ACTIVITY BASED COSTING (A.B.

C)

Activity-based costing (ABC) is a form of absorption costing that takes a

different approach to the apportionment and absorption of production
overhead costs.

Activity-based costing is based on the following ideas:

1. In a modern manufacturing environment, a large proportion of total

costs are overhead costs, and direct labour costs are relatively small.

2. It is appropriate to trace these costs as accurately as possible to the

products that create the cost because overhead costs are large.

3. The traditional methods of absorbing production overhead costs on the

basis of direct labour hours or machine hours have no rational
justification as many production overhead costs are not directly related to
the production work that is carried out.

Activities

Activity-based costing (ABC) takes the view that many production

overhead costs can be associated with particular activities other than
direct production work.

If such activities can be identified and costs linked to them overhead

costs can then be added to product costs by using a separate absorption
rate for each activity.

ABC costing of overheads and estimate of full production costs is

therefore based on activities, rather than hours worked in production.
Cost Drivers

For each activity, there should be a cost driver. A cost driver is the factor
that determines the cost of the activity. It is something that will cause the
costs for an activity to increase as more of the activity is performed.

Overhead costs are therefore caused by activities, and the costs of

activities are driven by factors other than production volume.

Each cost driver must be a factor that can be measured so that the
number of units of the cost driver that have occurred during each period
can be established.

Cost Pools

A cost pool is simply the overhead expenditure allocated and apportioned

to an activity. Overhead costs are allocated (or allocated and apportioned)
to each activity, and for each activity there is a ‘cost pool’.

ABC absorbs overheads into the cost of products (or services) at a

separate rate for each cost pool (each activity).

The total production cost for each product or service is therefore direct
production costs plus absorbed overheads for each activity.

Overhead Absorption Rate (O.A.R)

This is the rate that will enhance a fair absorption basis of the overheads.
Traditional method is based on labour hour,machine hour and any other
basis while ABC is based on the cost driver.
When Using ABC Might Be Appropriate

Activity-based costing could be suitable as a method of costing in the

following circumstances:

1. In a manufacturing environment, where absorption costing is required

for inventory valuations.

2. Where a large proportion of production costs are overhead costs, and

direct labour costs are relatively small.

3. Where products are complex.

4. Where products are provided to customer specifications.

5. Where order sizes differ substantially, and order handling and despatch
activity costs are significant.

Advantages

1. ABC provides useful information about the activities that drive

overhead costs. Traditional absorption costing and marginal costing do
not do this.

2. ABC also provides information that could be relevant to long-term cost

control and long-term product selection or product pricing.

3. With ABC, overheads are charged to products on the basis of the

activities that are required to provide the product: Each product should
therefore be charged with a ‘fair share’ of overhead cost that represents
the activities that go into making and selling it.

4. It might be argued that full product costs obtained with ABC are more
‘realistic’, although it can also be argued that full product cost information
is actually of little practical use or meaning for management.
5. There is also an argument that in the long-run, all overhead costs are
variable (even though they are fixed in the short-term). Measuring costs
with ABC might therefore provide management with useful information
for controlling activities and long-term costs.

Disadvantages

1. ABC systems are costly to design and use. The costs might not justify
the benefits.

2. The analysis of costs in an ABC system may be based on unreliable

data and weak assumptions. In particular, ABC systems may be based on
inappropriate activities and cost pools, and incorrect assumptions about
cost drivers.

3. ABC provides an analysis of historical costs. Decision-making by

management should be based on expectations of future cash flows.

4. Within ABC systems, there is still a large amount of overhead cost

apportionment. General overhead costs such as rental costs, insurance
costs and heating and lighting costs may be apportioned between cost
pools. This reduces the causal link between the cost driver and the
activity cost.

5. Many ABC systems are based on just a small number of cost pools and
cost drivers. More complex systems are difficult to justify, on grounds of
cost.

6. Identifying the most suitable cost driver for a cost pool/activity is often
difficult. Many activities and cost pools have more than one cost driver.

7. Traditional cost accounting systems may be more appropriate for the

purpose of inventory valuation and financial reporting.
SAMPLE QUESTION 1

MAY 2017 - QUESTION 2 (SADET NIGERIA LIMITED)

SAMPLE QUESTION 2

MAY 2021 - QUESTION 6 ( CHUKWUKAH NIGERIA LIMITED)

SAMPLE QUESTION 3

NOVEMBER 2017 - QUESTION 3 ( XYZ NIGERIA LIMITED)

SAMPLE QUESTION 4

NOVEMBER 2019 - QUESTION 2 (LUANDA NIGERIA LIMITED)

SAMPLE QUESTION 5

NOVEMBER 2022 - QUESTION 2 ( IBEZI NIGERIA LIMITED)

SAMPLE QUESTION 6