Activity Based

Costing (ABC)

Cost & Management Accounting

Hammad J. Vohra
Introduction to ABC
ABC is a method of allocating overhead cost. It is a method whereby cost are
assigned on the basis of different activities in an organization.

Unlike Traditional Costing approach, where overhead cost are allocated on

the basis of one single cost driver (normally Direct Labour Hours or Cost).

So in simpler terms,  Activity based costing first assigns costs to the activities
that are the real cause of the overhead. It then assigns the cost of those
activities only to the products that are actually demanding the activities.

The reasoning behind ABC cost allocation is simple:

Products consume activities, and activities consume resources
Introduction to ABC
In activity-based costing, an activity is any event, action, transaction, or
work sequence that incurs costs when producing a product or providing a
service.

An activity cost pool is the overhead cost attributed to a distinct type of

activity (e.g., ordering materials or setting up machines).

A cost driver is any factor or activity that has a direct cause-effect

relationship with the resources consumed.
Introduction to ABC
Need for the New Approach
Over the period, automation and computerization have changed production
processes.

Shift from traditional labour based approaches to machine based.

Many companies use traditional approach with machine hours as cost

drivers.

However, where production processes are complex, there is need for more
than one allocation base.
Steps Involved in ABC
1. Identify and classify the activities involved in the manufacture of specific
products, and allocate overhead to cost pools. (E.g. Machine Setup Cost)

2. Identify the cost driver that has a strong correlation to the costs
accumulated in the cost pool. (E.g. Number of Batches)

3. Compute the activity-based overhead rate for each cost driver.

4. Assign overhead costs to products, using the overhead rates determined

for each cost pool (cost per driver).
Benefit of ABC
The primary benefit of ABC is more accurate product costing.

1. ABC leads to more cost pools being used to assign overhead costs to products. Hence, costs
are assigned more directly on the basis of the cost drivers used to produce each product.

2. ABC leads to enhanced control over overhead costs. Under ABC, companies can trace many
overhead costs directly to activities—allowing some indirect costs to be identified as direct
costs. Thus, managers have become more aware of their responsibility to control the
activities that generate those costs.

3. ABC leads to better management decisions. More accurate product costing should
contribute to setting selling prices that can help achieve desired product profitability levels.
In addition, more accurate cost data could be helpful in deciding whether to make or buy a
product part or component, and sometimes even whether to eliminate a product.

Activity-based costing does not change the amount of overhead costs. What it does, is it allocate
those overhead costs in a more accurate manner.
Limitations of ABC
Limitations of ABC
Although ABC systems often provide better product cost data than traditional volume-based
systems, there are limitations:

1. ABC can be expensive to use. The increased cost of identifying multiple activities and
applying numerous cost drivers discourages many companies from using ABC. Activity-based
costing systems are more complex than traditional costing systems—sometimes significantly
more complex. Hence, one should first evaluate the cost-benefit analysis.

2. Some arbitrary allocations continue. Even though more overhead costs can be assigned
directly to products through ABC’s multiple activity cost pools, certain overhead costs
remain to be allocated by means of some arbitrary volume-based cost driver such as labor or
machine hours.
Limitations of ABC
Limitations of ABC
Although ABC systems often provide better product cost data than traditional volume-based
systems, there are limitations:

1. ABC can be expensive to use. The increased cost of identifying multiple activities and
applying numerous cost drivers discourages many companies from using ABC. Activity-based
costing systems are more complex than traditional costing systems—sometimes significantly
more complex. Hence, one should first evaluate the cost-benefit analysis.

2. Some arbitrary allocations continue. Even though more overhead costs can be assigned
directly to products through ABC’s multiple activity cost pools, certain overhead costs
remain to be allocated by means of some arbitrary volume-based cost driver such as labor or
machine hours.