ABC is a costing system where indirect costs are assigned to products and services. The system establishes a relationship between overhead costs and production activities by allocating overhead costs to them with high precision. As a result, overhead costs are allocated more accurately based on their relevant activity levels. The system has eliminated the defects of the traditional/absorption costing system. ABC is used both as a planning tool and as a controlling instrument after the production is finished. ABC provides the basis for pricing decisions, inventory valuation, profitability analysis and overhead allocation. The system can effectively be used for both products and services.

1. Activity-
Based
Costing
System

2. (2/13)
Activity-Based Costing System
Ahmad Tariq Bhatti, FCMA (Pak), ACMA (UK), CGMA, FPFA
Introduction
Determining an accurate manufacturing cost for each product is crucial for business decision-
making. For example, knowing the cost to manufacture a unit of a product affects not only how
business budgets to manufacture that unit of product, but it is often the starting point in
determining the sales price.
An important factor in determining the total production costs of a product or job is the
appropriate allocation of overhead costs. For some companies, the traditional system, often less
complex, does an excellent job of allocating overhead costs. However, for many products,
allocating overhead is a more complex issue, and an activity-based costing (ABC) system is the
most appropriate.
The ABC system, as opposed to the traditional/absorption costing system, first accumulates
overhead costs for each organization activity and then assigns the costs of the activities to the
products, services, or customers (cost objects).
A further consideration in determining which of the two major overhead allocation systems is
effective is the cost associated with collecting and analyzing the information. In deciding which
system to use, the company must take these costs into account, both in terms of time and money.
The ABC system is often more costly in terms of time and cost.
The difference between the traditional system (using one cost driver) and the ABC system (using
multiple cost drivers) is more complex than simply the number of cost drivers. When direct labor
is a large portion of the product cost, the overhead costs tend to be consistently driven by one
cost driver, which is typically direct labor or machine hours; the traditional system appropriately
allocates those costs. When overhead cost is a large portion of the product cost, the overhead
costs tend to be driven by multiple drivers, so using multiple cost drivers in the ABC system
allows for a more precise allocation of overhead.
Origin
The 1980s were a period in which the deficiencies of
the absorption costing system were felt deeply.
Companies sought a system that could reflect true
product costs to compete with other companies.
Absorption costing was developed decades ago when
most companies produced a small range of
products. Overhead costs were small enough to make
a big difference in identifying the exact cost
of products.

3. (3/13)
It was through this criticism of absorption costing that David Cooper and Robert Kaplan came
up with the idea of the ABC system. In 1990 and 1992, they wrote articles outlining the new
system discovered by them. These articles led to the new system being widely accepted and
becoming a reality. The ABC system is now part of every management accounting textbook and
is applied around the world.
Definitions
 ABC is a cost attribution to cost units based on benefits received from indirect activities.
— CIMA Official Terminology
 An activity is an event that incurs costs.
 A cost object (product or service or process or project) is defined as anything for which a
separate measure of cost is desired/required.
 An activity cost pool: The overhead cost allocated to a distinct type of activity or related
activities.
 A cost driver is any factor or activity that has a direct cause and effect relationship with the
resources consumed.
 Cost per unit: The amount of money spent on the manufacture of a unit of a product or in
the provision of a unit of service.
 Cost accounting: The process of identifying, analyzing, summarizing, recording and
reporting costs associated with the operations of a business.
 Direct costs: Those costs that are directly associated with the manufacturing process. They
include direct materials and direct labor costs.
 Indirect/overhead cost: The costs that are not directly identifiable with a unit of production.
They include Indirect materials, indirect labor and other indirect costs related to the
production of goods.
Related Concepts
Direct Costing System
A system of costing the products where direct costs (also referred to as variable costs) are
assigned to products only. It reflects the contribution to indirect costs. This system
is widely considered appropriate for decision-making purposes.
Traditional or Absorption Costing System
This is a system that reflects the full cost of a product. It is simple to apply and is widely used.
The traditional system assigns an overhead cost based on a single overhead rate.
The major differences between Absorption and the ABC system
The ABC system assigns overhead costs based on several cost pools and the activities that drive
costs. ABC assigns costs to activities based on their use of resources. ABC is a more precise system as
it allocates overhead costs based on the activities that generate those overhead costs. It utilizes
several cost drivers as opposed to the one in the absorption costing system. The cost per unit

