Activity-based costing (ABC) is designed for a simple problem: one broad overhead rate can make a straightforward, high-volume product subsidise a complex, low-volume product.
ACCA Performance Management (PM) expects you to identify suitable cost drivers, calculate driver rates and unit costs, and compare ABC with traditional overhead absorption. The calculation matters, but the management interpretation matters too:which activities consume resources, which products cause those activities, and what should management do with the information?
Current PM scope:this guide follows the September 2026 to June 2027 PM syllabus. Specialist cost techniques can be tested across Sections A and B, so practise short calculations, multi-task questions and concise interpretation.
1. Why one overhead rate can mislead
Traditional absorption costing collects production overheads and absorbs them using a volume measure such as labour hours, machine hours or units produced. This can work reasonably well where:
overheads are relatively small;
products are similar;
production runs are long and repetitive; and
the chosen absorption base is closely related to the way overhead resources are consumed.
Modern operations often look different. Automation increases overheads while direct labour becomes less important. A wide product range creates purchasing, scheduling, set-up, quality-control and material-handling work. Those activities may be driven by the number of orders, batches, inspections or components—not simply by the number of labour hours.
2. The language of ABC
Term | Meaning | Example |
|---|---|---|
Activity | Work performed using organisational resources. | Setting up a production run. |
Cost pool | The overhead cost collected for one activity. | Annual set-up costs of $90,000. |
Cost driver | A measurable factor that causes or closely explains the cost of the activity. | Number of set-ups. |
Driver volume | The total number of driver units expected for the period. | 30 set-ups. |
Cost-driver rate | Cost pool divided by total driver volume. | $90,000 ÷ 30 = $3,000 per set-up. |
Cost object | The item whose cost is being measured. | A product, service, customer or distribution channel. |
Study rule:a cost driver should explain consumption of the activity. “Units produced” is not automatically a sensible driver merely because it is easy to count.
3. The four-step ABC method
Split significant overhead into activity cost pools.Avoid one undifferentiated factory-overhead total.
Choose a cost driver for each pool.Use a causal or strongly related measure that can be collected reliably.
Calculate each driver rate.Divide the cost pool by total expected driver volume.
Assign costs to each product.Multiply the driver rate by the product’s use of that driver, then divide by units where necessary.
In symbols:
Cost-driver rate = cost pool ÷ total cost-driver volume
Activity cost assigned to a product = driver rate × product’s driver usage
4. Worked example: Ordinary and Deluxe
A company produces 20,000 Ordinary units and 2,000 Deluxe units. The products have the following unit information:
Per unit | Ordinary | Deluxe |
|---|---|---|
Direct material | $10 | $12 |
Direct labour | 5 hours × $12 = $60 | 6 hours × $12 = $72 |
Variable overhead | $5 | $6 |
Marginal cost | $75 | $90 |
Batch size | 2,000 units | 100 units |
Components per unit | 20 | 30 |
Budgeted production overhead is $224,000:
production set-ups: $90,000;
material handling: $92,000; and
other production overhead: $42,000.
Traditional absorption costing
Total labour hours are:
(20,000 × 5) + (2,000 × 6) =112,000 hours
The traditional overhead absorption rate is:
$224,000 ÷ 112,000 =$2 per labour hour
Per unit | Ordinary | Deluxe |
|---|---|---|
Marginal cost | $75 | $90 |
Production overhead | 5 × $2 = $10 | 6 × $2 = $12 |
Traditional absorption cost | $85 | $102 |
ABC step 1: production set-ups
Ordinary requires 20,000 ÷ 2,000 = 10 batches. Deluxe requires 2,000 ÷ 100 = 20 batches. There are 30 set-ups in total.
Set-up rate = $90,000 ÷ 30 = $3,000 per set-up
Ordinary: $3,000 ÷ 2,000 units =$1.50 per unit
Deluxe: $3,000 ÷ 100 units =$30 per unit
This is the key insight. Deluxe represents only 9.1% of total units, but it causes 66.7% of all set-ups.
