Cambridge International AS & A Level Accounting 9706
Activity Based Costing (ABC)
The big idea: Traditional absorption spreads overheads by one volume measure, usually labour or machine hours. ABC asks what actually causes each overhead (a set-up, an order, an inspection) and charges products for the activities they use, which can change a product’s cost, its price and whether it is worth making.
Summary — What This Chapter Covers
- A cost driver is the factor that causes the cost of an activity to change, e.g. the number of set-ups drives set-up costs.
- ABC in four steps: identify activities, find each one’s cost driver, calculate a cost driver rate (activity cost ÷ driver volume), then charge each product the rate × the drivers it uses.
- Unit cost = direct materials + direct labour + ABC overhead per unit; a mark-up or margin on that cost gives the selling price.
- Low-volume, complex products usually carry more overhead under ABC than under a labour-hour rate; high-volume, simple products carry less.
- Total profit is unchanged when all overheads are absorbed and all output is sold; what changes is how the profit is split between products, and so pricing and product decisions.
- ABC gives more accurate costs but is expensive to set up and run, and still relies on estimates.
1. What ABC Is and What a Cost Driver Is
Syllabus 4.1.1 · A Level · Paper 4
Charge overheads by what causes them
In absorption costing (Chapter 8) overheads are collected in cost centres and absorbed with one rate per centre, nearly always per direct labour hour or per machine hour. That works when overheads rise and fall with production volume. In a modern factory many overheads do not: the cost of setting up a machine depends on how many batches are run, not how many units are in each batch; the cost of a purchasing department depends on how many orders it raises.
Activity based costing (ABC) groups overheads by activity (a cost pool for each) and charges them to products using a cost driver: the factor that causes the activity’s cost to be incurred.
| Activity (cost pool) | Typical cost driver |
|---|
| Machine set-ups | Number of set-ups (or number of production runs/batches) |
| Purchasing / ordering materials | Number of purchase orders |
| Receiving and handling materials | Number of deliveries or material movements |
| Quality control | Number of inspections |
| Machining (power, maintenance, machine depreciation) | Machine hours |
| Despatch | Number of customer orders or despatches |
| Product design | Number of design changes or engineering hours |
Cost driver rate
Cost driver rate = Cost of the activity (cost pool) ÷ Total volume of the cost driver
Choosing the driver
The driver must cause the cost, so that a product which uses more of the driver really does make the activity cost more. When asked to “identify the appropriate cost driver”, name it and give the reason: “number of set-ups, because each set-up uses the same engineer time whatever the batch size”.
Practice Question 1
State an appropriate cost driver for each activity: (a) inspecting finished goods; (b) raising orders with suppliers; (c) running and maintaining machines; (d) loading customer orders onto delivery vehicles.
2. Apportioning Overheads and Costing a Unit with ABC
Syllabus 4.1.1 · A Level · Paper 4
Rates, product overheads, unit cost and price
4. Uses and Limitations of ABC
Memorise