Chapter 1: Activity Based Costing

Study Guide Highlights

Why overhead allocation matters

Traditional absorption costing can be a workable approximation where overheads broadly follow a volume measure such as labour or machine time. That relationship may weaken in more complex production environments, especially where products consume set-ups, purchasing, inspection and other activities in very different proportions. ABC is introduced as a way of reconnecting overhead allocation with the activities that cause cost.

Activities, pools and drivers

ABC separates the work an organisation performs from the costs collected for that work. Activities describe what is being done, cost pools gather the overhead associated with each activity, and cost drivers provide a measurable basis for relating activity consumption to products or other cost objects. A sensible driver should reflect the underlying cause of the cost rather than merely correlate with it.

When ABC adds value

Circumstances in which ABC is most useful include diverse products, substantial overheads and operations where non-volume activities are important. The practical costs of introducing and maintaining a more detailed system are also recognised. The point is not that ABC is automatically superior, but that its extra information must justify the additional data, systems and management effort required.

Management implications of ABC

Different cost allocations can change the apparent profitability of products and therefore influence decisions beyond costing itself. Implications reach pricing, sales strategy, product decisions and performance management. A change in reported product cost should be interpreted through the pattern of activity consumption, rather than treated as a purely mechanical difference between two costing systems.