4.1 Activity Based Costing (ABC)

Definition and Concept of Activity Based Costing

• Activity Based Costing (ABC) is a costing method that identifies activities within an organisation and assigns the cost of each activity to products and services according to the actual consumption by each.
• Unlike traditional costing systems, which use broad averages (e.g., allocating overheads based on direct labour hours or machine hours), ABC uses cost drivers that more accurately reflect the cause of overhead costs.
• ABC provides more precise product costing, especially where overheads are high, and products are diverse.

Key Features of Activity Based Costing

• Costs are traced to activities (e.g., machine setup, quality inspections, material handling) rather than directly to products.
• Activities are then linked to products through cost drivers (measures of activity usage).
• Provides better insight into which products, customers, or processes generate profit and which consume resources inefficiently.

What is a Cost Driver?

• A cost driver is a factor that creates or drives the cost of an activity.
• Examples of cost drivers:
  • Number of machine setups → drives setup costs
  • Number of purchase orders → drives purchasing costs
  • Number of quality inspections → drives inspection costs
  • Material movements → drives warehouse handling costs
• Correct identification of cost drivers is essential for accurate cost allocation.

Steps in Applying ABC

1. Identify Activities
   • Break down the production process into key activities that consume resources (e.g., ordering, machining, quality control, packaging).
2. Assign Costs to Activities
   • Collect all overhead costs and group them into cost pools corresponding to each activity.
3. Identify Cost Drivers
   • Select the most appropriate cost driver for each activity (e.g., number of setups for setup activity).
4. Calculate Cost Driver Rate
   • Cost driver rate = Total cost of activity ÷ Total number of cost driver units.
5. Allocate Costs to Products
   • Assign costs to products based on the number of cost driver units each product consumes.
6. Calculate Total Product Cost
   • Add allocated overheads to direct costs (materials, labour) to determine full product cost.

Example of ABC in Practice

• A company makes two products: X and Y.
• Overheads = $120,000, split into activities:
  • Machine setups ($40,000)
  • Quality control ($60,000)
  • Material handling ($20,000)
• Cost drivers identified:
  • Setups: 200 setups
  • Inspections: 600 inspections
  • Material moves: 400 moves
• Cost driver rates:
  • Setup = $40,000 ÷ 200 = $200 per setup
  • Inspection = $60,000 ÷ 600 = $100 per inspection
  • Material move = $20,000 ÷ 400 = $50 per move
• Product X uses: 50 setups, 100 inspections, 80 moves.
• Product Y uses: 150 setups, 500 inspections, 320 moves.
• Overhead allocation:
  • Product X: (50 × $200) + (100 × $100) + (80 × $50) = $10,000 + $10,000 + $4,000 = $24,000
  • Product Y: (150 × $200) + (500 × $100) + (320 × $50) = $30,000 + $50,000 + $16,000 = $96,000
• Total overhead allocated = $120,000 (balanced).
• More accurate cost distribution compared to traditional methods.

Comparison: ABC vs Traditional Costing

• Traditional costing:
  • Allocates overheads on simple bases (e.g., direct labour hours, machine hours).
  • Suitable where overheads are small or products are similar.
• ABC:
  • Allocates overheads based on actual activities.
  • More accurate when overheads are large and product range is diverse.
  • Helps identify loss-making products that traditional costing may hide.

Uses of ABC

• More accurate product costing and pricing decisions.
• Identifies high-cost activities, enabling cost reduction and process improvement.
• Highlights unprofitable products, customers, or services.
• Useful in service industries as well as manufacturing.
• Provides better information for management decision-making (e.g., outsourcing decisions, customer profitability analysis).

Limitations of ABC

• Complex and costly to implement compared to traditional costing.
• Requires detailed data collection and monitoring of activities.
• May be resisted by employees due to additional workload.
• Not always suitable for small businesses with simple production processes.
• Cost drivers may change over time, reducing accuracy.

Effect of Different Methods of Overhead Absorption

• Traditional absorption costing may distort product costs if one product uses significantly more of a specific activity than another.
• ABC costing reduces distortion by assigning overheads based on actual resource usage.
• Example: If Product A requires many quality inspections but few machine hours, ABC will allocate higher inspection costs to it, unlike traditional costing which may allocate costs equally by machine hours.
• This impacts profit margins, selling prices, and strategic decisions.

Business Decisions Using ABC

• Pricing strategy: ABC helps avoid under-pricing complex products or over-pricing simple ones.
• Product mix decisions: Identifies which products are more profitable and should be prioritized.
• Cost reduction: Identifies costly activities that may be eliminated or outsourced.
• Customer profitability analysis: Allocates costs to customers based on activities (e.g., number of support calls).
• Make-or-buy decisions: Helps determine whether in-house production or outsourcing is more cost-effective.

Advantages of ABC

• More accurate and fair overhead allocation.
• Improves pricing and profitability analysis.
• Highlights inefficiencies in production and resource usage.
• Supports better decision-making for managers and stakeholders.

Disadvantages of ABC

• High implementation and maintenance costs.
• Complex system requiring regular updates.
• Time-consuming to identify cost drivers and track activities.
• May be impractical where activities are too many or difficult to measure.

Conclusion

• Activity Based Costing (ABC) provides a modern approach to overhead allocation, particularly in complex businesses.
• It enhances accuracy and supports strategic decision-making, but comes with higher complexity and costs.
• Understanding ABC equips businesses to evaluate product profitability, improve efficiency, and make more informed financial and managerial decisions.