Activity-based costing

Activity-based costing (ABC) answers a simple question that traditional costing often gets wrong: what does each product really cost to make? You met the method in Management Accounting; in PM you must calculate it accurately under time pressure, compare the result with a traditional absorption cost, and explain what the difference means for pricing and product decisions. Expect calculation questions on cost driver rates and unit costs, and discussion of the benefits and limitations of ABC and of when it is worth the effort.

Why traditional absorption costing can mislead

Traditional absorption costing charges production overheads to products using one volume-based measure: units, labour hours or machine hours. That is reasonable when overheads are small and rise with volume. It breaks down when:

• overheads are a large share of cost, as in automated factories, so errors in spreading them matter;
• products differ in complexity: some are made in long runs, others in many small batches with frequent set-ups, inspections and special orders;
• many overheads are not driven by volume at all. The cost of a set-up is the same whether the run is 100 units or 10,000.

A volume-based rate spreads these costs in proportion to hours or units. High-volume, simple products therefore carry costs that low-volume, complex products cause. The simple products are over-costed and the complex ones under-costed: a cross-subsidy. A business that prices from these costs may undercut itself on complex products, lose sales on simple ones to competitors with better costing, and promote exactly the wrong products.

How ABC works

ABC traces overheads to the activities that cause them, then to the products that use those activities.

1. Identify the main activities that cause overhead cost, such as machining, setting up, purchasing, receiving materials and inspecting.
2. Collect the cost of each activity in a cost pool.
3. Identify the cost driver for each pool: the factor that makes the activity's cost rise.
4. Calculate a cost driver rate: cost pool ÷ total quantity of the driver.
5. Charge each product with the rate × the quantity of the driver it uses.
6. Divide each product's total overhead by its output to find the overhead cost per unit, then add direct costs for the full cost per unit.

A driver must have a cause-and-effect link with the cost, be measurable, and be recorded by the business's systems. A transaction driver counts events (number of set-ups); a duration driver measures time (set-up hours). If set-ups vary greatly in length, set-up hours describe the cost better than the number of set-ups.

The cost hierarchy

Grouping activities by level helps you choose drivers and explains where traditional costing goes wrong.

Traditional costing treats everything as unit-level. ABC recognises the batch-level and product-sustaining costs, which is where the cross-subsidy hides. Facility-sustaining costs have no causal driver, so any allocation of them is arbitrary, under ABC as much as under traditional costing.

Benefits and limitations

Worked example

Jos Components Co, a fictional manufacturer, makes three products. Production overheads total $680,000 a year and are currently absorbed on direct labour hours.

Step 1: the traditional absorption cost. The overhead absorption rate is $680,000 ÷ 34,000 labour hours = $20 per labour hour. Basic absorbs 1 × $20 = $20 a unit, Classic 1.25 × $20 = $25 and Elite 2 × $20 = $40.

Step 2: cost driver rates. An ABC study splits the overheads into four pools.

Step 3: charge each product.

Step 4: compare full costs and profits.

Total profit is the same under both methods, because the same $680,000 is absorbed and there is no change in inventory. Traditional: 20,000 × $10 + 8,000 × $13 + 2,000 × $34 = $200,000 + $104,000 + $68,000 = $372,000. ABC: $418,000 + $76,000 − $122,000 = $372,000. What changes is where the profit is made.

Step 5: interpret. Traditional costing makes Elite look like the most profitable product at $34 a unit. ABC shows it loses $61 a unit. The reason is in the drivers: Elite is 2,000 of 30,000 units and uses 4,000 of 34,000 labour hours (11.8%), but it causes half of all set-ups, deliveries and inspections. Its set-up cost alone is $90,000 ÷ 2,000 = $45.00 a unit, against $30,000 ÷ 20,000 = $1.50 for Basic. Basic has been over-costed by $10.90 a unit, $218,000 in total, which subsidised Elite (under-costed by $95 a unit, $190,000) and Classic ($3.50 a unit, $28,000).

