Cost accounting centers around recognizing and reporting costs in different ways. Accountants use different costing methods to meet different financial-reporting goals, such as deferring expenses until future periods or maximizing reported net income. Functional-based and activity-based cost accounting offer two fundamentally different frameworks for recognizing and reporting company expenses. Neither system is better than the other in every situation. Rather, the ideal costing system to use depends on your company's financial situation and cash-flow and reporting goals.
Activity-based costing (ABC) allocates expenses based on activities performed. Rather than adding all costs incurred in a single department, ABC breaks departmental workflows down into component tasks. Activity-based costing considers both resource drivers, such as the time and space required for each task, as well as activity drivers, such as the number of units produced or customers served, to determine the cost-efficiency of different activities. The ABC system pegs overhead costs directly to specific activities based on the actual amount of each fixed expense they incur. If an activity requires 10 hours of electricity, for example, accountants can easily determine an exact amount of electric utility expense incurred by the activity.
Functional costs are made up of the total costs of all activities performed by a functional unit. Functional-based costing considers total expenses incurred at the departmental, business-unit, work-group or individual level. Functional-based cost budgets for departments, for example, will include costs incurred by every activity performed in that department. In functional-based costing, accountants assign fixed costs such as manufacturing overhead to output on a per-unit basis.
Activity-based costing can be advantageous when analyzing the profitability or income contribution of different activities in an organization. A company can use activity-based cost figures to compare the cost of performing certain functions in-house, like shipping logistics, to the cost of outsourcing the activity.
Functional-based costing can be better-suited to providing big-picture overviews of company expenses. Functional-based cost data can reveal whether a company is generally proficient or poor at managing its expenses, which can be more useful for short-term investors.
Activity-based costing can be more time-consuming and prone to human error than functional-based costing. In order to determine the cost of single activity, accountants must consider compensation costs, materials costs and overhead costs to come up with a single activity cost, tripling the amount of research required.
The disadvantage of functional-based costing led to the creation of ABC. Functional-based costing cannot provide the type of insights that ABC can reveal for internal decision-making.