Alternative costing principles - Activity-based costing (ABC...

Learning Outcomes

After reading this article, you will be able to explain the purpose and key features of Activity-based costing (ABC), identify differences between ABC and traditional absorption costing, understand the roles of cost pools and cost drivers, and evaluate the advantages and limitations of ABC. You will also recognise where ABC is most appropriate and apply core ABC concepts to practical management accounting scenarios.

ACCA Management Accounting (MA) Syllabus

For ACCA Management Accounting (MA), you are required to understand both traditional and alternative costing approaches. This article addresses the following key syllabus areas for revision:

• Explain activity-based costing (ABC) as an alternative cost management technique
• Distinguish ABC from traditional absorption costing methods (no detailed calculations required)
• Identify the main components of ABC, including cost pools and cost drivers
• Discuss typical circumstances when ABC provides more accurate product costs than traditional methods
• Describe the benefits and limitations of ABC in decision-making and performance management

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. What are the two main elements in an activity-based costing system?
   1. Cost pools and cost units
   2. Cost centres and cost units
   3. Cost pools and cost drivers
   4. Cost codes and cost objects
2. Which statement best describes the main advantage of ABC compared to traditional absorption costing?
   1. It requires less information to implement
   2. It allows overheads to be allocated based on activities causing costs
   3. It is simpler to calculate
   4. It ignores indirect costs
3. In which type of business environment is ABC most likely to give significant benefits over traditional costing methods?
   1. Where direct material costs are very high
   2. Where most overheads are volume-related
   3. Where overheads form a large proportion of total costs
   4. Where only a single product is made

4. True or false? ABC systems always eliminate the need for arbitrary allocations of overhead.

Introduction

Activity-based costing (ABC) is a modern method of assigning overhead costs to products and services. It was developed in response to changes in production environments, where overheads have increased and become more complex, making traditional costing methods less accurate.

ABC analyses the activities that consume resources and assigns overheads to products or services using cost drivers—specific factors that drive the costs of activities. This results in more accurate product costing, particularly in businesses with diverse products or services and significant overheads.

Key Term: activity-based costing (ABC)
A costing technique that allocates overheads to products or services based on the activities they require and the factors (cost drivers) that cause those activities’ costs.

ACTIVITY-BASED COSTING: PURPOSE AND PRINCIPLES

Traditional absorption costing typically spreads overheads over products based on a single measure, such as direct labour hours or machine hours. However, in many modern businesses, overheads are not mainly caused by volume. Instead, they arise from a range of activities—such as setups, order processing, or quality control—which are not always proportional to production volume.

ABC addresses this by:

• Identifying major activities in the organisation
• Grouping overheads into activity cost pools
• Assigning these pooled costs to products using cost drivers that reflect the root cause of each activity’s costs

Key Term: cost pool
A grouping of all costs related to a particular activity, such as machine setup, order processing, or quality inspection.

Key Term: cost driver
A factor that causes the cost of an activity to change; used to assign activity costs to products or services based on usage.

ABC systems therefore focus on cause-and-effect relationships: products are charged with costs based on the activities they use, and the amount of each activity they demand.

ABBREVIATED ABC STEPS

The ABC approach generally involves:

1. Analysing and identifying activities involved in production or service processes.
2. Collecting overhead costs into cost pools for each activity.
3. Identifying cost drivers for each pool (e.g., number of setups, purchase orders, machine hours).
4. Calculating a cost driver rate for each activity (total cost pool ÷ total quantity of cost driver).
5. Charging products or services with activity costs according to their consumption of each cost driver.

Worked Example 1.1

A factory makes two products, Alpha and Beta. Overhead costs are as follows: machine setup $60,000; materials handling $30,000. Total setups: 100 (Alpha: 40, Beta: 60). Total orders: 200 (Alpha: 120, Beta: 80). Using ABC, how much setup and materials handling overhead would be assigned to each product?

