Standard costing and Activity Based costing

Standard costing and budgeting are two important techniques in the armory of management accounting. A comparison of these techniques is given below:

As techniques of management control, both of them involve target (or standard) setting, performance measurement, comparison of actual with the targets (or standards), and analysis and reporting of performance. Budgeting is broad in scope. It focuses on the entire organization and covers both revenues and costs. Standard costing is somewhat narrow in scope and its focus is mainly on manufacturing costs.

While budgeting and standard costing may be introduced independently, the two are complementary in nature. Standard costs provide a firmer basis for budgeting. Similarly, the budgets developed for factory overhead rates for standard costing purposes.


Standard costing has gained importance in practice because of the following advantage associated with it.

* Standard costing system establishes benchmarks for performance measurements. This promotes cost consciousness and checks inefficiencies.
* The spadework done before setting standards often results in simplification ad standardization of products, methods and operations.
* The procedure and paperwork relating to costing is simplified.
* Cost estimates are readily available for pricing, product planning and other decisions.

Though a useful tool, standard costing suffers from the following limitations in practice.

* Establishment of standards poses problems. Further, how well determined the standards are, they may become outdated soon.
* Due to the interaction of various factors, variances may not be readily explained. It becomes difficult to distinguish between controllable and un-controllable variances.
* Standards may have undesirable psychological effects – they may breed frustration.

Activity Based Costing:

Traditional costing systems assign indirect costs to products using drivers like direct labor hours, machine hours, or units produced. This is acceptable if activities are performed in proportion to physical production volumes. This may be the case in business environment characterized by limited product variety, low indirect costs, simple production methods, and local competition.

However, in today’s business environment marked by wide product range, high indirect costs, complex production methods, and intense global competition, the traditional costing systems provide inaccurate information about the drivers of cost and profitability that can lead to wrong decisions. This can lead managers to make poor decisions about pricing, product design, product mix, and so on.

To cope with the challenges of today’s business environment, activity based costing has been developed.

What is Activity Based Costing?

Activity based costing identifies the key activities that consume a firm’s resources, accumulates overhead costs for each of these activities, determines the drivers of these activities, and finally assigns the cost of these activities to the ultimate cost objects (products, services, or whatever).

Activity based costing may be viewed as an amplification and refinement of the traditional costing system. The Key differences between traditional costing and activity based costing are:

In traditional costing, overhead costs are usually accumulated in a single cost pool; in activity based costing, overhead costs are broken into several cost pools, each corresponding to a key activity.

In traditional costing the single overhead cost pool is assigned to cost objects (products or whatever) using a gross cost driver like direct labor hours, or machine hours, or units produced; in activity based costing, the cost driver of each activity is identified carefully and then used as the basis for assigning the cost pool associated with that activity.

Note that in traditional costing, the total overhead cost is allocated to a product on the basis of total direct labor hours. In activity based costing important overhead activities (designing, machining, assembling, quality control etc) and their costs are separately identified and later assigned to (allocated to) products using appropriate cost drivers like design time, machine hours, number of parts number of inspections etc.