Activity based

costing

Topic list Syllabus reference

1 Activity based costing A1 (a), (b)
2 Absorption costing versus ABC A1 (c)
3 Merits and criticisms of ABC A1 (c)

Introduction
Chapter 2 covers Part A of the syllabus, specialist cost and management
accounting techniques. It has been divided into five sub-chapters to emphasise
that all five techniques are equally important and equally examinable.
In this chapter we will be looking at a method of cost accumulation, activity
based costing (ABC), which is an alternative to traditional absorption costing.
ABC attempts to overcome the problems of costing in a modern manufacturing
environment, where a very large proportion of total production costs are
overhead costs.

19
 Study guide
Intellectual
level
A1 Activity based costing
(a) Identify appropriate cost drivers under ABC. 1
(b) Calculate costs per driver and per unit using ABC. 2
(c) Compare ABC and traditional methods of overhead absorption based on
production units, labour hours or machine hours. 2

Exam guide
ABC was examined in June 2008, June 2010, December 2011, December 2012, June 2014 and June 2015,
therefore it is a very examinable topic.

Exam focus Many ABC questions are set in a manufacturing environment, however, the June 2015 scenario was set in
point a hospital and this appears to have caused students some difficulty, according to the examiner’s report.
The examiner also commented that students failed to see the bigger picture when advising on whether or
not ABC should be introduced. As well as learning how to calculate ABC costs in a number of different
environments, students should ensure that they can advise a company on the adoption of ABC based on
their specific circumstances.

One of the competencies you require to fulfil performance objective 12 of the PER is the ability to apply
appropriate costing techniques to products and services. You can apply the knowledge you obtain from
this section of the text to help to demonstrate this competence.

1 Activity based costing 6/08, 6/10, 12/11, 12/12, 6/14, 6/15

FAST FORWARD
Activity based costing (ABC) is an alternative to traditional absorption costing as a method of costing.
ABC involves the identification of the factors (cost drivers) which 'cause' or 'drive' the costs of an
organisation's major activities. Overheads are allocated and apportioned to activity cost centres or 'cost
pools'. From these activity cost centres, the overhead costs are then absorbed into the product costs on
the basis of their usage of the activity. The absorption rate for each activity is a rate per unit of the relevant
cost driver.
· For activity costs that seem to relate to the volume of production, the cost driver will be volume-
related (labour or machine hours).
· For activity costs that do not seem to relate to production volume, a different cost driver is
identified, such as the number of production runs or number of orders received.

1.1 Reasons for the development of ABC

Traditional absorption costing was developed in a time when most manufacturers produced only a narrow
range of products, so that products underwent similar operations and consumed similar proportions of
overheads. In addition, overhead costs were only a very small fraction of total production costs: direct
labour and direct material costs accounted for the largest proportion of the costs.
With the dramatic fall in the costs of processing information, and with the advent of advanced
manufacturing technology (AMT), overhead costs have become a much larger proportion of total
production costs, and direct labour has become much less important. Direct labour may now account for

20 2a: Activity based costing ½ Part A Specialist cost and management accounting techniques
 as little as 5% of production costs. It is therefore now difficult to justify the use of direct labour hours as
the basis for absorbing overheads, to produce 'realistic' product costs.
The falling costs of information processing have also made it possible to switch to a different and more
complex system for accumulating and analysing overhead costs. ABC may now be cost effective whereas
in the past its high costs could have made it difficult to justify.
Many resources are used in non volume related support activities, which have increased due to AMT.
Non volume related support activities are activities that support production, but where the level of support
activity (and so the level of cost) depends on something other than production volume – such as setting-
up production runs, production scheduling and inspection. These support activities assist the efficient
manufacture of a wide range of products and are not, in general, affected by changes in production
volume. They tend to vary in the long term according to the range and complexity of the products
manufactured, rather than the volume of output.
The wider the range and the more complex the products, the more support services are required.
Consider, for example, Factory X which produces 10,000 units of one product, the Alpha, and Factory Y
which produces 1,000 units each of ten slightly different versions of the Alpha. Support activity costs in
Factory Y are likely to be a lot higher than in Factory X, even though the factories produce an identical
number of units. For example, Factory X will need to set up only a single production run, whereas Factory
Y will have to set up a production run at least ten times, for each of the ten different products. Factory Y
will therefore incur more set-up costs for the same volume of production.
Traditional absorption costing systems, which assume that all products consume all support resources
in proportion to production volumes, tend to allocate:
(a) Too great a proportion of overheads to high volume products, which cause relatively little
diversity and hence use fewer support services; and
(b) Too small a proportion of overheads to low volume products, which cause greater diversity and
therefore use more support services.
Activity based costing (ABC) attempts to overcome this problem.

