hidden losses and profits of the traditional
costing methods. The existence of S-Curve shows which ones
of the products are under or overcosted. As a further work, in
the company, performance analyses are expected to be done
and especially Balanced Score Card (BSC) implementations
can be performed. The existence of the ABC database is an
advantage for BSC applications since its financial phase
recommends an ABC implementation. Kaizen applications
and BSC can give the firm great advantages in the short and
long run under the scope of ABC.
M. Özbayrak, M.Akgün, and A.K. Türker, “Activity-based cost
estimation in a push/pull advanced manufacturing system,” International
Journal of Production Economics, vol. 87, pp. 49–65, 2004.
R. Cooper, and R.S. Kaplan, “How cost accounting distorts product
costs,” Management Accounting, vol. 69, pp. 20–27, 1988.
G. Kim, C.S. Park, and M. J. Kaiser, “Pricing investment and
production activities for an advanced manufacturing system,”
Engineering Economist, vol. 42, no. 4, pp.303-324, 1997.
A. Gunasekaran, and M.Sarhadi, “Implementation of activity-based
costing in manufacturing,” International Journal of Production
Economics, vol.56-57, pp. 231-242, 1998.