## **Learning Outcomes**

After reading this article, you will be able to describe and apply the principles of activity based costing (ABC) and activity based management (ABM). You will be able to identify and define cost drivers and cost pools, explain the allocation of overheads using ABC, compare ABC with traditional costing methods, and discuss the benefits and challenges of ABC and ABM in performance management scenarios. You will also be able to analyse scenarios using ABC data to aid operational and strategic decisions.

## **ACCA Advanced Performance Management (APM) Syllabus**

For ACCA Advanced Performance Management (APM), you are required to understand not only how overheads can be attributed using activity based methods but also how this information supports decision-making and performance management. Revision should focus on:

- The core steps in activity based costing, including identification of cost drivers and cost pools
- The process and rationale for allocating overheads using ABC principles, as opposed to traditional costing methods
- Applications of activity based management to improve operational efficiency
- Evaluation of the strengths and weaknesses of ABC and ABM for planning and control
- The analysis of resource consumption and the relationship between activities, costs, and performance

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What is a cost driver in the context of activity based costing?
2. Explain the difference between cost pools and cost centres.
3. In what situation might ABC provide a significantly different product cost than traditional absorption costing?
4. What steps should be followed to allocate overheads to products using ABC?
5. Give an example of how activity based management can improve process efficiency.

## **Introduction**

Accurately measuring the cost of products, services, or processes is a fundamental requirement in management accounting. Traditional overhead allocation methods often distort product and service costs, especially in complex or diversified operations. Activity based costing (ABC) was developed to provide a more precise view by linking overhead costs to the activities that generate them. Activity based management (ABM), in turn, uses ABC information to drive operational improvements.

This article explains the key elements of ABC: cost pools and cost drivers, details the process for allocating overheads to products, and evaluates the potential of ABM in managing performance. You will learn not only the mechanics, but also when, why, and how ABC and ABM are most effectively used in real-world business decision-making contexts.

> **Key Term: activity based costing (ABC)**
> A costing method that allocates overheads to products or services according to the activities that drive those costs, rather than on arbitrary volume-based methods.

## **Activity Based Costing: Principles and Key Elements**

The central idea behind ABC is that activities consume resources and products or services, in turn, consume activities.

### Cost Pools

A cost pool is a collection of individual costs, typically all costs related to a single activity. In ABC, costs are grouped into pools that relate to distinct business activities, such as machine setups, material handling, or quality inspections.

> **Key Term: cost pool**
> A grouping of individual costs, typically by activity, that are accumulated for the purposes of allocation to products or services.
>
> **Key Term: cost driver**
> A factor that directly causes a change in the cost of an activity; used as the basis for allocating costs in ABC systems.

### Cost Drivers

A cost driver is the event or factor that causally relates to the incurrence of costs in the cost pool. For each cost pool, an appropriate cost driver is selected, such as the number of setups, machine hours, purchase orders placed, or quality inspections performed.

The choice of cost driver is critical. It should have a strong, measurable, and direct relationship to the costs in the pool to ensure that the costs allocated are as accurate as possible.

### The ABC Allocation Process

Allocating overheads using ABC involves the following streamlined steps:

1. Identify and define activities that incur overheads.
2. Assign all overhead costs to appropriate activity cost pools.
3. Determine a suitable cost driver for each activity.
4. Calculate a cost driver rate for each pool (total pool cost divided by total quantity of cost driver).
5. Allocate costs from each pool to products, services, or customers based on their actual consumption of the relevant cost driver.

### **Worked Example 1.1**

**A manufacturer produces three products. Overhead activities include machine setups, quality inspections, and order processing. The total setups for the period are 100, costing \$20,000. Product A requires 10 setups; Product B uses 30 setups; Product C uses 60 setups. How much setup cost is allocated to each product under ABC?**

> **Answer:**
> The cost driver rate for setup is \$20,000 / 100 setups = \$200 per setup.
>
> - Product A: 10 setups × \$200 = \$2,000
> - Product B: 30 setups × \$200 = \$6,000
> - Product C: 60 setups × \$200 = \$12,000

## **Cost Drivers: Selection and Impact**

Selecting the appropriate cost driver is critical to ABC. The driver must reflect the real cause of the associated costs. The main categories of cost drivers include:

- Transaction drivers: Number of times an activity is performed (e.g. purchase orders, setups).
- Duration drivers: Amount of time required for an activity (e.g. hours spent).
- Intensity drivers: Direct measurement of resources consumed by an activity.