1.2 Definition of ABC

Key term Activity based costing (ABC) is a method of costing which involves identifying the costs of the main
support activities and the factors that 'drive' the costs of each activity. Support overheads are charged to
products by absorbing cost on the basis of the product's usage of the factor driving the overheads.

The major ideas behind activity based costing are as follows.

(a) Activities cause costs. Activities include ordering, materials handling, machining, assembly,
production scheduling and despatching.
(b) Manufacturing products creates demand for the support activities.
(c) Costs are assigned to a product on the basis of the product's consumption of these activities.

1.3 Outline of an ABC system

An ABC system operates as follows.
Step 1 Identify an organisation's major activities that support the manufacture of the organisation’s
products or the provision of its services.
Step 2 Use cost allocation and apportionment methods to charge overhead costs to each of these
activities. The costs that accumulate for each activity cost centre is called a cost pool.

Step 3 Identify the factors which determine the size of the costs of an activity/affect the costs of an
activity. These are known as cost drivers.

Key term A cost driver is a factor which has most influence on the cost of an activity.

Part A Specialist cost and management accounting techniques ½ 2a: Activity based costing 21
 Look at the following examples.
Cost pool Possible cost driver
Ordering costs: handling customer orders Number of orders
Materials handling costs Number of production runs
Machine set-up costs Number of machine set-ups
Machine operating costs Number of machine hours
Production scheduling costs Number of production runs
Despatching costs Number of orders despatched

Step 4 For each cost pool/activity cost centre, calculate an absorption rate per unit of cost driver.
Step 5 Charge overhead costs to products for each activity, on the basis of their usage of the
activity (the number of cost drivers they use). Overheads are charged by absorbing them
into product costs at a rate per unit of cost driver.

Question Cost driver

Which of the following definitions best describes a cost driver?

A Any activity which causes an increase in costs
B A collection of costs associated with a particular activity
C A cost that varies with production levels
D Any factor which causes a change in the cost of an activity

Answer
D Any factor which causes a change in the cost of an activity

Exam focus Questions on activity based costing may require a comparison with more traditional absorption costing
point methods.

2 Absorption costing versus ABC 6/08, 6/10,

12/10, 12/12, 6/14
The following example illustrates the point that traditional absorption costing techniques result in a
misleading and inequitable division of costs between low-volume and high-volume products, and that ABC
can provide a more meaningful way of charging overhead costs to products.

2.1 Example: Activity based costing

Suppose that Cooplan manufactures four products, W, X, Y and Z. Output and cost data for the period just
ended are as follows.
Number of
production runs Material cost Direct labour Machine
Output units in the period per unit hours per unit hours per unit
$
W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14
Direct labour cost per hour: $5

22 2a: Activity based costing ½ Part A Specialist cost and management accounting techniques
Overhead costs $
Short-run variable costs 3,080
Set-up costs 10,920
Expediting and scheduling costs 9,100
Materials handling costs 7,700
30,800
Required
Prepare unit costs for each product using:
(a) Conventional absorption costing, and
(b) ABC.
Assume that, in the traditional absorption costing system, overheads are absorbed at a direct labour hour
rate.

Solution
(a) Using a conventional absorption costing approach the absorption rate for overheads based on
direct labour hours or machine hours is:
$30,800 ÷ 440 hours = $70 per direct labour.
The product costs would be as follows.
W X Y Z Total
$ $ $ $ $
Direct material 200 800 2,000 8,000
Direct labour 50 150 500 1,500
Overheads 700 2,100 7,000 21,000
950 3,050 9,500 30,500 44,000

Units produced 10 10 100 100

Cost per unit $95 $305 $95 $305
(b) Using activity based costing, it will be assumed that the number of production runs is the cost
driver for set-up costs, expediting and scheduling costs and materials handling costs; and that
machine hours are the cost driver for short-run variable costs. Product costs per unit are as
follows.
W X Y Z Total
$ $ $ $ $
Direct material (no change) 200 800 2,000 8,000
Direct labour (no change) 50 150 500 1,500
Short-run variable overheads (W1) 70 210 700 2,100
Set-up costs (W2) 1,560 1,560 3,900 3,900
Expediting, scheduling costs (W3) 1,300 1,300 3,250 3,250
Materials handling costs (W4) 1,100 1,100 2,750 2,750
4,280 5,120 13,100 21,500 44,000
Units produced 10 10 100 100
Cost per unit $428 $512 $131 $215