4. (4/13)
under both systems will be different. ABC system reflects the cost per unit more accurately than
under the absorption system.
The traditional or absorption system allocates manufacturing overhead cost based on a single
cost driver, such as direct labor hours, direct labor dollars, or machine hours, and is optimal
when there is a relationship between the activity base and overhead. For example, labor hour rate
is most commonly used when direct labor accounts for a large part of the cost of the product. The
theory behind the single cost driver is that the selected cost driver increases as overhead cost
increases. The overhead cost assigned to a given product may, therefore, be incorrect under the
absorption costing system because of the single application rate to all production activities. This
is the main defect of the absorption costing system.
Each system has its advantages and drawbacks. These are the advantages of the traditional
system.
 All manufacturing costs are categorized as materials, labor, and overhead. They are
allocated to products, whether related to production directly or not.
 All manufacturing costs are part of the product cost, whereas non-manufacturing costs are
not considered to be production costs and are not assigned to products, regardless of whether
the costs are based on the products. For example, machines used to receive and process
customer orders are necessary because product orders must be taken, but their costs are not
allocated to specific products.
The pre-determined overheads rate is based on estimated costs at the budgeted activity level. As
a result, the overhead rate is consistent across products, the overhead cost may be over-or under-
applied.
Description Absorption Costing System ABC System
 Overhead assigned Single cost driver Multiple cost drivers
 Optimal usage
When direct labor is a large
portion of the product cost
When technology is a large
portion of the product cost
 Orientation Cost driven Process-driven
The Defect of Traditional or Absorption Costing System
The traditional or absorption costing system suggests spreading the overhead cost over the entire
product range. A single overhead recovery rate (also known as a predetermined overhead rate
or overhead absorption rate) is used to absorb the total overhead cost to all production. For
instance,
 For job order costing, overhead cost absorption rates are normally based on direct labor
cost or direct labor hours
 For process costing, overheads cost absorption rates are normally based on machine hours
worked

5. (5/13)
Results of the defect:
 The use of the single cost driver may over-allocate overhead to one product and under
allocate overhead to another product, resulting in erroneous total product cost per unit and
potentially setting an incorrect sales price. The fixing of inappropriate prices is one of the
major reasons for the product failure in the market. Such failures can be avoided by the
application of the ABC system.
 The use of the single cost driver does not allocate overhead cost accurately as compared to
using multiple cost drivers.
 Products with high-profit margins subsidized products with low-profit margins
 Inaccurate cost accumulation leads to the inaccurate profit planning of the products
 A product cannot compete in the market if its cost is not accurately accumulated and
reflected in costing records
Activity-Based Costing System
ABC is a costing system where indirect costs are assigned to products and services. The system
establishes a relationship between overhead costs and production activities by allocating
overhead costs to them with high precision. As a result, overhead costs are allocated more
accurately based on their relevant activity levels. The system has eliminated the defects of the
traditional/absorption costing system. ABC is used both as a planning tool and as a controlling
instrument after the production is finished. ABC provides the basis for pricing decisions, inventory
valuation, profitability analysis and overhead allocation. The system can effectively be used for both
products and services.
An overhead cost allocation system that:
 allocates overhead cost to multiple activity cost pools and
 Assigns the activity cost pools to products or services utilizing cost drivers.
The Overhead Cost Allocation Process
 Identify activities required to complete products
 Assign overhead costs to the activities
 Identify the cost driver for each activity
 Calculate a predetermined overhead rate for each
activity.
 Allocate overhead costs to products.
Caveat:
There are no exact standards for how activity cost drivers
should be determined. They are only used as a tool to help
understand which activities are driving certain expenses and
the true cost of producing particular products or services.
Especially with larger and more complex businesses, cost
drivers will always be an estimate.

6. (6/13)
Allocation Stage
In the diagram given below, it is explained how overhead cost relating to Design, Setup and
Shipping departments is allocated to Product A, Product B and Product C in the light of the
related cost drivers.
Examples of Cost Pools and Cost Drivers
Activity Cost Pools Activity Cost Drivers
 Production
 Number of units
 Number of set-ups
 Number electricity units consumed
 Marketing
 Number of sales personnel
 Number of sales orders
 Research& Development
 Number of research projects
 Personnel hours spend on projects
 Technical complexities of the projects
 Customer Service
 Number of service calls
 Number of products serviced
 Hours spend on servicing products
 Number of customer contracts
 Number of customer change orders
 Purchasing  Number of purchase orders
 Material Handling  Number of material requisitions

