Course: ACCT, Introduction to Management Accounting | Chapter: 7 (Week 9) Source: Lecture notes + textbook (Ch. 7) Difficulty: Intermediate Prerequisites: Understanding of traditional absorption costing, manufacturing overhead basics, and the distinction between product and period costs (Chapters 5 and 6 recommended).
Big picture: This topic introduces Activity-Based Costing as an alternative to traditional absorption costing for allocating overhead. It sits at the heart of management accounting because it changes how companies understand what their products and customers actually cost. If you have been working with a single plant-wide overhead rate, ABC is the next logical step: it breaks that one rate into many, each tied to a specific activity. You need to be comfortable with overhead allocation and cost behaviour before diving in.
Activity-Based Costing allocates overhead to products by tracing costs to the activities that cause them, rather than spreading everything with one volume-based rate. It uses multiple cost pools, each with its own driver, and can include some non-manufacturing costs while excluding idle capacity and organisation-sustaining costs. The result is more accurate product and customer profitability data for internal decisions, though ABC does not replace absorption costing for external (GAAP) reporting.
Activity-Based Costing (ABC)
A costing method designed to give managers cost information for strategic decisions that may affect capacity and therefore both fixed and variable costs. It supplements the usual costing system and is used for internal decision-making.
In simple terms, ABC figures out what activities actually drive your costs and charges products accordingly, instead of lumping everything under one overhead rate.
Activity
Any event that causes the consumption of overhead resources.
Think of it as any identifiable task or process (machine setups, quality inspections, purchase orders) that uses up company resources.
Activity cost pool
A "bucket" in which costs are accumulated that relate to a single activity measure in the ABC system.
In simple terms, it is the total cost collected for one specific activity, like all costs related to processing customer orders.
Activity measure (cost driver)
An allocation base in the ABC system, the factor used to assign costs from an activity cost pool to cost objects.
Think of it as the thing you count to figure out how much of an activity a product or customer consumed.
Transaction driver
A simple count of the number of times an activity occurs (e.g. number of purchase orders placed, number of bills sent).
Easier and cheaper to track, but less precise than duration drivers.
Duration driver
A measure of the amount of time required to perform an activity (e.g. hours spent preparing individual customer bills).
More accurate than transaction drivers because it captures the effort per occurrence, but more costly to collect.
Cost object
Anything to which costs are assigned for analysis: a unit of product, a customer order, a customer, a product line, or a product.
In simple terms, it is whatever management wants to know the true cost of.
First-stage allocation
The process of assigning functionally organised overhead costs from a company's general ledger to the activity cost pools.
Think of it as sorting all your overhead into the right activity buckets.
Second-stage allocation
The process of using activity rates to apply overhead costs from cost pools to cost objects (products, customers, etc.).
This is where you actually charge products and customers based on how much of each activity they consumed.
Organisation-sustaining costs
Manufacturing overhead costs that are unaffected by which products are made during a period (e.g. factory security guard wages, plant controller salary). Under ABC, these are treated as period expenses and are not assigned to products.
Unused capacity costs (idle capacity costs)
The cost of capacity that exists but is not used. Under ABC, products are charged only for the capacity they actually use.
Activity-based management (ABM)
The management approach that uses ABC data to focus on activities, with the goal of eliminating waste, decreasing processing time, and reducing defects.
Benchmarking
A systematic approach to identifying the activities with the greatest room for improvement, often used alongside ABM.
Traditional (absorption) costing applies all manufacturing overhead to units of production using a single, plant-wide predetermined overhead rate based on a volume-based driver: direct labour hours, machine hours, or units produced.
ABC recognises that many overhead costs are not related to production volume at all. A production supervisor's salary, for instance, does not rise and fall with the number of units coming off the line.
ABC allocates overhead based on the activities that actually create the costs, rather than spreading everything through one volume-based rate.
Three key differences from traditional costing:
Non-manufacturing costs (e.g. shipping, sales commissions, warranty repairs) may be assigned to products on a cause-and-effect basis, because they are directly driven by getting the product to the customer.
Some manufacturing overhead costs are excluded from product costs:
Organisation-sustaining costs (factory security, plant controller salary) become period expenses.
Unused (idle) capacity costs are not charged to products.
Numerous overhead cost pools are used, each allocated to products and other cost objects using its own unique activity measure, rather than one blanket rate.
ABC assigns overhead in two distinct stages.
Stage 1: Assign overhead costs to activity cost pools (first-stage allocation)
Study all manufacturing overhead and relevant non-manufacturing overhead to determine which activities cause them to be incurred.
Assign (allocate) those costs to the cost pools that correspond to those activities.
This step is often the most challenging and time-consuming part of ABC. It involves studying the manufacturing process, understanding the main activities, and interviewing employees who have first-hand knowledge.
Information typically comes from the general ledger, but the ledger classifies costs by department, not by activity, so reclassification is required.
Stage 2: Assign costs from activity cost pools to cost objects (second-stage allocation)
Compute an activity rate for each cost pool (total cost in the pool divided by the estimated total activity, i.e. the cost driver).
