Activity Based Costing Traditional Cost Accounting Smes

Roots of the SME's

Small-to-medium size enterprises (SME) are the fastest growing enterprise in the modern economy. Thus, these SME's are operating under immense pressure in order to remain competitive within the current global economy. The American Institute of Certified Public Accountants (AICPA) has issued its Financial Reporting Framework for Small-to-medium size enterprises. 

Financial Reporting Framework (FRF) for SME's accounting framework is designed to benefit America's micro business community. The FRF accomplishes its purpose by delivering financial statements providing crucial and relevant information in a clear, coherent and cost-effective way. The need for FRF for SME's framework may be felt sometimes when there is no requirement for financial statements of Generally Accepted Accounting Principles (GAAP).

The significance of Maintaining an Accounts Book in SME's

It is very crucial for SME's to maintain an accounts book to track their revenue accurately. It doesn't matter if the organization is small or medium. To achieve success in business, the organization should keep a clear track of its income and expenditure to prepare the financial statement reducing the risk of any errors. Thus, to prepare the financial statement it requires some key elements like balance sheet, profit and loss account, and cash flow statement. All these elements contribute to reporting of crucial information about the financial status of the enterprise, and to prepare these financial statements you need an accounts book. Some SME's fails in financial management due to weak or no accounting records. They do not maintain their accounts book, as they fail to understand the significance of maintaining an accounts book for the growth of their business. Thus, financial management is the key player for the success of Small-to-medium size enterprises (SME's). There are multiple programs for SME's to achieve fruitful ways of market response, cost reduction, and financial productivity. Moreover, they include concurrency concerning established management approaches and refined accounting structures. Therefore, to achieve success in SME's and to survive in the competitive market, you need to maintain an accounts book sincerely. However, the prime focus of this article is to paint the foundation and method behind Activity-Based Costing (ABC). Moreover, it reveals the benefits of using ABC method over the Traditional Cost Accounting (TCA) method.

Activity-Based Costing (ABC) or Traditional Cost Accounting (TCA)

The two widely used methods for assigning indirect costs to products are:  

(A) Activity-Based Costing (ABC) 

(B) Traditional Cost Accounting (TCA)

Both of these methods are programmed to overhead cost and then attach these costs to products based on certain cost drivers. Now, a cost driver is nothing but any component charging money or other factors to a cost occurring. It can either be a volume of production or the number of man-hours.

(A) Activity-Based Costing (ABC)

One of these methods is activity-based costing, also known as "ABC". This method specifies all sort of activities associated with production. Also, it entrusts a cost to the activities associated with production and then determines the cost of the product. The reason why the Activity-Based Costing (ABC) method is more accurate than the Traditional Cost Accounting (TCA) is that it takes important factors into account before assigning a cost to a product. On contrary, this also makes the whole process complicated and more time-consuming. Moreover, this method more consummate as it includes nonmanufacturing expenses as well. For example, administrative and managerial costs.

Pros and Cons of Activity-Based Costing (ABC)

Activity-Based Costing (ABC) is widely accepted as the most accurate method, but it is also the most challenging and expensive method to implement. It can be stated as the ABC method is more suited for business with high overhead costs that manufacture products rather than companies that offer services. So, companies manufacturing a large number of different products prefer an activity-based system as it provides them with more accurate costs for each product. Thus, with the help of activity-based costing, it becomes more convenient to identify areas where expenses are done on non-profitable products.

(B) Traditional Cost Accounting (TCA)

As it relies completely on assigning average overhead rates, making it a much easier way to determine the cost of a product. This also contributes to compromising with the accuracy sometimes as it doesn’t factor in nonmanufacturing expenses. Also, it doesn't clarify which overhead costs actually affects specific products.

You can understand these costing methods with the help of an example. For example, you decided to pool a car with a friend of yours to any particular destination. Once you arrive at your destination, you will simply divide the total cost into exactly two equal halves. This would be similar to traditional costing.

Pros and Cons of Traditional Cost Accounting (TCA)

Traditional costing is mostly used when the overhead of a company is low compared to the direct costs of production. It gives reasonably accurate cost figures when the production volume is large, and changes in overhead costs do not create a substantial difference when calculating the costs of production. This type of method is not very expensive to implement. Generally, companies prefer traditional costing for external reports as it becomes easy and convenient for outsiders to understand. However, managers are not able to get a picture of accurate product costs. This is because the application of overhead burden rates is absolute and applied evenly to the cost of all products.

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Benefits of Activity-Based Costing (ABC) Over Traditional Cost Accounting (TCA) in SME's

There are various benefits of using Activity-based accounting (ABC) over traditional cost accounting (TCA) in the SME's. The ABC method enables the financial managers to concern about the cause and effect connection between distributions and expended resources, accurateness of cost allocations, the suitability of cost, profit facts, and the ability to update the accounting systems. Moreover, the ABC method offers immense provisions for operational, financial, and strategical decision makings. The financial managers enjoy the opportunity to integrate the ABC method more effectively into the planning processes. The ABC method has better and sophisticated financial supports for the strategical making of any product or customer decisions.

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