7. (7/13)
Types of Cost Drivers
Levels of Activities
1. Unit-level activities
The costs of direct materials, direct labor, and machine maintenance are examples of unit-
level activities.
2. Batch-level activities
Examples of costs incurred every time a group (batch) of units is produced. Purchase orders,
machine setup, and quality tests are examples of batch-level activities.
3. Product-line activities
Examples of product-line activities are engineering changes made on the assembly line,
product design changes, and warehousing and storage costs for each product line.
4. Facility support activities
The costs associated with the activities are administrative in nature, including depreciation,
property taxes, plant security, insurance, accounting, landscape maintenance, and salaries of
the plant management and support staff.
Cost Ascertainment
A product has three cost elements. They are direct materials, direct labor and overhead cost. The
overhead cost has again three components like indirect materials, indirect labor and indirect
costs. Direct materials cost and direct labor cost together are called the direct cost of a product.
The overhead cost has two parts i.e. fixed overhead and variable overhead. The examples of
fixed overhead costs are factory rent, factory insurance, depreciation of plant and machinery,
plant insurance, etc. whereas examples of indirect overhead costs include supplies, materials
used in production, electricity bill, indirect labor, etc. Under both absorption and ABC systems,

8. (8/13)
direct material and direct labor cost for a product are the same. However, the allocation of
overhead cost is differently applied to products. The accurate estimation and attribution of the
overhead cost of the product help in the accurate determination of the product cost. This accurate
product cost is used for various decision-making situations in a business. The ABC system
applies overhead costs to all products in a more systematic manner as it uses various cost drivers.
In contrast to this, the absorption overhead system applies a single overhead recovery rate based
on the nature of the production. If the production is labor-intensive, the most appropriate
recovery rate is based on labor hours worked. And if the production is machine-intensive, the
most appropriate overhead recovery rate will be based on the machine hours worked. The
diagram given below explains the cost allocation process.
Impacts of adopting the ABC system
 Adopting the ABC overhead allocation system can allow a company to shift manufacturing
overhead costs from a period or product-based to activity-based.
 Using the ABC system to better assign unit-level, batch-level, product-level, and factory-
level costs can increase the per-unit costs of the low-volume products and decrease the per-
unit costs of the high-volume products.
 The effects are not symmetrical; there is usually a larger change in the per-unit costs of the
low-volume products.

9. (9/13)
An Illustrative Model
Alpha Ltd is manufacturing two products A and B. Both products are manufactured on the same
machines and undergo the same processes. Here is the detail of budgeted data obtained for the
two products for the financial year ending on December 31, 2022:
Description A B
Budgeted production quantity (units) 25,000 2,500
Number of purchase orders 400 200
Number of set-ups 150 100
Resources required/unit:
Direct material (Rs.) 25 62.5
Direct labor (Hours) 10 10
Machine time (Hours) 5 5
The budgeted production overhead cost for the year have been calculated as follows:
Description Amount (Rs.)
 Volume related overhead cost 275,000
 Purchase related overhead cost 300,000
 Set-up related overhead cost 525,000
Total overhead cost 1,100,000
The budgeted labor rate is Rs. 20 per hour.
The company’s present system is to absorb overhead by-product units using rates per labor hour.
However, the company is considering implementing a system of activity-based costing.
Following cost drivers for overheads are used.
 Volume related overheads  Machine hours
 Purchase related overheads  Number of purchase orders
 Set-up related overheads  Number of set-ups
Requirements:
a) Calculate the unit costs for products A and B using:
i.The absorption costing system
ii.The proposed activity-based costing system
b) Compare the results in (i) and (ii) and explain the differences.

10. (10/13)
Solution:
a) The first step is to determine the overheads absorption rate or cost driver rates for each
activity. Then utilize these rates to data given for each product.
Description A B Total
Production quantity (units) 25,000 2,500
Direct labor hours required 250,000 25,000 275,000
Rs.
Total production overheads 1,100,000
Description A B Total
Overhead absorption rate per labor hour (Rs. 1,100,000/275,000) Rs. 4
 Machine hours required 125,000 12,500 137,500
 Number of purchase orders 400 200 600
 Number of set-ups 150 100 250
Cost per cost driver
Volume related overhead cost Rs. 275,000
Machine hours required 137,500
Volume related overhead cost/machine hour (Rs. 275,000/137,500) Rs. 2
Purchases related overhead cost Rs. 300,000
Number of purchase orders 600
Purchase related overhead cost/order (Rs. 300,000/600) Rs. 500
Set-ups related to overhead cost Rs. 525,000
Number of set-ups 250
Set-up related overhead cost per set-up (Rs. 525,000/250) Rs. 2,100

