The market economy has created conditions under which the competitiveness of a company, in the long run, depends on the efficient use of resources, minimizing costs, and expanding sales markets. Due to changes in the worldwide business climate, accurate cost determination and evaluation are vital for enterprises, including manufacturing, commerce, and the service sector. Thus, certain accounting systems are often used in businesses: volume-based and activity-based costing systems. Despite a volume-based costing system being recognized as a more traditional accounting approach, many organizations have switched to an activity-based costing system in the last decades. It is a more useful and productive management tool in cost accounting.
A volume-based costing system (VBC) is an accounting system of factory overhead costs based on a unit of activity rather than a price. Examples of such costing systems may be the number of labor hours used, the number of units produced, etc. Activity-based costing (ABC) is a cost accounting method that involves identifying processes within a firm and allocating costs proportionally to their use in different processes. Unlike traditional costing methods, this methodology also converts overhead costs to direct costs.
A volume-based costing system is usually based on the statement that all overheads are related to production volume. The VBC accounting system is considered a traditional accounting method; however, there are some limitations of this system that make it an old and irrelevant approach. For instance, a volume-based costing system does not consider that different products need different amounts of materials, leading to overestimating or underestimating the actual costs (Hansen et al., 408). Thus, companies that apply the VBC accounting system do not produce reliable cost data.
For those companies that work under intense competitive conditions and depend on technological improvements, product cost distortions can be damaging. Hence, adopting an activity-based costing system usually results in an improvement in costing systems. The main advantage is that the ABC system accumulates the costs by activity rather than all overhead costs separately (Quesado, 1). However, there are several limitations of an activity-based system as well, which are resistance to unknown numbers and reports and potential misinterpretation of those numbers.
The development of an activity-based costing system involves several steps. The first is identifying significant activities involved in organizational operations and assigning the appropriate costs associated with those activities. The second step is determining the cost drivers that impact activity costs and estimating total annual cost driver usage. The third step is computing the ABC overhead rate for each activity cost. Finally, the last step is assigning overhead costs to products using overhead rates (Weygandt et al., 23). Compared with the VBC system, ABC is less vulnerable to technological changes. It mainly uses databases to incorporate specific numbers for orders, processes, and customers, which is easy to implement and update.
The productivity of the company and its profit depend on factors like an efficient use of resources, minimizing costs, and changes in the worldwide business environment. To gain better costing and pricing, most companies, organizations, and manufacturers have replaced traditional volume-based costing systems with activity-based accounting systems. If the volume-based costing system uses a volume-based overhead rate, the activity-based costs system helps to reduce cost directions found in volume-based systems and provide accurate product costs. Therefore, an activity-based costing system allows greater control in the production process.
Works Cited
Hansen, Don, S., et al. Cost Management. Cengage Learning, Inc., 2021
Quesado, Patricia, and Rui Silva. “Activity-Based Costing (ABC) and Its Implication for Open Innovation”. Journal of Open Innovation: Technology, Market, and Complexity, vol. 7, no.1, 2021. Web.
Weygandt, Jerry, et al. Financial and Managerial Accounting. John Wiley & Sons, 2018