Workings
1 $3,080 ÷ 440 machine hours = $7 per machine hour
2 $10,920 ÷ 14 production runs = $780 per production run
3 $9,100 ÷ 14 production runs = $650 per production run
4 $7,700 ÷ 14 production runs = $550 per production run

Part A Specialist cost and management accounting techniques ½ 2a: Activity based costing 23
 Summary
Conventional absorption
costing ABC Difference per Difference in
Product unit cost unit cost unit total
$ $ $ $
W 95 428 +333 +3,330
X 305 512 +207 +2,070
Y 95 131 +36 +3,600
Z 305 215 –90 –9,000
These figures might suggest that the traditional volume-based absorption costing system is flawed,
because the low-volume products W and X are not being charged with a 'fair share' of the costs of
overhead support activities.
More specifically, traditional absorption costing may be unsatisfactory for two main reasons.
(a) It under-allocates overhead costs to low-volume products (here, W and X) and over-allocates
overheads to higher-volume products (here Z in particular).
(b) It under-allocates overhead costs to smaller products (here W and Y, with just one hour of work
needed per unit) and over-allocates overheads to larger products (here X and particularly Z).
ABC addresses these problems and arguably produces a more 'realistic' or 'satisfactory' cost.

2.2 Cost drivers

ABC focuses attention on what factors are most influential in determining the level of support activity
costs, ie the cost drivers. However, it is important to understand that activity based costs should not be
regarded as variable costs that vary with the volume of the cost driver. Some activity costs may be
variable, but many are not. Cost drivers affect or influence total costs of the activity, but not in a direct
'variable cost' relationship between activity level and cost.
(a) Activity costs that relate to production volume, such as power costs, should be traced to products
using production volume-related cost drivers, such as direct labour hours or direct machine hours
worked.
Overheads which do not relate to production volume but to some other activity should be traced to
products using transaction-based cost drivers, such as number of production runs and number of
orders received.
(b) Traditional absorption costing charges overhead costs to products in a way that ignores the costs
of support activities and their cost drivers. As a consequence, it produces less satisfactory or
'reliable' product costs.

Question Traditional costing (v) ABC

A company manufactures two products, L and M, using the same equipment and similar processes. An
extract of the production data for these products in one period is shown below.
L M
Quantity produced (units) 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 40
Orders handled in the period 15 60
Overhead costs $
Relating to machine activity 220,000
Relating to production run set-ups 20,000
Relating to handling of orders 45,000
285,000

24 2a: Activity based costing ½ Part A Specialist cost and management accounting techniques
Required
Calculate the production overheads to be absorbed by one unit of each of the products using the following
costing methods.
(a) A traditional costing approach, using a direct labour hour rate to absorb overheads
(b) An activity based costing approach, using suitable cost drivers to trace overheads to products

Answer
(a) Traditional costing approach
Direct labour
hours
Product L = 5,000 units ´ 1 hour 5,000
Product M = 7,000 units ´ 2 hours 14,000
19,000
\ Overhead absorption rate = $285,000
19,000

= $15 per hour

Overhead absorbed would be as follows.
Product L 1 hour ´ $15 = $15 per unit
Product M 2 hours ´ $15 = $30 per unit
(b) ABC approach
Machine hours
Product L = 5,000 units ´ 3 hours 15,000
Product M = 7,000 units ´ 1 hour 7,000
22,000

Using ABC the overhead costs are absorbed according to the cost drivers. The absorption rate for
each cost pool is as follows.
$ Absorption rate, ABC
Machine-hour driven costs 220,000 ¸ 22,000 m/c hours = $10 per m/c hour
Set-up driven costs 20,000 ¸ 50 set-ups = $400 per set-up
Order driven costs 45,000 ¸ 75 orders = $600 per order
Overhead costs are therefore as follows.
Product L Product M
$ $
Machine-driven costs (15,000 hrs ´ $10) 150,000 (7,000 hrs ´ $10) 70,000
Set-up costs (10 ´ $400) 4,000 (40 ´ $400) 16,000
Order handling costs (15 ´ $600) 9,000 (60 ´ $600) 36,000
163,000 122,000
Units produced 5,000 7,000
Overhead cost per unit $32.60 $17.43

These figures suggest that, with traditional absorption costing, Product M absorbs an 'unfair'
amount of overhead costs using a direct labour hour absorption rate. If overhead costs are
absorbed accordingly for each activity, based on the cost drivers for the activity, the resulting costs
are more 'fair'.