Each pool will likely have a unique cost driver.
Apply costs to cost objects (products, customers, orders, product lines) based on how much of each activity the cost object consumed.
Cost objects are chosen because management wants to determine how profitable they are. This information feeds pricing decisions, product mix decisions, and marketing plans.
Each activity cost pool collects the total overhead associated with one activity. The activity measure (cost driver) for that pool is the factor used to distribute those costs onward.
Two types of cost driver:
Transaction drivers count how many times an activity occurs.
Example: number of purchase orders placed, number of bills sent to customers.
Simpler and cheaper to track.
Duration drivers measure how much time an activity takes.
Example: hours spent preparing individual customer bills.
More accurate because they capture effort per occurrence, but more expensive to collect.
In practice, transaction drivers are more common because of their lower data-collection cost, even though duration drivers give a truer picture of resource consumption.
ABC classifies activities into five levels. Getting this hierarchy right is important because it determines which cost driver makes sense for each pool.
Unit-level activities are performed each time a unit is produced. Cost is proportional to the number of units.
Example: electricity to run processing equipment.
Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. Cost depends on the number of batches, not the number of units.
Examples: placing purchase orders, setting up equipment, arranging shipments.
Product-level (product-sustaining) activities relate to specific products and must be carried out regardless of how many batches or units are produced or sold.
Examples: designing a product, advertising a product, maintaining a product manager.
Customer-level activities relate to specific customers and are not tied to any particular product.
Examples: sales calls, catalogue mailings, technical support for a specific customer.
Organisation-sustaining activities are carried out regardless of which customers are served or which products are made. These costs are not allocated to products under ABC; they are treated as period expenses.
Examples: heating the factory, cleaning executive offices, providing the computer network.
\text{Activity Rate} = \frac{\text{Total Cost in Activity Pool}}{\text{Total Expected Activity (cost driver)}}\text{Overhead Applied to Cost Object} = \text{Activity Rate} \times \text{Actual Activity Consumed by Cost Object}\text{Product Margin} = \text{Sales} - \text{Total Cost (direct materials + direct labour + shipping + all allocated overhead)}The activity rate is not computed for the "Other" category (organisation-sustaining and idle capacity costs), because those costs are not assigned to products under ABC.
ABC is widely used in manufacturing, healthcare, and service industries where products or customers consume overhead resources in very different proportions. A hospital might use ABC to discover that certain procedures consume far more support-staff time than their billing codes suggest. A manufacturer might find that a low-volume custom product line, which looks profitable under traditional costing, is actually losing money once setup, design, and order-processing costs are properly traced.
The practical payoff is better pricing and product-mix decisions. Companies that adopt ABC often discover that a small number of high-maintenance customers or niche products are quietly draining profits, information that a single plant-wide rate would never reveal.
"ABC replaces absorption costing." It does not. ABC is a voluntary supplement used for internal decision-making. Absorption costing remains required for GAAP-compliant external financial reports.
"ABC assigns all manufacturing overhead to products." Wrong. ABC deliberately excludes two categories: organisation-sustaining costs (which become period expenses) and unused capacity costs (which are not charged to products).
"More cost pools always means more accuracy." Not necessarily. Each additional pool adds data-collection cost. The benefit must outweigh the effort, which is why ABC adoption is ultimately a cost-benefit decision.
"ABC and traditional costing always give different product costs." They converge when overhead is genuinely driven by volume. The divergence shows up most clearly when a company produces a mix of high-volume and low-volume products with very different activity profiles.
⚠️ Know the five levels of activity (unit, batch, product, customer, organisation-sustaining) and be able to classify a given cost into the correct level. This is a very common exam question.
⚠️ Be able to compute an activity rate and apply it to a cost object. Expect a numerical problem that walks through both stages of allocation.
⚠️ Understand which costs ABC excludes from products (organisation-sustaining costs and unused capacity) and why.
⚠️ Be ready to explain why ABC product costs differ from traditional absorption costing product costs, particularly for low-volume products.
⚠️ Know the limitations: ABC is resource-intensive, voluntary, not GAAP-compliant, and its data can be misinterpreted. Exam questions may ask you to evaluate whether a company should adopt ABC.
Q: True or false: ABC assigns all manufacturing overhead costs to products.
A: False. ABC excludes organisation-sustaining costs and unused capacity costs from product costs.
Q: A factory runs 50 batches of Product A (100 units each) and 10 batches of Product B (500 units each). Setup costs total $60,000. Under ABC, which product bears more setup cost?
A: Product A. It has 50 batches vs. 10 for Product B, so it consumes five times more of the batch-level setup activity.
Q: Fill in the blank: Activity Rate = Total Cost in Pool ÷ ______
A: Total expected activity (the estimated cost driver).
Q: True or false: ABC product costs can be used in GAAP-compliant external financial statements.
A: False. ABC does not conform to GAAP and is used only for internal decision-making.
Q: Name the two types of cost driver and state which is more common in practice.
A: Transaction drivers (counts of occurrences) and duration drivers (time required). Transaction drivers are more common because they are cheaper to collect.
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