| Activity-based costing (ABC) | | | | accurately reflect the activities performed and |
| Traditional absorption costing was developed at a | | | | resources used to make the product. |
| time when many organisations produced only a | | | | ABC can help in distinguishing between profitable and |
| narrow range of products and when overhead costs | | | | unprofitable products and customers. |
| were only a small fraction of total costs. | | | | By focussing attention on cost drivers it will help |
| Activity based costing uses a number of different | | | | managers understand and manage overhead cost. |
| cost drivers to absorb different overheads, whereas | | | | An understanding of cost driver rates can help in |
| traditional absorption costing only uses one, for | | | | budgeting overhead expenditure. |
| example labour hours, machine hours or per unit. | | | | ABC concerns itself with all overhead costs, and as a |
| In activity based costing fixed overhead costs may | | | | consequence it has proved very useful in service |
| include machine set-up costs. These costs will not be | | | | industries. |
| incurred on a per unit basis but will be incurred each | | | | Circumstances in which activity based costing would |
| time the machine has to be set-up. It would not, | | | | be an appropriate approach to product costing. |
| therefore, be sensible to allocate costs per unit since | | | | Activity based costing can be used in almost any |
| that is not how the cost is incurred. It is, however, | | | | product-costing situation. |
| better to use the number of set-ups for this | | | | It is most useful when:v Overheads form a high |
| particular cost to allocate costs to units. | | | | proportion of total cost.v More than one product is |
| In this way an organization can precisely estimate the | | | | made.v Different products result in different levels |
| cost of its individual products and services for the | | | | of activities and resource consumption.v Where |
| purposes of identifying and eliminating those which | | | | overhead expenditure is not driven by volume of |
| are unprofitable and lowering the prices of those | | | | output, but by the complexity and diversity of |
| which are overpriced. | | | | operations. |
| ABC is widely used in the public sector, including by | | | | COST DRIVER is the unit of an activity that causes |
| the United States Marine Corps. | | | | the change of an activity cost. A cost driver is any |
| Its use by the UK Police has been mandated since | | | | activity that causes a cost to be incurred. |
| the 2003-04 UK tax year | | | | The Activity Based Costing (ABC) approach |
| ADVANTAGES | | | | relates indirect cost to the activities that drive them |
| Unit costs calculated under ABC should more | | | | to be incurred. |