Activity-Based Costing

Traditional absorption costing assigns overhead costs to products using a single, volume-based overhead absorption rate — typically based on direct labour hours, machine hours, or units of production. This approach assumes that overhead costs are driven by production volume.

The problem: In modern manufacturing and service environments, a significant proportion of overheads are not driven by production volume. Instead, they are driven by the complexity and diversity of activities. For example:

• Set-up costs are driven by the number of production runs, not the number of units produced. A short run of 100 units requires the same set-up as a long run of 10,000 units.
• Quality inspection costs are driven by the number of inspections, which may depend on product complexity rather than volume.
• Material handling costs are driven by the number of material movements or orders processed.
• Order processing costs are driven by the number of orders, not the size of each order.
• Purchasing costs are driven by the number of purchase orders.

When a single volume-based rate is used, high-volume, simple products absorb a disproportionately large share of overheads (because they use more labour/machine hours), while low-volume, complex products absorb too little. This creates a cross-subsidy: high-volume products are over-costed and low-volume products are under-costed.

ABC addresses this by identifying the activities that actually cause overhead costs and assigning costs to products based on their actual consumption of those activities.

ABC follows a structured process:

Step 1: Identify the major activities

Analyse the organisation's operations and identify the distinct activities that consume overhead resources. Examples: machine set-up, quality inspection, material handling, order processing, purchasing, despatch, customer service, design/engineering.

Step 2: Create cost pools

Group all the overhead costs associated with each activity into a cost pool. A cost pool is the total cost of performing a particular activity. For example, the "machine set-up" cost pool includes: set-up labour, set-up materials, set-up equipment depreciation, and set-up supervision.

Step 3: Identify cost drivers

For each cost pool, identify the cost driver — the factor that causes the cost to be incurred. The cost driver should have a causal relationship with the cost pool.

Step 4: Calculate cost driver rates

Cost driver rate = Total cost pool ÷ Total number of cost driver units

This gives the cost per "unit of activity" — for example, the cost per set-up, the cost per inspection, the cost per order.

Step 5: Assign costs to products (cost objects)

Multiply each product's consumption of each activity by the relevant cost driver rate, then sum across all activities to get the total overhead cost assigned to each product.

Overhead assigned to product = Σ (Product's cost driver consumption × Cost driver rate)

The key insight from ABC is the cross-subsidy: under traditional costing, high-volume products subsidise low-volume products.

Under traditional costing:

• A single OAR (e.g., per machine hour or per labour hour) is used
• High-volume products use more total hours → absorb MORE overhead → appear more expensive
• Low-volume products use fewer total hours → absorb LESS overhead → appear cheaper

Under ABC:

• Costs are assigned based on actual activity consumption
• Low-volume, complex products may require: more set-ups per unit (short production runs), more inspections, more special material movements, more purchase orders for unique components
• The overhead per unit for low-volume products is therefore much higher under ABC than under traditional costing
• High-volume, simple products require fewer set-ups and interventions per unit → overhead per unit is lower under ABC

Consequence: ABC reveals that the low-volume, complex products may be unprofitable (or less profitable than thought), while high-volume products are more profitable than traditional costing suggests. This has critical implications for pricing, product mix, and product discontinuation decisions.

ABC is most beneficial when:

• Overheads are a significant proportion of total costs: If overheads are small, the allocation method matters less
• The product range is diverse: Different products consume overhead activities in very different proportions (e.g., some are high-volume/simple, others are low-volume/complex)
• Products are manufactured in different batch sizes: Short-run products consume proportionally more set-up, inspection, and handling activities per unit
• Traditional volume-based drivers do not reflect the actual cause of overheads: Overhead costs are driven by complexity, variety, and diversity rather than production volume
• Product pricing or mix decisions are critical: ABC provides more accurate costs for pricing decisions and for evaluating which products to promote, discontinue, or reprice
• The organisation is in a competitive market: Inaccurate product costs may lead to mispricing — overpricing profitable products (losing market share) and underpricing unprofitable products (winning unprofitable business)

ABC is less useful when: overhead costs are small relative to direct costs, all products are similar and consume activities in similar proportions, or the cost of implementing and maintaining ABC exceeds the benefit of improved accuracy.

Advantages:

• More accurate product costs: By using multiple cost drivers that reflect the actual causes of overhead costs, ABC produces costs that better represent the resources consumed by each product
• Better understanding of cost behaviour: Identifying activities and cost drivers gives managers deeper insight into what drives costs and where resources are consumed
• Supports better decision-making: More accurate costs lead to better pricing decisions, product mix decisions, make-or-buy decisions, and customer profitability analysis
• Identifies non-value-adding activities: The process of mapping activities can reveal inefficient or unnecessary activities that can be reduced or eliminated (links to Lean/BPI)
• Reveals cross-subsidies: Shows which products are truly profitable and which are being subsidised — essential for strategic product portfolio management
• Better cost control: Understanding cost drivers enables managers to control costs by managing the activities that drive them (e.g., reducing the number of set-ups, consolidating orders)

Limitations:

• Complex and costly to implement: Requires significant time, effort, and resources to identify activities, determine cost drivers, collect data, and maintain the system
• Requires extensive data collection: Detailed data on cost driver volumes for each product must be collected and maintained — this can be expensive and time-consuming
• Cost drivers may be difficult to identify: For some activities, it is not easy to find a cost driver with a clear causal relationship to the cost pool
• Some costs cannot be meaningfully assigned to activities: Costs like general management salaries, building insurance, or corporate overhead may not be driven by any specific activity and must still be allocated arbitrarily
• Still involves estimation and subjectivity: The selection of cost pools, cost drivers, and the grouping of activities involves judgement — different choices can produce different costs
• May not be cost-effective for simple operations: If the product range is homogeneous or overheads are small, the extra complexity of ABC may not be justified
• Can create information overload: Too many cost pools and drivers can overwhelm managers rather than clarify decisions