Activity Based Costing
1 Introduction
Traditional absorption costing shares overheads across all products on a single cost driver, usually machine or labour hours (chapter 3 §3.2). Where every product passes through the factory in much the same way, that is a reasonable approximation.
It stops being reasonable when products differ. A modern manufacturing environment makes a wide range of products in short runs, and a large part of its overhead is caused not by volume but by complexity — by the number of times the machines have to be reset, the number of deliveries taken in, the number of orders shipped. A low-volume product can consume as much of those activities as a high-volume one and, under a volume-based rate, be charged almost nothing for them.
Under activity based costing, overhead costs are given greater attention and visibility, because they are assigned to products according to the extent to which each product drives — causes — that cost.
ABC can be time-consuming and costly to implement, but it is worth doing where manufacturing overhead is significant and a diverse product range exists. It applies equally to service organisations, and section 8 sets out why it often suits them better than it suits a factory.
Part 1 of this chapter's two recordings. Two points before you play it.
Currency: the recording quotes the overheads and the cost pools in pounds. Every figure in the chapter, and in the question it is working, is in dollars. The arithmetic is unaffected.
Rounding: the recording rounds each cost-driver rate before it multiplies, and so prints $13,640, $23,400 and $29,250 where this chapter prints $13,636, $23,404 and $29,255. Both routes give the same cost per unit to the nearest cent — $3.90, $3.79 and $8.63 — and the recording says so itself. Section 4.3 explains why the difference disappears.
Second lecture. The chapter's second recording, on the advantages and limitations of ABC, is at section 6.
2 Activities, cost pools and cost drivers
The three terms
Activity — something the organisation does that causes overhead to be incurred: setting up machines, receiving materials, despatching orders, running machines, inspecting, processing customer orders.
Cost pool — the total cost of one activity, gathered from every cost that goes into it. The set-up pool is the wages of the staff who reset the machines plus the cost of their workshop and equipment.
Cost driver — the factor that causes the size of the cost pool to change, and therefore the measure used to charge it out. For the set-up pool it is the number of set-ups.
The cost driver is the whole of the idea. A traditional system asks how much output went through? ABC asks what caused this cost, and who consumed it? — and charges accordingly. That is why a cost driver has to be chosen for each activity separately: machine hours drive machining costs and tell you nothing about despatch.
Note what the diagram does not show, because it does not exist under ABC: a single rate for the whole factory. Chapter 3 §3.2 makes the same point from the other side — a plant-wide rate is the simplification, and different cost centres should already use different bases even before ABC is considered.
3 The steps
Identify the major activities that give rise to overheads — machine set-ups, receiving, despatch, quality testing, and so on.
Determine what causes the cost of each activity: its cost driver — number of set-ups, number of deliveries, number of orders.
Calculate the total cost of each activity: its cost pool.
Calculate a cost per unit of cost driver — a cost per set-up, per delivery, per order.
Charge the overhead to products according to their usage of each cost-driving activity.
Divide by the number of units to get an overhead cost per unit for each product.
An objective test will not ask you to run the whole sequence from beginning to end — there is not time in one question. It will ask for one step of it: a cost per set-up, the overhead charged to one product, an overhead cost per unit, or the reason ABC gives a different answer from absorption costing. You still have to see the whole sequence once to be able to answer any single step of it, which is what section 4 is for.
4 ABC and absorption costing compared — a worked example
Una: absorption costing against ABC
Una manufactures three products: A, B and C. Data for the period just ended is as follows:
A | B | C | |
Production (units) | 20,000 | 25,000 | 2,000 |
Sales price (per unit) | $20 | $20 | $20 |
Material cost (per unit) | $5 | $10 | $10 |
Labour hours (per unit) | 2 hours | 1 hour | 1 hour |
Labour is paid at the rate of $5 per hour.
Overheads for the period were as follows:
Set-up costs | 90,000 |
Receiving | 30,000 |
Despatch | 15,000 |
Machining | 55,000 |
$190,000 |
Cost driver data:
A | B | C | |
Machine hours per unit | 2 | 2 | 2 |
Number of set-ups | 10 | 13 | 2 |
Number of deliveries received | 10 | 10 | 2 |
Number of orders despatched | 20 | 20 | 20 |
Required:
Calculate the cost, and hence the profit, per unit, absorbing all the overheads on the basis of labour hours.
Calculate the cost, and hence the profit, per unit, absorbing the overheads using an activity based costing approach.
