Activity based costing (ABC)

Accounting A2 · Cost and management accounting. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Traditional absorption costing shares overheads using one base, such as labour hours or machine hours. This suits a factory where overheads rise with volume. Today many overheads come from activities such as setting up machines, ordering materials and inspecting quality, and these do not depend on how many hours a product takes.

Activity based costing collects the overheads of each activity in a cost pool and finds what causes that cost, the cost driver. Each product is then charged for the amount of each activity it actually uses.

The result is a more accurate product cost, which helps with pricing and with decisions about which products to make. The system is costly to set up, and some overheads, such as rent, have no clear driver.

Rules to remember

Cost driver: the factor that causes the cost of an activity to change, for example the number of set-ups or purchase orders.
Cost driver rate = total overhead in the cost pool ÷ total number of cost driver units.
Overhead charged to a product = cost driver rate × number of driver units the product uses, added up for every activity.
Overhead per unit = overhead charged to the product ÷ number of units made.
Total cost per unit = direct materials + direct labour + overhead per unit; selling price = total cost + profit mark-up.
Total overheads are the same under ABC and absorption costing; only the share charged to each product changes.
Low-volume, complex products usually cost more under ABC; high-volume, simple products usually cost less.

Common mistake

Students divide the cost pool by the product’s own driver units. The rate uses the total driver units of all products; the product’s own units are used only when charging the cost.

Worked example

A factory has two cost pools: machine set-ups $60 000 (40 set-ups in total) and inspection $36 000 (900 inspections in total). Product X uses 25 set-ups and 300 inspections, and 10 000 units are made. What is the overhead cost per unit of X under ABC?

Set-up rate = $60 000 ÷ 40 = $1500 per set-up; inspection rate = $36 000 ÷ 900 = $40 per inspection.
Overhead for X = (25 × $1500) + (300 × $40) = $37 500 + $12 000 = $49 500.
Overhead per unit = $49 500 ÷ 10 000 = $4.95.

Answer: The overhead cost of product X is $4.95 per unit.

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