Activity-based costing (ABC) vs traditional costing method

November 27, 2025

Traditional costing system uses arbitrary methods to allocate overheads to products. Generally, this method allocates overheads using a single overhead rate, also known as a blanket overhead rate or predetermined rate.

For example making use of direct labour hours, Machine hours, Production units, floor space etc.

Consider this example of Ms PriceCut clothing store. There are 3 departments, Women, Men and children.

The floor space and floor labour hours is 800m2 and 15 000 hours for Women's department, 300m2 and 1500 hours for the men's department and 500m2 and 3500hours for the children's department.

The company’s only overheads is $2,6 million of rent expenses. These overheads are allocated to the department using floor labour hours.

Based on this information, the blanket overhead allocation rate is $130 per floor hour, that is $2,6 million/20 000hours

The allocations to the departments will be:

Women: 15 000 x $130 = R1 950 000
Men: 1 500 x $130 = R195 000
Children: 3 500 x $130 = R455 500

Activity Based Costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs.

it is a costing system that uses activities to allocate costs

Activity-based costing assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on a volume basis such as machine hours.

Activity-based costing first assigns costs to the activities that are the real cause of the overhead cost. It then assigns the cost of those activities only to the products that are actually demanding the activities.

Activity-Based Costing Basic Premise

Cost objects consume activities.
Activities consume resources.
This consumption of resources is what drives costs.
Understanding this relationship is critical to successful budget management.

Treatment of Costs under Activity Based Costing

In ABC, products are assigned the overhead costs that are supposed to be related to the allocation base.

Non-manufacturing costs.
Manufacturing costs.
Plant wide Overhead Rate.
Departmental Overhead Rates.
Costs of idle capacity.

ABC’s Basic Steps

Analyze activities.
Gather cost data.
Trace costs to activities.
Establish output measures.
Analyze costs.

Activity-Based Management

Activity based management involves any use of ABC information to support the organization’s strategy, improve operations, or manage activities and their resulting costs.

the following are differences between activity-based costing and traditional costing method

allocation basis

traditional costing method allocate fixed manufacturing overhead cost to products and/or service on an arbitrary 'one volume' driven basis while activity-based costing allocates fixed manufacturing overhead cost to products and/or services on the basis of activities

also, the traditional costing method uses a single absorption rate which is calculated based on budgeted operation capacity while activity-based costing use multiple activity rates based on the actual operation capacity

costs

The traditional costing method is inexpensive to implement and maintain while activity-based costing is costly to implement and maintain

ease of use

The traditional costing method is straightforward to use and implement while activity-based costing is complex to use and implement due to a diverse set of activities that must be identified, recorded, and assigned to each product and/or service