Chapter 2 – Activity Based Costing

Activity Based Costing (ABC)

Traditional Absorption costing: Overheads are absorbed on the basis of activity level (Units produced,
Labour hours or Machine Hours)

But in a company with complex manufacturing processes, it is less likely that overheads are closely
related to the activity level (Units produced or Labour hours).

Lets take the example of Delivery Costs. A company has delivery costs of $100000, with 100 deliveries.
The company also produced 20000 units.

Here, we can clearly say that the delivery costs are more closely related to the Number of Deliveries
rather than the units produced.

In order to more accurately find the Costs/unit, we need to absorb costs based on a better system.

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 Activity Based Costing (ABC)
Traditional absorption costing was developed in a time when:
(a) Most manufacturers produced only a narrow range of products.
(b) Products underwent similar operations and consumed similar proportions of overheads.
(c) 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.

Modern businesses:
(a) Have experienced a dramatic fall in the costs of processing information
(b) Use advanced manufacturing technology (AMT) and therefore overhead costs have become a
much larger proportion of total production costs, and direct labour has become much less
Important

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. 3
 Activity Based Costing (ABC)
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.
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. 4

 Activity Based Costing (ABC)
Activity based costing (ABC): ABC is a costing method which involves identifying the costs of the main
support activities and the factors that ‘drive’ the costs of each activity. Overheads are then absorbed pn
the basis of the product’s usage of the factor driving the overheads.

Activities cause costs: They include ordering, despatching (Delivery), materials handling, production
scheduling etc.

Cost driver: Cost driver is a factor that has most influence on the cost of an activity.

ABC is an extension of absorption costing specifically considering what causes each type of overhead
category to occur, ie what the cost drivers are.

Each type of overhead is absorbed using a different basis depending on the cost driver.

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Activity Based Costing (ABC)

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 Activity Based Costing (ABC)
Steps in ABC

(a) Identify an organisation’s major activities that support the manufacture of the organisation’s
products or the provision of its services.

(b) Group overheads into activities, according to how they are driven. These are known as cost
pools.

(c) Identify the cost drivers for each activity, ie what causes the activity cost to be incurred.

(d) Calculate a cost per unit of cost driver.

(e) Absorb activity costs into production based on usage of cost drivers.

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Activity Based Costing (ABC)

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Activity Based Costing (ABC)

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Activity Based Costing (ABC)

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Activity Based Costing (ABC)

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Activity Based Costing (ABC)
When ABC should be used
(a) When production overheads are high relative to prime costs (eg service sector)
(b) When there is a whole diversity of product range
(c) When there are considerable differences in the use of resources by products
(d) Where consumption of resources is not driven by volume

ABC has both advantages and disadvantages and tends to be more widely used by larger
organisations and the service sector.

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Activity Based Costing (ABC)
Benefits of ABC
The use of ABC provides opportunities for:
(a) Cost control and reduction by the efficient management of cost drivers
(b) Better costing information used to assist pricing decisions
(c) Re-analysis of production and output/product mix decisions
(d) Profitability analysis (by customer, product line etc)
(e) A more realistic estimate of costs and profits which can be used in a performance appraisal
(f) It provides a more accurate cost per unit.

Criticisms of ABC
(a) It Is time consuming and expensive.
(b) It will be of limited benefit if overhead costs are primarily volume related.
(c) The benefit is reduced if the company is producing only one product or a range of products
with similar costs.
(d) Complex situations may have multiple cost drivers.
(e) Some arbitrary apportionment may still exist

Do Akbaber Plc (Q248 Kaplan Kit) 13

ABC in the public sector
 Many governments have put the public sector under increasing pressure to deliver
more services, for less money, and with greater transparency. Public sector
organisations thus need to identify, allocate and control costs more than ever before.
ABC is seen as one possible tool to help with this.

 The main drivers for introducing ABC are:

Public responsibility – responsible public organisations must have tight control of
running costs at a time when resources provided by central government are strictly
limited.

Public accountability– many organisations are being challenged as to whether or

not they spend taxpayer
 money wisely and feel a need to demonstrate this when the questions are asked.

Resource allocation within organisations – there have been concerns in many

organisations as to whether the services provided had an equitable distribution of
scarce resource – or whether those who shouted loudest got the most resource.

Helping managers to manage – managers need a better awareness of what 14

activities actually cost to provide before they can think which to cut.
ABC in the public sector
 Resistance
 However, many public sector organisations have resisted the introduction of ABC.

 To measure the cost of a service and take into account resource costs, the resource
used must be measured
 – which often means recording time spent.

 Timesheets allow accountability for what people are actually doing, and for this
cost then to be allocated to services. This is a challenge for the public sector, and for
those that wish to use ABC or take a similar approach, a culture change is definitely
required.

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Thank you