Answer:
Setup rate = $60,000 ÷ 100 setups = $600 per setup
Alpha setups: 40 × $600 = $24,000
Beta setups: 60 × $600 = $36,000
Materials handling rate = $30,000 ÷ 200 orders = $150 per order
Alpha orders: 120 × $150 = $18,000
Beta orders: 80 × $150 = $12,000
Total overhead (Alpha): $24,000 + $18,000 = $42,000
Total overhead (Beta): $36,000 + $12,000 = $48,000

ABC VS TRADITIONAL ABSORPTION COSTING

Traditional absorption costing systems often use a single overhead rate based on production volume. This can distort product costs when products consume resources differently (e.g., complex products requiring more setups, or services with varying support needs).

ABC more accurately reflects resource consumption by using multiple cost drivers and linking costs to the activities products actually require.

Comparison Table

Worked Example 1.2

A company produces high-volume Product X and low-volume Product Y. Both use similar amounts of machine hours, but Product Y requires more setups and quality checks. Will ABC or traditional costing likely give a higher cost per unit for Product Y, and why?

Answer:
ABC will assign more overheads to Product Y due to its higher usage of setup and quality activities, providing more accurate product costing than traditional methods which depend only on machine hours.

Exam Warning

Using single overhead rates can lead to incorrect product costs. In exams, make sure you understand which method is more appropriate for complex, multi-product businesses.

COST DRIVERS: EXAMPLES AND CHOICE

A cost driver must have a logical, measurable link to the costs in its pool. Typical examples of cost drivers include:

• Number of machine setups (for setup costs)
• Number of purchase orders (for purchasing costs)
• Number of quality inspections
• Machine hours (for machine operation)
• Number of customer orders (for customer service)

Selecting appropriate cost drivers is essential for accurate cost allocation.

ADVANTAGES OF ABC

ABC offers several benefits compared to traditional costing systems:

• More accurate product/service cost information, supporting better pricing and profitability analysis
• Identifies non-value-adding activities that can be targeted for cost reduction or process improvement
• Useful in complex environments with multiple products, services, or customer types
• Aids management decision-making (e.g., discontinuing unprofitable products, improving processes)

Revision Tip

When revising, focus on how ABC improves costing accuracy by linking overheads to actual resource consumption via cost drivers.

LIMITATIONS OF ABC

Despite its advantages, ABC also has drawbacks:

• More complex and time-consuming to set up than traditional systems
• Data collection and analysis require significant effort
• Benefits may not justify costs if overheads are mainly volume-related or if the business operates only a few, similar products
• Some overheads may still need to be apportioned arbitrarily if they cannot easily be linked to activities

Worked Example 1.3

A company’s total overheads are mainly machine-related and almost all products and processes are identical. Is ABC likely to provide benefits over absorption costing here? Why or why not?

Answer:
ABC is unlikely to add value in this situation since overheads are all driven by machine usage and products are similar. A simple volume-based rate is sufficient.

WHEN TO USE ABC

ABC is most beneficial when:

• Overheads are significant and not all related to production volume
• There is product or customer diversity (different activities required)
• Management needs accurate cost information for strategic decisions

For simple operations with few products and mainly volume-driven overheads, traditional absorption costing may suffice.

Summary

Activity-based costing enables organisations to assign overheads based on resource usage driven by activities, resulting in more meaningful product or service costs. ABC is particularly valuable when overheads are high and products or services differ in their consumption of activities. However, it may be less appropriate where overheads mainly vary with production volume or products are similar.

Key Point Checklist

This article has covered the following key knowledge points:

• Understand the purpose and process of activity-based costing (ABC)
• Identify cost pools and cost drivers and their roles in ABC
• Compare ABC with traditional absorption costing approaches
• Recognise advantages and situations where ABC is more appropriate
• Evaluate limitations and practical challenges of implementing ABC

Key Terms and Concepts

• activity-based costing (ABC)
• cost pool
• cost driver