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4.1 Reading the two answers
A | B | C | |
Overhead per unit — absorption | $5.67 | $2.84 | $2.84 |
Overhead per unit — ABC | $3.90 | $3.79 | $8.63 |
Profit per unit — absorption | $(0.67) | $2.16 | $2.16 |
Profit per unit — ABC | $1.10 | $1.21 | $(3.63) |
Neither method changes the total overhead. $190,000 is spent either way, and both methods charge all of it out. ABC changes which product carries which part of it, and that is the whole of its value — and the whole of the reason a wrong answer here is expensive.
4.2 Where ABC differs from a multi-rate absorption system
Chapter 3 §3 already used two different absorption rates for two different cost centres. The difference is not the number of rates:
A traditional system pools costs by where they are incurred — a department, a cost centre — and absorbs on a volume measure of that department's output.
ABC pools costs by what activity causes them, which may cut across departments, and absorbs on a measure of that activity, which is usually not a volume measure at all.
Number of set-ups, number of deliveries and number of orders are the three drivers in Example 1 that have nothing to do with how many units were made. That is where the answer changes.
4.3 A note on rounding
The cost-driver rates in part (b) do not divide cleanly: $30,000 over 22 deliveries and $55,000 over 94,000 machine hours both recur. Rounding them and then multiplying leaves the product columns a dollar or two short of $190,000.
It makes no difference to the answer, and it is worth understanding why: the pool totals are divided by 20,000, 25,000 and 2,000 units, so a discrepancy of a few dollars disappears long before the cent that the cost card is stated to. Carry more decimals if it bothers you; the cost per unit is $3.90, $3.79 and $8.63 either way.
Round at the end, not in the middle, and never round the driver rate before you multiply if you can avoid it.
Part (a) shows what it costs. The absorption rate is $2.8358 per hour. Product A takes two hours, so its overhead is 2 × $2.8358 = $5.6716, which is $5.67 to the nearest cent. Rounding the rate first, to $2.84, and then multiplying gives $5.68, and A's full cost $20.68. Neither route is bad arithmetic: $5.68 follows correctly from a rate stated as $2.84. What separates them is a rounding instruction, and where a question does not give one the convention in these notes is to carry the full precision and round ONCE, at the end — which is why $5.67 and $20.67 are the answers printed here. It changes no decision, but in a multiple-choice question with $20.67 and $20.68 both on offer it changes the mark, so read the requirement for the instruction before you round.
5 The ABC cost hierarchy
ABC classifies activities — and therefore the costs they cause — by what makes them happen. This classification is called the cost hierarchy, and it matters because it says which costs a decision can actually change.
Level | What makes the cost happen | Examples | A decision changes it by |
Unit level | Each unit produced | Power used by a machine per unit; direct materials | Making more or fewer units |
Batch level | Each batch processed, whatever its size | Machine set-ups; a delivery received; an order despatched; a first-item inspection | Changing the number of batches — usually by changing batch size |
Product sustaining | The existence of the product line, whatever the volume | Design and specification work; product-specific tooling; keeping a product's technical file current | Adding or discontinuing a product |
Facility sustaining | The existence of the plant, whatever it makes | Factory rent and rates; plant management salaries; general administration | Opening or closing the facility — and by nothing short of that |
The point of the hierarchy
Batch-level costs are the ones traditional absorption costing gets most wrong, because they are driven by the number of batches and absorbed on volume. Facility-sustaining costs are the ones no driver explains — nothing short of closing the plant changes them — which is why the honest treatment is often to leave them out of the product cost altogether and cover them from total contribution.
It is also the link to chapter 14: a cost is only relevant to a decision if the decision operates at the level of the hierarchy that drives it. Discontinuing a product removes its product-sustaining and batch-level costs; it removes none of the facility-sustaining ones.
The cost hierarchy is not the list of activities.
The activities in Example 1 are set-ups, receiving, despatch and machining. That is a list, and calling it a hierarchy is wrong. The hierarchy is the four levels in the table above — unit, batch, product sustaining, facility sustaining — and it classifies each of those activities: machining is unit level, the other three are batch level. An examiner asking about the hierarchy is asking about the four levels.
6 Advantages of ABC over other costing systems
The syllabus names this topic in exactly those words. There are three advantages and they come in an order, because the second depends on the first and the third is the one that actually saves money.
Part 2 of this chapter’s two recordings. On Example 1’s figures it covers sections 6 and 7 — more accurate costs, better pricing and product decisions, and the real point of ABC, that it makes the cause of each cost visible — then the difficulty of finding a driver, the hybrid answer, and the terms activity, cost pool and cost driver. Two points before you play it.
Hierarchy: near the end it calls the list of activities — set-ups, receiving, despatch, machining — the “hierarchy of activities”. That is only a list. The cost hierarchy is section 5’s four levels — unit, batch, product sustaining and facility sustaining — and that is what an examiner means by the word.
Coverage: section 8, ABC in service organisations, is taught only in these notes.
