ACCA F5 Article – Activity Based Costing

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Section A of the F5 syllabus lists five specialist cost and management accounting
techniques:

1. Activity-based costing
2. Target costing
3. Life-cycle costing
4. Back-flush accounting
5. Throughput accounting

This article, on activity based costing (ABC,) is the first of a series of three articles
explaining and examining these techniques in some detail.

Conventional costing distinguishes between variable and fixed costs. Typically it is
assumed that variable costs vary with the number of units output (and that these costs
are proportional to the output level) whereas fixed costs do not vary with output. This is
often an over-simplification of how costs actually behave. For example, variable costs
per unit often increase at high levels of production where overtime premiums might have
to be paid or when material becomes scarce. Fixed costs are usually fixed over certain
ranges of activity only, then they often step up as additional manufacturing resources
have to be employed to allow high volumes to be produced.

Variable costs per unit can at least be measured, and the sum of the variable costs per
unit is the marginal cost per unit. These are the extra costs caused when one more unit
is produced. However, there has always been a problem dealing with fixed production
costs, such as factory rent, heating, supervision and so on. Making a unit does not
cause more fixed costs, yet production cannot take place without these costs being
incurred. To say that the cost of producing a unit consists of marginal costs only will
understate the true cost of production and this can lead to problems. For example, if the
selling price is based on a mark-up on cost, then the company needs to make sure that
all production costs are covered by the selling price. Additionally, focusing exclusively on
marginal costs may cause companies to overlook important savings that might be made
by better controlling fixed costs.

The conventional approach to dealing with fixed overhead production costs is to assume
that the various types of these costs can be lumped together and a single overhead
absorption rate derived. The absorption rate is usually in terms of overhead cost per
labour hour or cost per machine hour. This approach is likely to be an over-simplification,
but it has the merit of being relatively quick and easy.