11. (11/13)
(a) (i) Unit cost working under traditional/absorption costing system
Description of cost components A B
Rs. Rs.
Direct materials cost 25.00 62.50
Direct labor cost (Rs. 20 x 10 labor hours/unit) 200.00 200.00
Overheads (10 labor hours x RS. 4) 40.00 40.00
Total cost per unit 265.00 302.50
(a) (ii) Unit cost working under Activity-Based Costing system
Description of cost components A B
Rs. Rs.
Direct materials cost 25.00 62.50
Direct labor cost 200.00 200.00
Volume related overhead cost (Rs. 2 x 5 machine hours/unit) 10.00 10.00
Purchases related overhead cost:
 Product A: [(Rs. 500 x 400 Orders)/ 25,000 Units]
 Product B: [(Rs. 500 x 200 Orders)/2,500 Units]
8 40
Set-up related overhead cost:
 Product A: [(Rs. 2,100 x 150 Set-ups)/25,000 Units]
 Product B: [(Rs. 2,100 x 100 Set-ups)/25,00 Units]
12.60 84.00
Total cost per unit 255.60 396.50
(b) Difference in cost per unit under the two systems
Description A B
Rs. Rs.
Cost per traditional costing system 265.00 302.50
Cost per ABC costing system 255.60 396.50
Increase/(Decrease)  (9.40) 94.00
% Change (3.55%) 31.07%

12. (12/13)
Advantages of the ABC System
Some advantages of activity-based costing include:
1. The ABC system provides accurate costing of products/services.
2. Management has a better understanding of overhead costs.
3. The system utilizes unit cost rather than total cost, unlike under the absorption costing
system.
4. The ABC system integrates well with Six Sigma and other continuous improvement
programs.
5. The in-depth study of overhead cost under the ABC system makes all wastages visible to the
management and all non-value-added activities known to them. Thus, better controls can be
imposed on them to avoid production wastages and cost leakages.
6. It supports performance management and the development of the Balanced Scorecard.
7. The system enables accurate costing processes, supply chains, and value streams.
8. The ABC system helps in benchmarking other products.
9. There are multiple overhead cost pools, and each has its unique measure of activity. This
provides more accurate rates for applying overhead, but it takes more time to implement and
results in a higher cost.
10. The allocation bases (i.e., measures of an activity) often differ from those used in traditional
allocation. Multiple cost pools allow management of group costs being influenced by similar
drivers and to consider cost drivers beyond the typical labor or machine hour. This results in
a more accurate overhead application rate.
11. The activity rates may consider the level of activity at capacity instead of the budgeted level
of activity.
12. Both non-manufacturing and manufacturing costs may be assigned to products. The rationale
in assigning costs is the relationship between the cost and the product. If the cost increases as
the volume of the product increase, overhead cost increases accordingly.
Drawbacks of the ABC System
1. Implementing the ABC system requires a bigger budget initially.
2. After implementation, the maintenance of the system is costly. Data concerning numerous
activity measures must be collected, checked, and entered into the system regularly.
3. The ABC system produces numbers such as product margins that are different from the
profits produced by the traditional costing system. Management may be double-minded as
they are used to working with traditional costing systems, as a requirement for external
reporting.
Explanation, Conclusion & Recommendation
Under the Traditional Costing System, the cost of Product A is higher by Rs. 9.40 per unit
(i.e., 3.55%) and the cost of Product B is lower by Rs. 94 per unit (i.e., 31.07%).
These variances in cost per unit are because of inappropriate absorption of overhead costs
under the Traditional Costing System. Therefore, ABC system is highly recommended for
the company, to book the correct overhead cost for Products A and B.

13. (13/13)
4. The ABC system-generated data can be misinterpreted and must be used with care when
used in making decisions. Costs assigned to products, customers and other cost objects are
only potentially relevant.
5. Reports generated by the ABC system do not conform to Generally Accepted Accounting
Principles (GAAP)/IFRSs. Consequently, an organization involved in ABC should have
two cost systems - one for internal use and one for preparing external reports. However, the
traditional allocation assigns costs as the period or product costs, and all product costs are
included in the cost of inventory, which makes this system in compliance with the
GAAP/IFRSs.
6. Some manufacturing costs may be excluded from product costs. For example, the cost to heat
the factory may be excluded as a product cost because it is necessary for production, it does
not fit into one of the activity-driven cost pools.
Implementation Challenges
Changing from the traditional allocation system to ABC costing is not a simple and easy job.
There are several challenges faced by companies during the implementation of the ABC system.
The list of challenges normally faced by the companies are:
 Convincing employees about the benefits of the ABC system. It is ultimately their job to
patiently respond to the queries of the ABC system consultant.
 The initiative to implement the ABC system must be strongly supported by the top
management. The workings involve a tremendous job of making inquiries from employees.
 The design and implementation of the ABC system should be the responsibility of a cross-
functional team of technicians. Normally, the team would include representatives from
accounting, finance, IT, marketing, production and engineering departments.
 The services of an ABC system consultant must be hired to prevent the wastage of resources
and time.
 The ABC system takes more time to implement and operate, as information on cost drivers
must be collected objectively.
 It is more expensive, as there is a cost to collect and analyze cost driver information as well
as to allocate overhead based on multiple cost drivers.
 Selection of ABC software that could implement and automate the processing of the system
should be made upon expert advice.