Activity Based Costing (ABC)

In absorption costing, overheads are absorbed solely on volume-based cost drivers such as units of output, machine hours and direct labour hours. The overhead rate is usually expressed as cost per direct labour hour (labour intensive) or cost per machine hour (capital intensive). It is usually assumed that variable costs vary in direct proportion to the changes in the output level whereas fixed costs remain constant in total. However, fixed costs only remain constant over a certain range of time period or output level as in of ‘step costs’. In the same manner, variable costs per unit may often increase at higher output levels.

This usually results in over or under-costing of products. In over-costing a product is allocated high cost per unit while it is actually consuming low level of resources. On the other hand, in under-costing low cost per unit is allocated to a product which is using a high level of resources.

Activity based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. Resources are assigned to activities and activities to cost objects, based on consumption estimates. Activity is any event, action, transaction, or work sequence that incurs cost when producing a product. Cost pool is the overhead cost attributed to a distinct type of activity. Cost driver is any activity that has a direct relationship with the resources consumed.

ABC allocates overhead to multiple activity cost pools, and assigns the activity cost pools to products or services by means of cost drivers. Overheads are absorbed using both volume-based and non-volume based cost drivers, such as number in the production set-up, number of material requisitions and number of purchase orders.

When the cost for each cost driver has been accumulated in a cost pool, then a cost driver rate can be determined. The cost driver rate can be used to apportion overheads to products in accordance with the use of each activity for each of the products.

The following are few examples of cost drivers with particular reference to their related activity levels.

Advantages of Activity-Based Costing (ABC):

1. Product cost determination under activity-based costing is more accurate and reliable because it focuses on the cause and effect linkage of costs and activities in the context of producing goods.
2. Determining selling price for multi-products under activity-based costing is fair and correct because overheads are allocated on the basis of relevant cost drivers.
3. Control of overheads consisting of fixed and variable becomes possible by controlling and monitoring activities. Relationship between cost and activities are clearly identified in activity-based costing and thus provides opportunities to control overhead costs.
4. Sufficient information can be obtained to make decisions about the profitability of different product lines.
5. Fair allocation of overheads occupies a considerable portion in the total cost components.
6. This system is particularly helpful in identifying business activities which are wasteful or non value adding services.

Disadvantages or Limitations Of Activity-Based Costing (ABC)

1. Difficult to identify the overall activities that influence costs.
2. Not easy to select the most suitable cost driver.
3. Difficult to evaluate cost on the basis of activities.
4. Not suitable for small manufacturing concerns.
5. The implementation and running of ABC requires significant amount of time and costs.
6. Some costs do not have appropriate or relevant activity consumption cost driver.

Example 1

 The following information is available:

a) Calculate the cost per driver (Cost Driver Rate)

To produce product A

b) Calculate the total overheads applicable to Product A.

STEP 3 - Product A

Example 2

A company has the following information applicable to its products

Calculate the cost per unit of A and B under Activity Based Costing?

STEP 3

Example 3

Explorer Limited produces two products, Y and Z. The budgeted data for the two products for the year ending 31 December 2017 is as follows:

The cost of raw materials is $ 2.50 per kilo and the labour force are paid $ 8 per hour. Annual overheads are as follows:

Additional information

Calculate the cost per unit for each product using ABC.