## **Learning Outcomes**

After reading this article, you will be able to explain the principles of activity-based costing and activity-based management, identify suitable cost drivers, calculate product costs using ABC, distinguish ABC from traditional absorption costing, and discuss the advantages and limitations of ABC for performance measurement and decision-making in the ACCA Performance Management (PM) exam.

## **ACCA Performance Management (PM) Syllabus**

For ACCA Performance Management (PM), you are required to understand modern approaches to costing such as activity-based costing (ABC) and activity-based management (ABM). Key knowledge and skills include:

- Describing the reasons for using ABC versus traditional absorption costing, especially in complex or diverse production environments
- Identifying appropriate activity cost pools and cost drivers for ABC
- Calculating overheads per cost pool and per unit using ABC methods
- Contrasting ABC and traditional overhead absorption based on units, labour or machine hours
- Discussing the advantages, disadvantages, and limitations of ABC in practice
- Explaining the concept of activity-based management and how ABC information supports cost control and process improvement

## **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. Which of the following most clearly distinguishes activity-based costing (ABC) from traditional absorption costing?
   a) ABC treats all production costs as variable  
   b) ABC attributes overheads based on a single factor  
   c) ABC uses multiple activity cost pools and cost drivers  
   d) ABC excludes fixed overheads from product costs

2. When is ABC likely to give significantly different results compared to traditional overhead absorption?
   a) Where overheads are a minor cost  
   b) Where all products are similar and produced in bulk  
   c) Where production environments are complex and diverse  
   d) Where only direct materials and direct labour costs exist

3. True or false? In ABC, cost drivers should reflect the cause of overhead costs, not just production volume.

4. Briefly define an “activity cost pool” and give one example of a typical cost driver.

## **Introduction**

Businesses increasingly need accurate product cost information, not just for inventory valuation but for competitive pricing, cost control, and strategic decisions. As manufacturing processes have become more complex, traditional absorption costing often fails to reflect the real consumption of resources. Overheads driven by factors other than simple production volume can distort product costs, leading to poor decision-making. Activity-based costing and activity-based management address this issue by tracing overhead costs to specific activities and assigning them to products based on cost drivers that reflect actual resource use.

> **Key Term: activity-based costing (ABC)**
> A costing method that assigns overheads to products based on each product’s use of specific activities, using multiple cost pools and cost drivers rather than a single volume-based allocation.

## WHY TRADITIONAL COSTING OFTEN FAILS

Traditional absorption costing assumes that all overheads are incurred in proportion to output volume—typically allocating them on the basis of direct labour or machine hours. This approach may be reasonable for a single-product, labour-intensive environment. However, in modern production, overheads are often driven by activities such as machine setups, order processing, or quality inspections, which may be caused by product complexity or batch size rather than the number of units made. As a result, traditional methods can over-cost high-volume, simple products and under-cost complex, low-volume ones.

> **Key Term: cost driver**
> A measurable factor that causes a particular activity’s costs to increase or decrease—for example, the number of setups, purchase orders, or machine hours.
>
> **Key Term: activity cost pool**
> A grouping of overhead costs relating to the same activity, which are later allocated to products using cost drivers.

## PRINCIPLES OF ACTIVITY-BASED COSTING (ABC)

ABC allocates overheads in a two-step process:

1. **Allocate overheads to activity cost pools.** These pools represent the major activities that consume resources, such as setups, machine running, or quality inspections.
2. **Absorb costs from each activity pool to products using appropriate cost drivers.** Each driver represents the cause of costs for that activity, making overhead allocation more accurate.

ABC is particularly useful where:

- Products are diverse in complexity, batch size or production process
- Overheads form a large part of total cost
- Indirect resource consumption varies significantly between products

### Comparison to Traditional Absorption Costing

| Feature                | Traditional Absorption Costing         | Activity-Based Costing                 |
| ---------------------- | -------------------------------------- | -------------------------------------- |
| Overhead allocation    | Generally one base (e.g. labour)       | Multiple activity cost pools/drivers   |
| Overhead cost accuracy | May distort for complex/mixed products | Improved for complex environments      |
| Volume link            | Tied to output volume                  | Linked to actual cost-causing activity |

### **Worked Example 1.1**

ABC Ltd manufactures three products. Overhead costs for the period are:

- Machine running costs: \$10,000 (driven by machine hours)
- Set-up costs: \$30,000 (driven by number of set-ups)
- Quality inspection: \$12,000 (driven by inspections)

Product data:
| | Product X | Product Y | Product Z |
|----------------|-----------|-----------|-----------|
| Units made | 1,000 | 500 | 100 |
| Machine hours | 200 | 300 | 100 |
| Set-ups | 10 | 20 | 30 |
| Inspections | 5 | 10 | 15 |

Calculate the overhead cost per unit for each product using ABC.

