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ACTIVITY BASED COSTING (ABC)

This is an alternative way of apportionment and absorption of overhead costs to different activity
centres or departments, as against the traditional overhead absorption methods. It focuses on the
apportionment of overhead on the basis of activities benefited by each cost centre, through the use
of cost pools responsible for such overhead costs, e.g. production section, machining section and so
on. ABC makes use of cost drivers or determinants, which are the activities of such organization, to
apportion and allocate overhead costs.

ABC tries to redress the disadvantages of the traditional methods of absorption. The traditional
method assumes that all products consume all resources in proportion of their production volume,
thereby allocating high overhead cost to high production volume and low overhead costs to low
production volume. On the other hand, ABC makes use of a larger no of cost drivers and centres to
allocate overhead costs based on usage of such activity (ies) by each cost centre. Therefore, any cost
centre that does not enjoy any activity (e.g. repairs and maintenance overhead costs to store section),
will not bear the cost from such activity centre, and avoids the reapportionment of service department
costs.

The major difference between the traditional absorption methods and the ABC is that the traditional
method makes use of 2 bases to assign overhead costs to products.
These bases are the labour hours and machine hours. ABC on the other hand, makes use of a large
number of costs drivers as absorption bases. Some of them are: no of production runs, no of
dispatches, no of orders, and so on.
More so, the rate of absorption used in ABC must be closely linked to the causes of overhead costs
(cost driver). Cost drivers are the causes of the increase in costs. Using ABC, overhead costs are
assigned or charge using the following basis:
1. The costs that are direct in nature, or that vary in sympathy with the production process,
should be charged using Production-Related Cost Drivers ( i.e. direct labour hours or
direct machine hours), E.g. Power cost light and heat
2. Overhead costs do not vary with production process but other activities, and should be
charged to product using Transaction-based Cost Drivers. E.g. No of orders, No of
Production runs, and so on.
Examples of cost drivers.
S/n Costs Cost driver
1 Ordering cost No of orders
2 Set-up cost No of product runs
3 Material handling No of production runs
4 Inspection costs No of inspections or inspection hours
5 Dispatching cost No of dispatches
6 Raw materials inventory handling etc No of purchase orders delivered

Criticisms of ABC
1. Implementation is often problematic
2. The costs of implementing and maintaining ABC sometimes exceeds benefits.
3. It makes use of cost apportionment like the traditional method, in pooling costs for units
like rent, rates and building depreciations
4. Cost drivers are only limited to activity that is measurable in quantitative terms, and
which can be related to production output.

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5. There exists a constraint, in which a single cost driver cannot be said to explain the cost
behaviour of all items in its associated pool.

Advantages of ABC Technique

• ABC provides a more accurate cost per unit. As a result, pricing, sales strategy, performance
management and decision making should be improved.
• It provides much better insight into what drives overhead costs.
• ABC recognises that overhead costs are not all related to production and sales volume.
• In many businesses, overhead costs are a significant proportion of total costs, and
management needs to understand the drivers of overhead costs in order to manage the
business properly. Overhead costs can be controlled by managing cost drivers.
• It can be applied to derive realistic costs in a complex business environment.
• ABC can be applied to all overhead costs, not just production overheads.
• ABC can be used just as easily in service costing as in product costing.

Disadvantages of ABC Technique

• ABC will be of limited benefit if the overhead costs are primarily volume related or if the
overhead is a small proportion of the overall cost.
• It is impossible to allocate all overhead costs to specific activities.
• The choice of both activities and cost drivers might be inappropriate.
• ABC can be more complex to explain to the stakeholders of the costing exercise.
• The cost of implementing and maintaining ABC is very high.
• The benefits obtained from ABC might not justify the costs.
• Other systems may need to be changed - for example, how variances are calculated.
• ABC does not conform to GAAP

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ILLUSTRATION QUESTIONS ON ABC TECHNIQUE

Questions 1
PZ Ltd has the following information for its products and has just employed you as their financial
accountant. They expect you to help them compute figures for decision making.
Data for the last period Cough Anti
Syrup Malaria
Production units 15,000 18,000
Labour hours (per unit) 3 4
Machine hours (per unit) 2 3
Set-up in period 18 42
Orders handled in the period 12 36
Direct costs (N’000) 356 488
Overheads per period N
Product ion set-ups 600,000
Order handling 480,000
Machine activity 250,000
1,330,000
Require:
Using the methods below, determine the overhead to be absorbed into a unit each of the products
and the total cost for unit.
1. Traditional absorption costing method using machine hour absorption rate
2. Activity based costing (ABC) approach using suitable cost drivers
Question 2
Obasanjo farms located in Ogun state have been considering the best way of absorbing overhead
costs into its production. The manager heard that you are an accounting professional, and has
consulted you for advice on the best approach to adopt. He provides you with the following data:
Poultry crop farming total
Product ion units 450,000 610,000 1060,000
Labour hr/unit 6 10 16
Machine hr/unit 5 12 17
Order handling cost (N) - - 2,050,000
Dispatch cost (N) - - 1,000,000
Inspection cost (N) - - 620,000
Direct materials cost (N) 12,600,000 12,800,000 25,400,000
Direct labour cost (N) 3,500,000 4,600,000 8,100,000
You are also given the following:
No of order handling 56 44
No of dispatches 220 180
No of inspections 118 132
The company uses labour hour basis to absorb overhead into production.
You are required to:
1. Compute the OAR and total cost/unit in line with the existing approach adopted by the
company (farms)

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2. Using ABC approach, compared with the traditional method of labour hours basis,
determine the cost per unit of production. Advise the company on the best method among
the methods in (1) and (2) above, and selling price is at 25% profit on sale.
Question 3
The following details have been recorded for the four batches made in a period for Fluorescent Ltd
Batch A B C D
Output units 250 60 200 120
Direct cost per batch N N N N
Direct materials 1,650 750 2,100 500
Direct Labour 9,200 1,520 6,880 2,400
Labour hours per batch 1,150 190 860 300
The total production overhead costs for the period has been analysed as follows:
N
Machine related costs 14,600
Material handling & dispatch 6,800
Stores 8,250
Inspection/ Quality control 5,850
Set – up cost 6,200
Engineering support 8,300
The cost drivers and cost pools for these costs have been identified and analyses as follows:
Cost Pool Cost Driver
Machine costs Machine hours
Stores Requisitions raised
Inspection/Quality control No of inspections
Set – up cost No of set – ups
Material Handling & dispatch Material orderings
Engineering support cost Engineering hours
The following cost drivers volumes consumed were as follows:
Batches A B C D Total
Machine hours per batch 520 255 610 325 1,710
Material Orderings 180 70 205 40 495
Requisition raised 40 21 43 26 130
Set – up times 12 7 16 8 43
Inspection/Quality control 25 15 18 22 80
Engineering hours 65 38 52 35 190
Required: Calculate for Fluorescent Ltd the following
1. The overhead cost and total cost per batch, using the traditional costing based on labour hour
overhead absorption rate.
2. The overhead and total cost per batch, using ABC technique
3. Summarise and compare the overhead costs in (1) and (2) above.
4. Comment on your findings.

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