6.1 More accurate product costs
Overheads are charged according to what each product consumes rather than according to how many units of it were made. Example 1 is the demonstration: the same $190,000, charged two ways, and the product that appeared to be losing money was profitable while the one that appeared profitable was losing $3.63 a unit.
On its own this is worth nothing, and it is worth saying why. The total overhead is $190,000 whichever method is used, so the entity's overall profit is identical. Accuracy only matters because of what is done with it.
6.2 Better decisions
Pricing. If C is genuinely costing $23.63 to make and sell, a price of $20 is a loss on every unit and a volume increase makes it worse. Under absorption costing the entity would have raised A's price — the wrong product.
Product range. Whether to discontinue a line, and which line, depends on which line is losing money. The cost hierarchy (section 5) says which of C's costs would actually disappear if C were dropped, and chapter 14 works that decision properly.
Product mix and batch size. If the selling price of all three is capped at $20, the useful question becomes which product to make more of — and ABC gives the contribution figures that chapters 5, 8 and 15 need.
6.3 Cost management: it makes the cause visible
This is the advantage ABC was invented for, and the one traditional absorption costing cannot give at all.
Under absorption costing the entity records $190,000 of overhead and shares it out. Nobody is ever required to ask why it is $190,000. ABC forces the question at every step: what is this money being spent on? — set-ups, $90,000. What makes us do set-ups? — the number of production runs. How many runs are we making, and why?
Follow that through Example 1. A is made in 10 batches of 2,000 units; C is made in 2 batches of 1,000. If C could be made in one batch of 2,000, one set-up disappears — and if enough set-ups disappear across the range, the entity needs fewer people resetting machines and the $90,000 itself falls. Traditional costing offers no route to that conversation at all, because it never asks what causes the cost.
The benefits of a better costing system
Explain the benefits that can be gained from changing to a more effective costing system.
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7 Limitations of ABC
Limitation | What it means in practice |
Identifying the driver is hard, and sometimes impossible | Machining has an obvious driver. Factory rent has none — nothing about a product causes the rent to be what it is. Where there is no genuine driver, ABC has nothing to offer |
It is expensive to set up and to run | Activities have to be identified, costs traced into pools and driver volumes counted and kept up to date. That is a real, continuing cost, and the chapter 1 test applies: it is worth doing only if it costs less than the better decisions it produces |
Choosing the driver is still a judgement | Two reasonable people can pick different drivers for the same pool and get different product costs. ABC reduces arbitrariness; it does not remove it |
It can produce a false sense of precision | A cost of $23.63 to the cent looks authoritative. It rests on estimated pools, estimated driver volumes and a chosen driver |
It does not change the total | $190,000 is spent either way. ABC improves decisions; it does not by itself save a dollar |
The usual practical answer is a hybrid, and it is what most entities that adopt ABC actually do: use activity based rates for the overheads that have a genuine driver — set-ups, receiving, despatch, machining — and absorb the residue, the facility-sustaining costs that no driver explains, on a conventional labour-hour or machine-hour rate. That is section 5's hierarchy applied to the design of the costing system itself.
8 ABC in service organisations
The syllabus topic is product and service costing using ABC, and the service half is not an afterthought. Chapter 2 §2.1 set out why a service is hard to cost: there is no physical unit, output cannot be stored, and a high proportion of the cost is indirect and fixed. Every one of those makes ABC more useful, not less.
With little or no direct material, the overhead is the cost. A method that charges it out well is not a refinement; it is the whole costing system.
There is often no natural volume measure to absorb on. A bank does not produce units. But there are excellent drivers — number of transactions, number of accounts opened, number of calls handled, number of statements issued.
Services vary enormously from one delivery to the next, which is exactly the high-complexity, low-volume situation in which a volume-based rate fails.
Organisation | Activity | Cost driver |
Bank | Processing payments · opening accounts · handling queries | Number of transactions · number of accounts opened · number of calls |
Hospital | Admissions · theatre time · diagnostic imaging | Number of admissions · theatre hours · number of scans |
Professional firm | Client take-on · engagement management · file review | Number of new clients · number of engagements · number of files reviewed |
Digital business | Customer support · payment processing · onboarding | Number of tickets · number of transactions · number of new subscribers |
The last row is where chapter 7 picks the argument up. Digital costing is a named outcome of its own (P1A3e) and belongs there; what matters here is that the ABC machinery — activity, pool, driver — is what makes a cost object with no physical unit costable at all.
9 Test your knowledge
Two quick checks before you move on: work through the flashcards to fix this chapter’s key terms and definitions, then sit the objective questions for exam-style practice. Both mark themselves and explain the answers as you go.
Activity Based Costing
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