Generally, more precise (often more complex and costly) cost drivers lead to more accurate allocations. The key is to balance accuracy with the practicality and cost of data capture.

> **Exam Warning**
> In the exam, you may be asked to evaluate whether a chosen cost driver actually reflects the cause of the activity costs. Always question whether the cost driver closely aligns with cost incurrence, and suggest a better alternative when appropriate.

## **ABC versus Traditional Costing**

Traditional absorption costing systems allocate overheads to products using a single driver, typically based on direct labour hours or machine hours. This approach assumes all products consume overhead resources in proportion to volume, which is rarely the case in complex environments.

ABC, in contrast, recognises that different products may require different levels and types of activities regardless of output volume. This distinction often results in more accurate, sometimes significantly different, product costs.

### **Worked Example 1.2**

**A company allocates all overheads based on machine hours. Product X requires plenty of machine time but few setups and inspections. Product Y requires fewer machine hours but frequent setups and quality checks. Under traditional costing, which product's cost is likely to be overstated?**

> **Answer:**
> Traditional costing will overstate Product X's cost because it has higher machine hours, but understate Product Y's true cost since its high requirements for setups and inspections are ignored. ABC would allocate more of these overheads to Product Y, reflecting its actual resource usage.

## **Activity Based Management (ABM): Using ABC Data for Improvement**

Activity based management leverages the information provided by ABC to improve efficiency and support better decision-making at both operational and strategic levels.

> **Key Term: activity based management (ABM)**
> The practice of using activity based costing information to improve business processes, efficiency, and profitability through analysis and operational change.

ABM focuses on:

- Identifying non-value-adding activities that can be reduced or eliminated
- Determining areas for process improvement and cost reduction
- Supporting product and customer profitability analysis
- Informing pricing, mix, and outsourcing decisions

### **Worked Example 1.3**

**A company discovers via ABC that a substantial portion of overhead costs come from excessive material movements. What ABM action could be taken to reduce costs without sacrificing output?**

> **Answer:**
> The company could redesign the layout of its production floor to reduce the distance or number of times materials need to be moved, thereby reducing the activity creating the cost and improving operational efficiency.

## **Benefits and Limitations of ABC and ABM**

Advantages:

- Accurate product and service costing
- Improved pricing and product mix decisions
- Better identification of unprofitable products or customers
- Greater focus on activities and process improvement

Limitations:

- Implementation is time-consuming and may require significant data collection
- May be costly, especially in environments with many activities and products
- Benefits may be limited if overheads are low or product diversity is minimal
- Not all costs can always be strictly linked to specific drivers

### **Revision Tip**

Familiarise yourself with typical activity and cost driver pairs—quick recall will save time in both calculation and evaluation questions.

## **Summary**

ABC provides a structured, activity-focused approach to assigning overheads, leading to more accurate cost allocation and better decision-making. By analysing activities and their drivers, ABM goes beyond costing to improve efficiency and profitability. Correct identification of cost pools, cost drivers, and their relationships is essential for success in performance management and in the ACCA APM exam.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Explain the purpose and principles of activity based costing
- Distinguish between cost pools and cost centres
- Define and select cost drivers for different activities
- Describe the steps to allocate overheads using ABC
- Contrast ABC with traditional absorption costing methods
- Apply ABC principles to product and customer profitability analysis
- Use ABC data in activity based management for process and efficiency improvement
- Evaluate potential benefits and challenges when implementing ABC and ABM

## **Key Terms and Concepts**

- activity based costing (ABC)
- cost pool
- cost driver
- activity based management (ABM)

Activity based costing and management - Cost drivers cost pools and allocation