Activity Based Costing (ABC)

Absorption Costing appears to be relatively straightforward way of adding overhead costs to units of production using, more often than not, a volume-related absorption basis (Such as direct labour hours or direct machine hours). The assumption that all overheads are related primarily to production volume is implied in this system. Absorption costing was developed at a time when most organizations produced only a narrow range of products and when overhead costs were only a very small fraction of total costs, direct labour and direct material costs accounting for the largest proportion of the costs. Errors made in adding overheads to products were therefore not too significant.

Nowadays, however, with the advent of advanced manufacturing technology, overheads are likely to be far more important and in fact direct labour may account for as little as 5% of a product’s cost. Moreover, there has been an increase in the costs of non-volume related support activities, such as setting-up, production scheduling, inspection and data processing, which assist the efficient manufacture of a wide range of products. These overheads 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 products manufactured rather than the volume of output.

Because traditional absorption costing methods tend to allocate too great a proportion of overheads to high-volume products (which cause relatively little diversity), and too small a proportion of overheads to low-volume products (which cause greater diversity and therefore use more support services), alternative methods of costing have been developed. Activity-based costing (ABC) is one such development.

The major ideas behind activity-based costing are as follows:

  • Activities cause costs; activities include ordering, materials handling, machining, assembly, production scheduling and dispatching,
  • Products create demand for the activities
  • Costs are assigned to products on the basis of a product’s consumption of the activities.

Absorption rates under ABC should therefore be more closely linked tot eh cause of overhead costs and hence product costs should therefore be more realistic especially where support overheads are high.

Outline of an ABC System

An ABC costing system operates as follows:

Step 1

Identify an organisation’s major activities.

Step 2

Identify the factors which determine the size of the costs of an activity/cause of the costs of an activity. These are known as cost drivers. Look at the following examples:

Activity Possible cost driver
Ordering Number of orders
Materials handling Number of production runs
Production scheduling Number of production runs
Dispatching Number of dispatches

For those costs that vary with production levels in the shorn term, ABC uses volume-related cost drivers such as labour or machine hours. The cost of oil used a lubricant on the machines would therefore be added to products on the basis of the number of machine hours since oil would have to be used for each hour the machine ran.

Step 3

Collect the costs of each activity into what are known as cost pools (equivalent to cost centres under more traditional costing methods).

Step 4

Charge support overheads to products on the basis of their usage of the activity. A product’s usage of an activity is measured by the number of the activity’s cost driver it generates.

Suppose, for example, that the cost pool for the ordering activity totaled Ksh.100,000 and that there were 10,000 orders (the cost driver). Each product would therefore be charged with Ksh.10 for each order it required. A batch requiring five orders would therefore be charged with Ksh.50 as its share of the ordering costs for the period.

Absorption costing and ABC are similar in many respects. In both systems, direct costs go straight to the product and overheads are allocated to production cost centres/cost pools. The difference lies in the manner in which overheads are absorbed into products.

Absorption costing most commonly uses two absorption bases (labour hours and /or machine hours) to charge overheads to products

ABC uses many cost drivers as absorption bases (number of orders, number of dispatches and so on).

This refers to the distribution or assignment of a group of costs to cost centers. Such costs are assimilated in a similar and should be allocated on the same base. Allocation base is the measure of activity used to allocate a cost pool to the cost centers.

Reasons for Cost Allocation

  • To facilitate comparison with externally provided services: It assists in assessing whether to continue the service or contact outsiders.
  • To provide ideas on the efficiency of service departments: It helps to determine whether a service department is operating efficiently and its size is optimal.
  • To discourage unnecessary service by some managers as they know they’ll be charged.
  • To provide opportunity for cost price-quality trade offs: Cost allocation helps to eliminate friction between departments. This is because a user department that demands higher quality knows that it will have to bear higher costs.