> **Answer:**
>
> Step 1: Calculate OARs for each activity:
>
> - Machine running: \$10,000 ÷ (200+300+100) = \$20 per machine hour
> - Set-up: \$30,000 ÷ (10+20+30) = \$750 per set-up
> - Inspection: \$12,000 ÷ (5+10+15) = \$400 per inspection
>   Step 2: Allocate costs by product:
> - Machine running: X=\$4,000; Y=\$6,000; Z=\$2,000
> - Set-ups: X=\$7,500; Y=\$15,000; Z=\$22,500
> - Inspection: X=\$2,000; Y=\$4,000; Z=\$6,000
>   Overhead total for X: \$4,000+\$7,500+\$2,000=\$13,500 (per unit: \$13.50)
>   Y: \$6,000+\$15,000+\$4,000=\$25,000 (per unit: \$50)
>   Z: \$2,000+\$22,500+\$6,000=\$30,500 (per unit: \$305)
>   ABC highlights that Product Z, though low in volume, absorbs significantly more overhead per unit because it requires more setups and inspections. Traditional absorption costing would likely have spread costs based solely on units or hours and missed this distinction.

### **Exam Warning**

Always check if the scenario has products differing in complexity, setup, or batch size. These are clues that ABC might produce a very different—and more accurate—cost per product than traditional methods. In the exam, use cost drivers that reflect actual resource use, not just output volume.

## WHEN TO USE ABC

ABC is most valuable when:

- Overheads are high relative to direct costs
- Products vary in complexity or require different support activities
- Cost structure is shifting from direct labour to overheads
- Management requires improved cost information for decision-making, pricing, or process improvement

> **Key Term: activity-based management (ABM)**
> The use of ABC information to identify cost control opportunities, improve processes, and manage activities for better performance.

## ACTIVITY-BASED MANAGEMENT (ABM) AND PERFORMANCE IMPROVEMENT

Once ABC data identifies cost drivers, companies can manage or reduce costs in high-impact areas. Management might focus on:

- Reducing the number of setups or rework
- Streamlining processes to eliminate non-value-adding activities
- Targeting process improvements where costs are concentrated

ABM supports continuous improvement by relating costs to activities, allowing targeted action.

### **Worked Example 1.2**

A factory finds that set-up activities are the largest source of overhead. The manager notices one product (Product C) requires small frequent batches, causing more setups.

Suggest two management actions to reduce Product C's cost per unit using ABC/ABM information.

> **Answer:**
>
> Action 1: Increase the batch size for Product C to reduce the number of setups per period, cutting set-up costs per unit.
> Action 2: Invest in faster or automated setup procedures to lower the time and cost per setup event.

## ADVANTAGES AND LIMITATIONS OF ABC

**Advantages:**

- More accurate product cost information, aiding decisions
- Highlights cost drivers for better control and cost reduction
- Supports process improvement through ABM
- Reduces arbitrary allocation of overheads

**Limitations:**

- Can be time-consuming and costly to implement
- Not all overheads can be directly traced to activities
- May not provide significant benefit if overheads are small or volume-related
- Choice of activities and drivers may be subjective

### **Revision Tip**

Practice identifying scenarios where ABC meaningfully improves cost accuracy—especially when overheads are not volume-driven or when products have diverse resource usage.

## SUMMARY COMPARISON: WHEN TO USE WHICH SYSTEM

| Scenario                       | Traditional Absorption Costing | ABC/ABM                      |
| ------------------------------ | ------------------------------ | ---------------------------- |
| Simple, high-volume production | Frequently sufficient          | Likely unnecessary           |
| Diverse, complex production    | Can distort product cost       | Produces more accurate costs |
| Overheads mainly volume driven | Reasonable approach            | Adds limited benefit         |
| Overheads activity-driven      | Likely inaccurate              | Essential for accuracy       |

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- Define and explain "activity-based costing" (ABC) and its contrast with traditional costing
- Identify and describe "cost drivers" and "activity cost pools" in ABC
- Calculate product costs using ABC using appropriate drivers
- Explain the concept of "activity-based management" (ABM) and its link to process improvement
- Discuss situations where ABC/ABM is most useful
- List main advantages and limitations of ABC

## **Key Terms and Concepts**

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


Costing systems - Activity-based costing and activity-based management