This document provides an overview of activity-based costing (ABC). It explains that ABC identifies cost drivers that cause overhead costs and allocates those costs to products based on their usage of activities. Traditional absorption costing allocated overhead based solely on direct costs like labor hours. ABC is more accurate when products have different levels of overhead usage and direct costs make up a small portion of total costs. The document outlines the steps of ABC, including identifying activities, assigning costs to cost pools, determining cost drivers, calculating absorption rates, and charging overhead to products.

1. Prepared by: Jessy Chong
URL: chongsk818.blogspot.com

2.  Activity based costing (ABC) is an alternative to traditional absorption
costing as a method of costing.
 ABC involves the identification of the factors (cost drivers) which ‘cause’
or ‘drive’ the costs of an organisation’s major activities. Overheads are
allocated and apportioned to activity cost centres or ‘cost pools’. From
these activity cost centres, the overhead costs are then absorbed into the
product costs on the basis of their usage of the activity. The absorption
rate for each activity is a rate per unit of the relevant cost driver.
 For activity costs that seem to relate to the volume of production, the cost
driver will be volume-related (labour or machine hours).
 For activity costs that do not seem to relate to production volume, a different
cost driver is identified, such as the number of production runs or number of
order received.

3.  The traditional cost accumulation system of absorption costing was developed in time when most organizations
produced only a narrow range of products using similar operations and consumed similar proportions of
overheads, and overheads were only a very small fraction of total costs. The benefits of more accurate system
for overhead allocation (using ABC) would probably have been relatively small. In addition, information
processing costs were high.
 Under current situation, there has been a dramatic fall in the costs of processing information and with the
advent of advanced manufacturing technology (AMT), overheads costs rise significantly and proportion of direct
production costs such as material and labour costs fall. In some cases direct costs amount to less than 5%/10% of
total manufacturing cost. Therefore using traditional absorption costing based on labour cost/hours to absorb
overhead costs can no longer represent a fair basis to allocate overheads costs to products.
 In addition, with the increase in range of products produced and increase in non-volume related support
activities due to the use of AMT such as set-up, production scheduling, inspection and data processing. 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.
 As a result, using traditional absorption costing will tend to over-allocate overhead costs to high volume
products and under-allocate overheads to low volume products with high complexity of production involving
more support activities.Therefore ABC was developed to attempt to overcome this problem.
 ABC argues that traditional cost system only emphasizes the allocation of overheads costs and ignores where
the costs come from, whereas ABC examines the forces/factors behind the costs. The forces behind the
overhead costs are known as cost drivers. Therefore the allocation of costs requires the understanding of cost
behaviour so that appropriate cost drivers can be identified.

4. Total costs
VC
STVC
Vary with volume
Use volume based
cost driver, eg
Lhrs, Mhrs,
Material Cost,
Production units
FC
LTVC
Vary with activity
Use activity based
cost driver, eg
- No of production
runs
FC
Do not vary
Write of as a
period cost

5.  Step 1 Identify an organization’s major activities that
support the manufacture of the organization’s products or
the provision of its services.
 Step 2 Use cost allocation and apportionment
methods to charge overhead costs to each of these
activities. The costs that accumulate for each activity cost
centre is called a cost pool.
 Step 3 Identify the factors which determine the size of
the costs of an activity/affect the costs of an activity.
These are known as cost drivers.
 Examples of cost drivers:

6. Cost pool Possible cost driver
Ordering costs: handling customer orders Number of orders
Materials handling costs Number of production runs
Machine set-up costs Number of machine set-ups
Machine operating costs Number of machine hours
Production scheduling costs Number of production runs
Despatching costs Number of orders despatched

7.  Step 4 For each cost pool/activity cost
centre, calculate an absorption rate per unit
of cost driver.

 Step 5 Charge overhead costs to products
for each activity, on the basis of their usage of
the activity (the number of cost drivers they
use). Overheads are charged by absorbing
them into product costs at a rate per unit of
cost driver.

8. 1. Factory Cost eg, rent, rates… $x
2. Line 1 Line 2 Line 3 eg, line manager,
maintenance, R&D $x
3. Product A Product B eg, design cost $x
4. Batches eg, set-up, inspection, order $x
5. Unit Cost eg, material, labour, direct expenses
$x
Total Costs $xx
 Hierarchy of activities can show what costs are avoidable on
which level of activities are discontinued.