Accounting (9706) | Activity based costing (ABC)

Activity Based Costing (ABC) Study Notes (9706 A Level)

Hello future accountants! This chapter takes us beyond the traditional costing methods (like Absorption Costing) you learned in AS Level. We are diving into a more detailed, modern approach called Activity Based Costing (ABC).

Why is this important? Traditional costing often miscalculates product costs, especially in modern, complex manufacturing environments. ABC solves this by giving managers much more accurate data, leading to better pricing and decision-making. Don't worry if this seems tricky at first—we'll break down the steps clearly!

1. The Flaw in Traditional Costing (TAC)

Before we embrace ABC, let's briefly recall the problem with traditional absorption costing (TAC).

Under TAC, most overheads are grouped together (often into one or two cost centers) and then absorbed using a single volume-based rate, such as direct labour hours or machine hours.

• Example: A company makes two products, A (simple, high volume) and B (complex, low volume). Both take 1 hour of direct labour.
• TAC would assign the same overhead cost to A and B, based on that 1 labour hour.
• However, Product B might require 10 machine setups and 5 quality inspections, while Product A requires 1 setup and 1 inspection. TAC ignores these non-volume related activities!

Analogy: Traditional costing is like sharing a single bill equally at a restaurant. If one person ordered only water while another ordered steak and dessert, splitting the bill equally feels unfair and inaccurate!

2. What is Activity Based Costing (ABC)?

Activity Based Costing (ABC) is a costing method that identifies activities in an organisation, assigns the cost of resources to those activities, and then assigns the cost of activities to cost objects (like products or services) based on their actual consumption of the activities.

2.1 Key Concepts

• Activity: A unit of work or task performed within the organisation (e.g., machine setup, materials ordering, quality inspection).
• Cost Pool: A grouping of all overhead costs related to a specific activity (e.g., all costs related to "Machine Setup" like wages of setup staff, forms, maintenance).
• Cost Driver: The factor that directly causes or influences the consumption of costs within a cost pool. It is the basis used to absorb the overheads into the final product.

ABC moves away from the idea that all costs are driven by production volume and focuses on how the production process consumes resources.

3. How to Use Activity Based Costing (ABC): The 4 Steps

Applying ABC involves a logical, four-stage process to correctly allocate overheads.

Step 1: Identify Activities and Group Costs into Cost Pools (Allocation & Apportionment)

Management first identifies all the major activities that consume resources (e.g., ordering, setting up, inspecting). All the overhead costs associated with each activity are then grouped into a Cost Pool.

• In practice: You take the total indirect costs (overheads) and allocate or apportion them into these separate pools based on factors like space used or estimates of staff time.

Step 2: Identify the Cost Driver for Each Activity

For each cost pool, the factor that *causes* the costs to change must be identified. This is the Cost Driver.

• Example: The "Machine Setup" cost pool is driven by the number of setups required. The "Quality Inspection" cost pool is driven by the number of inspections.

Step 3: Calculate the Cost Driver Rate (CDR)

The Cost Driver Rate is calculated by dividing the total overheads in the cost pool by the total volume of the cost driver.

Formula for Cost Driver Rate (CDR):

\[\text{Cost Driver Rate} = \frac{\text{Total Overheads in Cost Pool}}{\text{Total Volume of Cost Driver}}\]

Example: If the total cost for the "Order Processing" pool is $50,000, and the total number of orders expected is 1,000, the CDR is $50 per order ($50,000 / 1,000 orders).

Step 4: Apportion and Calculate the Total Unit Cost and Selling Price

Finally, you apply the calculated CDRs to each product based on how many units of the cost driver that product consumes.

• Total Overheads per Unit: Sum of (Cost Driver Rate \(\times\) Driver Quantity per Unit).
• Total Cost per Unit: Direct Material + Direct Labour + Total Overheads per Unit.

This new total cost figure is much more accurate for calculating the minimum selling price.

4. Identifying Appropriate Cost Drivers

The choice of Cost Driver is the most critical element of ABC. It must be a factor that has a direct cause-and-effect relationship with the cost incurred.

Common Examples of Cost Drivers

Activity/Cost Pool	Appropriate Cost Driver	What it measures
Machine Setups	Number of setups	Batch complexity, frequency of switching production
Material Ordering	Number of purchase orders	Complexity of the purchasing function
Quality Control/Inspection	Number of inspections or Inspection hours	Need for checking (often linked to complexity or newness of design)
Production scheduling	Number of production runs	Administrative effort needed for planning

Did you know? ABC costing often reveals that low-volume, specialised products are actually much more expensive to produce than managers previously thought under Traditional Costing.

5. Effect of ABC on Cost and Profit

When a business switches from Traditional Absorption Costing (TAC) to ABC, the costs of different products usually change significantly.

Impact on Cost and Profit

• High-Volume, Simple Products: These products usually absorb less overhead under ABC than under TAC, because they do not consume complex non-volume-based activities (like many setups or inspections). As a result, the calculated Profit Margin increases.
• Low-Volume, Complex Products: These products usually absorb more overhead under ABC than under TAC, because they consume a high number of activity-based resources (e.g., they require frequent setups, special handling, or many quality checks). As a result, the calculated Profit Margin decreases (or they may even show a loss!).

This shift provides management with a more truthful picture of which products are truly profitable.

6. Uses and Benefits of ABC (Supporting Management Decision Making)

Because ABC provides highly accurate cost data, it is a powerful tool for strategic decisions:

Accurate Pricing and Profitability Analysis

• ABC allows the business to set accurate selling prices based on the true cost of production.
• If ABC shows a product is unprofitable, the business can decide to discontinue it, renegotiate input costs, or increase its price.

Better Resource Allocation

• Managers can easily identify activities that are adding the most cost but providing the least value (e.g., excessive rework or inspection time). This helps target areas for cost reduction.

Decision Making (Make-or-Buy, Special Orders)

• ABC gives robust unit cost data for make-or-buy decisions, ensuring the company does not underestimate the true cost of 'making'.
• When evaluating special orders, ABC ensures all associated batch-level costs (like setups) are considered, preventing the company from accepting a low price that results in a loss.

7. Limitations of ABC

While powerful, ABC is not without its drawbacks:

1. High Cost and Complexity: ABC is expensive and time-consuming to implement. Identifying all activities and accurately measuring all cost drivers requires significant effort and sophisticated IT systems.
2. Selecting Cost Drivers: Choosing the "right" cost driver can be subjective. If the chosen driver does not truly reflect the resource consumption, the resulting costs will still be inaccurate.
3. Time Consuming: Collecting data on the usage of many different drivers (e.g., counting every setup, order, and inspection) is far more complex than tracking just machine hours.
4. Applicability: ABC is most beneficial in complex businesses that produce a wide range of products or services with varying degrees of complexity. It offers less benefit to simple businesses producing only one or two homogeneous products.