Activity-Based Costing
Cost Fundamentals
Activity-Based Costing
Syllabus tag: KASNEB CPA | Intermediate Level | CA25 Management Accounting | Topic 8 Activity-Based Costing
Lesson objectives
By the end of this topic, you will be able to:
- Explain why a single volume-based absorption rate distorts product costs
- Identify cost pools and select appropriate cost drivers
- Compute a cost driver rate and absorb overhead by activity
- Compare ABC and traditional absorption on the same figures
- State the practical limitations of ABC
Why this matters
Absorption costing spread overhead using labour hours because, when it was designed, labour was most of the cost. In a modern factory overhead is the larger figure and much of it has nothing to do with how long a product takes to make. ABC asks what actually causes each overhead, and charges it there.
One company throughout
Chui Ltd makes two products with total production overhead of KES 8,800,000.
| Product X | Product Y | |
|---|---|---|
| Units | 20,000 | 2,000 |
| Labour hours per unit | 2 | 2 |
| Machine setups | 40 | 180 |
| Inspections | 150 | 400 |
X is the high-volume simple product. Y is low-volume and fiddly — few units, but constant setups and inspections.
Traditional absorption
Total labour hours = (20,000 × 2) + (2,000 × 2) = 44,000 hours
OAR = 8,800,000 / 44,000 = KES 200 per labour hour
Since both products take 2 hours, both absorb 2 × 200 = KES 400 per unit.
| Product X | Product Y | |
|---|---|---|
| Overhead per unit | 400 | 400 |
| Total overhead | 8,000,000 | 800,000 |
X carries 91% of the overhead because it has 91% of the labour hours. Whether it causes 91% of the overhead is a question the method never asks.
Activity-based costing
Split the overhead into pools and find what drives each.
| Cost pool | Amount | Driver | Volume | Rate |
|---|---|---|---|---|
| Machine setups | 4,400,000 | setups | 220 | 20,000 per setup |
| Inspections | 4,400,000 | inspections | 550 | 8,000 per inspection |
Product X = (40 × 20,000) + (150 × 8,000) = 800,000 + 1,200,000 = KES 2,000,000
Product Y = (180 × 20,000) + (400 × 8,000) = 3,600,000 + 3,200,000 = KES 6,800,000
Total 8,800,000, which reconciles. ABC never changes the total overhead — only where it lands.
The comparison
| Overhead per unit | Traditional | ABC | Difference |
|---|---|---|---|
| Product X | 400 | 100 | overstated by 300 |
| Product Y | 400 | 3,400 | understated by 3,000 |
Product Y was costed at 400 a unit and actually consumes 3,400. Under traditional absorption it looked profitable and was quietly being subsidised by X.
This is the pattern ABC almost always exposes: high-volume simple products subsidise low-volume complex ones, because volume-based absorption charges by output while much overhead is driven by the number of transactions, not the number of units.
:::checkpoint Product Y sells for KES 3,000 a unit. Using each costing method in turn, say whether it is profitable, and explain what the company would probably have done had it relied on the traditional figure. :::
Choosing cost drivers
A driver must actually cause the cost. Setups drive setup costs because a setup is performed whenever a batch changes. Labour hours do not, because a batch of 10 and a batch of 10,000 need the same setup.
Common pools and their drivers:
- Setup costs — number of setups
- Ordering costs — number of purchase orders
- Inspection costs — number of inspections
- Materials handling — number of movements
- Machine costs — machine hours
Note the pattern: most are transaction counts, not volume measures. That is the whole difference from traditional absorption.
Limitations
ABC is more accurate and not free.
- Cost. Identifying pools and drivers and then collecting the transaction data is expensive and continuing.
- Judgement remains. Some overheads, such as the chief executive's salary, have no sensible driver and must still be apportioned arbitrarily.
- Still historic. ABC produces better product costs; it does not by itself produce better decisions.
- Not for short-term decisions. For a special order the relevant costing rules still apply. An ABC cost per unit includes fixed costs that will not change.
ABC is worth the effort where overhead is large, products differ markedly in complexity, and volumes differ markedly. Where a company makes one product, it changes nothing at all.
:::checkpoint A single-product company is considering adopting ABC. Explain what it would gain, and say what that tells you about when ABC is worth its cost. :::