Activity Based Costing (ABC)
Welcome to your study guide on Activity Based Costing (ABC)! If you have already studied absorption costing, you know that businesses often struggle to figure out exactly how much it costs to make a single product, especially when "indirect costs" (overheads) like rent, electricity, and management salaries are involved.
In this chapter, we are going to learn a more modern and accurate way to handle these costs. Don't worry if it sounds complicated at first—by the end of these notes, you’ll see that ABC is just a more detailed way of being fair to your products!
1. What is Activity Based Costing?
Activity Based Costing (ABC) is a method of assigning overhead costs to products based on the activities that go into making them.
In traditional costing, we usually just pile all the overheads together and split them based on something simple, like how many hours a machine ran. ABC says: "Wait a minute! Not every product uses the same amount of 'effort' from the office, the warehouse, or the setup team."
The ABC Philosophy:
1. Activities cause costs.
2. Products create the demand for activities.
Real-World Analogy: Imagine you go to a restaurant with three friends. One friend orders just water, but you order a 3-course meal with steak. If you split the bill equally (Traditional Costing), the water-drinker pays way too much! If you pay for exactly what you ordered (ABC), the costs are shared much more fairly.
Quick Review: ABC is about accuracy. It links the cost of "doing things" directly to the products that require those things to be done.
2. Key Terms You Must Know
To master ABC, you need to understand these three pillars:
A. Activity: Any process or event that consumes resources.
Example: Setting up a machine, inspecting a product, or processing a purchase order.
B. Cost Pool: The total amount of money spent on a specific activity.
Example: If it costs $5,000 a month to run the "Quality Inspection" department, that $5,000 is your Cost Pool.
C. Cost Driver: The factor that causes the cost of an activity to go up or down. This is the "trigger."
Example: For the "Quality Inspection" cost pool, the driver would likely be the number of inspections performed.
Common Activity and Driver Pairings:
• Activity: Ordering materials -> Cost Driver: Number of purchase orders.
• Activity: Setting up machines -> Cost Driver: Number of production runs (setups).
• Activity: Customer Support -> Cost Driver: Number of service calls.
Key Takeaway: Costs are grouped into pools, and we use drivers to "drive" those costs into the final product cost.
3. The 5-Step Process to Calculate Costs using ABC
Don't be intimidated by the math! Follow these steps in order, and you’ll get the right answer every time.
Step 1: Identify the main activities (e.g., Machining, Packing, Setup).
Step 2: Assign overhead costs to Cost Pools (The total money spent on each activity).
Step 3: Identify the Cost Driver for each activity (What makes the cost happen?).
Step 4: Calculate the Cost Driver Rate. Use this formula:
\( \text{Cost Driver Rate} = \frac{\text{Total Cost in the Pool}}{\text{Total Quantity of the Cost Driver}} \)
Step 5: Assign the costs to the products. Multiply the rate by how much of that driver the specific product used:
\( \text{Overhead Assigned} = \text{Cost Driver Rate} \times \text{Units of Driver used by Product} \)
Example:
Total Setup Costs (Pool): $10,000
Total Setups (Driver): 100
Rate: \( \frac{\$10,000}{100} = \$100 \) per setup.
If Product A requires 5 setups, it gets assigned $500 of the cost.
4. Benefits and Limitations of ABC
In your exam, you are often asked to evaluate whether a company should switch to ABC. Here are the points you need:
Benefits (The "Pros"):
• Greater Accuracy: It provides a much more realistic cost for each product, especially when products are complex.
• Better Pricing: If you know the true cost, you can set a better selling price and avoid losing money.
• Cost Control: By identifying "activities," managers can see which processes are too expensive and try to make them more efficient.
• Understanding Complexity: It highlights that low-volume, complex products often cost more than we think!
Limitations (The "Cons"):
• Expensive and Time-Consuming: It takes a lot of work to identify and track all these activities.
• Complexity: It is much harder to explain to staff and manage than simple traditional costing.
• Arbitrary Allocations: Some costs (like the CEO's salary or factory rent) still have to be split in a "best guess" way.
• Not always necessary: If a company only makes one type of product, ABC won't give you any better information than traditional costing.
Key Takeaway: ABC is great for accuracy but can be a headache to set up. It’s best for companies with many different, complex products.
5. ABC vs. Traditional Costing (The Big Comparison)
Why do we bother with ABC? Here is the main difference you should remember for your 9706 exam:
Traditional Absorption Costing:
• Often uses a single Overhead Absorption Rate (OAR) for the whole factory.
• Usually based on Volume (Labour hours or Machine hours).
• Simple, but can be "unfair" to simple products while "subsidising" complex ones.
Activity Based Costing (ABC):
• Uses multiple rates based on different activities.
• Based on Cause-and-Effect (Drivers).
• Complex, but provides a much clearer picture of what is actually happening in the factory.
Common Mistake to Avoid: When calculating the Cost Driver Rate, make sure you use the TOTAL number of drivers for the whole company in the denominator, not just the drivers for one product!
6. Quick Summary & "Must-Knows"
• ABC is about assigning costs based on the activities that create the cost.
• Use Cost Pools (money groups) and Cost Drivers (triggers).
• Formula: Total Activity Cost / Total Number of Drivers = Rate per Driver.
• Why switch? To get better pricing and understand which products are actually making a profit.
• Why stay traditional? It's cheaper, simpler, and fine for businesses with only one product.
Don't worry if this seems tricky at first! The math is just division and multiplication. The real "trick" is simply picking the right driver for the right activity. Keep practicing those past paper questions, and you'll find the pattern!