This does not mean Elite should be dropped tomorrow. First ask which of Elite's activity costs would actually disappear without it: many set-up and inspection costs are staff salaries that are fixed in the short term. Elite also earns $120 − $30 − $16 = $74 a unit over its direct costs, and customers who buy Basic may expect Elite in the range. Better responses are to raise Elite's price, make it in larger batches so that it needs fewer set-ups, reduce its inspections by improving quality at source, and consolidate its material deliveries. Basic, meanwhile, could be priced more competitively.

Common mistakes

• Dividing a product's activity cost by the total output of all products, or by its number of batches, instead of by its own output.
• Using a volume-based driver, such as labour hours, for a batch-level cost such as set-ups.
• Forgetting a cost pool, so that the products' overheads do not add back to the total. Always check the total column.
• Concluding that a product showing an ABC loss should be dropped, without asking which costs are avoidable.
• Treating ABC as a different total cost. It redistributes the same overheads; total profit changes only through inventory valuation.

Exam technique

The study guide says the two 20-mark Section C questions come from the decision-making, budgeting and performance measurement areas (with possible requirements on information systems and on environmental accounting), so ABC calculations will most often be tested as objective test questions in Sections A and B, although the ideas can feed a Section C answer, for example on activity-based budgeting. Lay out the four-step tables above: pools and rates first, then products, then per unit. In an objective test question you may need only one product's cost, so compute only what is asked. In written answers, explain why the costs differ using the drivers in the scenario, and qualify any decision with avoidability and customer factors.

Study with AI

I am studying ACCA Performance Management (PM), activity-based costing. Create a
question with three products, total overheads, four cost pools with drivers, and the
data needed to compare ABC with absorption on labour hours. Ask me for the ABC cost
per unit of each product, the traditional cost per unit, and one reason for the
difference. Wait for my answers, then mark them with full workings.

AI assistants can make arithmetic slips in multi-step tables: check every figure against these notes, and check that the overheads charged add back to the total, before you rely on it.

Lecturer's note: ABC does not create or remove cost: it moves the same overheads to the products that cause them. When a question shows a low-volume, complex product looking very profitable under traditional costing, expect ABC to reverse the picture, because a set-up costs the same for 100 units as for 10,000. If you remember that batch-level costs are spread over each batch, not over each hour, you will understand every ABC result before you calculate it, and you will be able to explain it in the words markers reward.

Key points

• Traditional absorption spreads overheads on one volume-based measure, which over-costs simple, high-volume products and under-costs complex, low-volume ones.
• ABC collects overheads in activity cost pools, finds a cost driver for each, calculates a driver rate, and charges products by their use of each driver.
• The cost hierarchy separates unit-level, batch-level, product-sustaining and facility-sustaining costs; facility-sustaining costs have no causal driver.
• ABC redistributes the same total overheads, so total profit is unchanged when there is no inventory change.
• ABC is most useful where overheads are high and products diverse, but it is costly, needs judgement, and gives full costs rather than relevant costs.

Quick check

1. Set-up costs are $96,000 a year for 40 set-ups. Product K needs 6 set-ups to make its annual output of 1,500 units. What is the set-up cost per unit of K under ABC?
2. Which product is a labour-hour absorption rate more likely to under-cost: a high-volume product made in long runs, or a low-volume product made in many small batches?
3. Suggest a cost driver for each of: the purchasing department, the despatch department, and machine power.

Answers

1. Rate $96,000 ÷ 40 = $2,400 per set-up. K: 6 × $2,400 = $14,400, and $14,400 ÷ 1,500 units = $9.60 a unit.
2. The low-volume product made in small batches: it causes many batch-level costs, such as set-ups, but uses few labour hours, so a labour-hour rate charges it too little.
3. Number of purchase orders; number of customer orders or despatches; machine hours.