ABC step 2: material handling
Total components handled are:
(20,000 × 20) + (2,000 × 30) =460,000 components
Material-handling rate = $92,000 ÷ 460,000 = $0.20 per component
Ordinary: 20 × $0.20 =$4 per unit
Deluxe: 30 × $0.20 =$6 per unit
ABC step 3: other overhead
No better driver is supplied for the remaining $42,000, so labour hours are used:
Other-overhead rate = $42,000 ÷ 112,000 = $0.375 per labour hour
Ordinary: 5 × $0.375 =$1.875 per unit
Deluxe: 6 × $0.375 =$2.25 per unit
ABC unit costs
Per unit | Ordinary | Deluxe |
|---|---|---|
Marginal cost | $75.000 | $90.00 |
Set-ups | $1.500 | $30.00 |
Material handling | $4.000 | $6.00 |
Other overhead | $1.875 | $2.25 |
ABC absorption cost | $82.375 | $128.25 |
Always perform a control check:
(20,000 × $7.375 ABC overhead) + (2,000 × $38.25 ABC overhead) = $147,500 + $76,500 =$224,000
The cost pool has been reassigned, not increased.
5. What the result means
Cost per unit | Ordinary | Deluxe |
|---|---|---|
Traditional | $85.000 | $102.00 |
ABC | $82.375 | $128.25 |
ABC minus traditional | ($2.625) | $26.25 |
The traditional method overcosted the high-volume Ordinary product and substantially undercosted the low-volume Deluxe product. Labour hours did not capture the expensive batch-level work caused by Deluxe.
Possible management implications include:
review the price and profitability of Deluxe;
increase its batch size where demand and inventory consequences allow;
redesign the product or process to reduce components and set-ups;
improve set-up procedures rather than simply discontinue the product;
reconsider customer or product-range complexity; and
use activity information to manage cost drivers—often called activity-based management.
Do not conclude automatically that Deluxe must be dropped. ABC is still a model based on chosen pools, drivers and budget data. Management also needs selling prices, demand, avoidable costs, capacity effects and strategic considerations.
6. Try the worked example in the spreadsheet
The scenario data are locked. Complete the driver rates and product costs in the blank cells. Use formulas as you would in the ACCA CBE spreadsheet, then selectShow answerto compare your work with the model.
| ABC working | Annual cost | Driver volume | Driver rate | Ordinary / unit | Deluxe / unit |
| Set-ups | 90,000.000 | 30.000 | |||
| Material handling | 92,000.000 | 460,000.000 | |||
| Other overhead | 42,000.000 | 112,000.000 | |||
| Total ABC overhead / unit | |||||
| Marginal cost / unit | 75.000 | 90.000 | |||
| Total ABC cost / unit | |||||
| Traditional overhead | 224,000.000 | 112,000.000 | |||
| Traditional overhead / unit | |||||
| Traditional total cost / unit | |||||
| ABC less traditional |
7. Choosing cost drivers in an exam
Activity cost pool | Possible driver | Why it may fit |
|---|---|---|
Purchasing | Purchase orders | Each order creates purchasing work. |
Production scheduling | Production runs or batches | Each run must be planned and released. |
Machine set-ups | Set-ups or set-up hours | Set-up resources are consumed when production changes. |
Material handling | Material moves or components | More movements or components require more handling. |
Quality control | Inspections or inspection hours | Inspection work follows testing activity. |
Dispatch | Deliveries | Each shipment creates packing and dispatch work. |
The “best” driver balances causality, measurability and cost. A theoretically perfect driver may be impractical to collect; an easy driver may be misleading.
8. Benefits and limitations of ABC
Benefits
More realistic product or service costs where overhead is significant and operations are diverse.
Better pricing, product-mix and customer-profitability information.
Greater visibility of non-value-adding activity and cost-reduction opportunities.
Recognition that many overheads are driven by complexity rather than production volume.
Useful information for target costing, process improvement and activity-based management.
Limitations
Identifying activities and collecting driver data can be costly.
The choice of cost pools and drivers requires judgement.
Some facility-sustaining costs do not have an obvious causal driver.
Driver rates are often based on budgeted volumes and can become outdated.
Too many pools create complexity; too few recreate the distortion ABC was meant to solve.
Allocated ABC costs are not automatically relevant cash flows for a short-term decision.
9. CBE method and common mistakes
Build a small table with one row per cost pool.
Calculate total driver volume before calculating the rate.
Keep annual totals, batch costs and unit costs clearly labelled.
Use a separate product column so driver usage is visible.
Reconcile assigned overhead to the original total.
Compare ABC with the traditional result and explain the direction of the change.
Common mistakes:dividing a batch cost by total annual units, using units as every cost driver, adding marginal cost twice, failing to distinguish a rate per set-up from a cost per unit, and giving numbers without explaining the effect of product complexity.
10. Continue studying PM
In a nutshell:traditional costing asks how many volume units a product used. ABC asks which activities the product caused. The second question is often much more useful.