Activity Based Costing A2 Accounting / ACCA F5 by Taha Popatia

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 or apportioned to activity cost centres or cost pools.

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.

Rate = Costs for activity/ frequency of activity.

Difference between activity-based costing and absorption costing

• Activity Based Costing uses cost drivers and cost pools whereas, absorption costing uses direct labour
hours or machine hours.
• ABC is expensive to set up whereas, absorption costing is easy to set up.
• ABC is more realistic than absorption costing.
• Absorption costing is more easily understood than activity-based costing.

Benefits of ABC method

• Avoids absorption of costs into a product using a basis that may not be relevant example machine hours
for despatching costs.
• More realistic / fair.
• Considers batch sizes which are ignored by absorption costing.
• It charges each product with an accurate cost based on its use of an activity (cost driver).
• If the activity (cost driver) changes then the relevant effect on the cost can be assessed so costs are
controlled.

Drawbacks of ABC method

• ABC is often of little benefit if there is only one product because the overhead cost per unit will be the
same.
• The cost of implementing and maintaining an ABC system can exceed the benefits of improved accuracy
in product costs.
• This method may be time consuming and require a specialist to collect the data.
• It is not possible to attribute all costs to activities.

Why a business may use ABC for allocating overhead costs

• Fairer/ more accurate allocation of overhead costs.

• Provides good understanding of what drives the cost.
• Uses multiple cost drivers so recognizes complexity of manufacturing.

Difference between cost pool and cost driver

• Cost pool – an account collecting the cost of each activity.

• Cost driver – the separate activity of each department.

Examples of cost pools and their possible cost driver

1. Ordering costs – number of orders 2. Machine set-up costs – number of machine set-ups 3. Despatching
costs – Number of orders despatched 4. Machine operating costs – Number of machine hours.

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