Part A Specialist cost and management accounting techniques ½ 2a: Activity based costing 25
 3 Merits and criticisms of ABC 6/10
FAST FORWARD
ABC has both advantages and disadvantages, and tends to be more widely used by larger organisations
and the service sector.

Exam focus There is an article on the ACCA website on the topic of activity based costing which you should read.
point
As you will have discovered when you attempted the question above, there is nothing difficult about ABC.
Once the necessary information has been obtained it is similar to traditional absorption costing. This
simplicity is part of its appeal. Further merits of ABC are as follows.
(a) The complexity of manufacturing has increased, with wider product ranges, shorter product life
cycles and more complex production processes. ABC recognises this complexity with its multiple
cost drivers.
(b) In a more competitive environment, companies must be able to assess product profitability
realistically. ABC facilitates a good understanding of what drives overhead costs.
(c) In modern manufacturing systems, overhead functions include a lot of non factory floor activities
such as product design, quality control, production planning and customer services. ABC is
concerned with all overhead costs and so it can take management accounting beyond its
'traditional' factory floor boundaries.

3.1 ABC and decision-making 12/10

Many of ABC's supporters claim that it can assist with decision-making in a number of ways.
· It provides accurate and reliable cost information.
· It establishes a long-run product cost.
· It provides cost data which may be used to evaluate different ways of delivering business.
It is particularly suited to the following types of decision.
· Pricing, where selling prices are derived by adding a profit mark-up to cost
· Promoting or discontinuing products or parts of the business, since ABC may help management to
identify activity costs that may be either incurred or saved
· Developing new products or new ways to do business, because ABC focuses attention on the
support activities that would be required for the new product or business procedure
Note, however, that an ABC cost is not a variable cost. ABC is a form of absorption costing that seeks to
charge overheads to products on a more 'fair' basis than traditional absorption costing. An ABC cost is
therefore not a relevant cost for decision-making purposes.
ABC attempts to relate the incidence of costs to the level of activities undertaken. A hierarchy of
activities has been suggested.

Classification level Cause of cost Types of cost Cost driver

Unit level Production/acquisition of a Direct materials Units produced
single unit of product or Direct labour
delivery of single unit of
service
Batch level A group of things being made, Purchase orders Batches produced
handled or processed Set-ups
Inspection
Product level Development, production or Equipment maintenance Product lines
acquisition of different items Product development produced

26 2a: Activity based costing ½ Part A Specialist cost and management accounting techniques
Classification level Cause of cost Types of cost Cost driver
Facility sustaining Some costs cannot be related Building depreciation None – supports the
level to a particular product line; Organisational overall production
instead, they are related to advertising or service process
maintaining the buildings and
facilities. These costs cannot
be related to cost objects with
any degree of accuracy and are
often excluded from ABC
calculations for this reason.

3.2 Criticisms of ABC

It has been suggested by critics that activity based costing has some weaknesses.
(a) Cost apportionment may still be required at the cost pooling stage for shared items of cost, such
as rent, rates and building depreciation. Apportionment can be an arbitrary way of sharing costs.
(b) A single cost driver may not explain the cost behaviour of all items in a cost pool. An activity may
have two or more cost drivers.
(c) Unless costs are 'driven' by an activity that is measurable in quantitative terms, cost drivers cannot
be used. What drives the cost of the annual external audit, for example?
(d) There must be a reason for using a system of ABC. ABC must provide meaningful product costs or
extra information that management will use. If management is not going to use ABC information
for any practical purpose, a traditional absorption costing system would be simpler to operate and
just as good.
(e) The cost of implementing and maintaining an ABC system can exceed the benefits of 'improved
accuracy' in product costs.
(f) Implementing ABC is often problematic due to problems with understanding activities and their
costs.
(g) ABC is an absorption costing system. Absorption costing has only limited value for management
accounting purposes.

Part A Specialist cost and management accounting techniques ½ 2a: Activity based costing 27