## Activity Based Costing vs Traditional Absorption Costing

### Core Distinction

Traditional costing lumps overheads into cost centres/departments and uses time (hours) as the single assumed cost driver. ABC traces overheads to activities first, then to cost objects — making cost behaviour far more realistic.

Dimension	ABC	Traditional
Overhead grouping	Activity cost pools	Cost centres / departments
Cost driver	Activity-specific driver	Time (hours) assumed for all
Recovery rate	One rate per activity	Single or departmental rates
Cost objects	Products, customers, services, departments	Products, jobs, hours
Cost control	Eliminate unnecessary activities	Cannot eliminate cost centres
Realism	Higher — reflects actual consumption	Lower — arbitrary allocation

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## Levels of Activities

ABC classifies activities into four hierarchical levels based on what triggers their consumption:

### 1. Unit-Level Activities

Consumed in proportion to every unit produced
Examples: indirect materials/consumables, testing every 100th item

### 2. Batch-Level Activities

Triggered once per batch, regardless of batch size
Cost varies with number of batches, not individual units
Examples: machine set-up, purchase order processing, first-item-in-batch inspection

### 3. Product-Level Activities

Support a product line as a whole, not individual units or batches
Examples: product design, parts specifications, maintaining technical drawings

### 4. Facility-Level (Sustaining) Activities

Cannot be traced to individual products; sustain the entire manufacturing process
Examples: building maintenance, plant security

> Exam tip: The level determines which cost driver is appropriate. Batch-level costs should never be divided by units produced — that distorts unit cost.

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## Common Cost Drivers by Activity Pool

Activity Pool	Cost Driver
Ordering & Receiving Materials	Number of purchase orders
Machine Set-up	Number of set-ups
Machining	Machine hours
Assembling	Number of parts
Inspecting & Testing	Number of tests
Painting	Number of parts
Supervising	Direct labour hours

Worked example

### Example 1

Identifying the right level:

A factory produces two products — X (high volume) and Y (low volume, many variants).

Machine set-up cost ₹2,00,000 for 40 set-ups → Batch-level; cost driver = number of set-ups
Rate = ₹2,00,000 ÷ 40 = ₹5,000 per set-up
Product X requires 5 set-ups; Product Y requires 35 set-ups
Cost assigned: X = ₹25,000; Y = ₹1,75,000

Under traditional costing, if X produces 80% of units, it would absorb 80% of set-up cost = ₹1,60,000 — massively overstated for X and understated for Y.

### Example 2

ABC vs Traditional — overhead distortion:

Two products share a machine department. Traditional rate = ₹50/machine hour.

Product A: 1,000 units × 2 machine hours = 2,000 hrs → overhead absorbed = ₹1,00,000
Product B: 500 units × 2 machine hours = 1,000 hrs → overhead absorbed = ₹50,000

ABC reveals Product B also triggers 80 purchase orders vs Product A's 20. If ordering cost pool = ₹1,00,000 for 100 orders → ₹1,000/order:

Product A: 20 × ₹1,000 = ₹20,000
Product B: 80 × ₹1,000 = ₹80,000

Product B is actually far more expensive to support than traditional costing showed.

⚠️ Common exam mistakes

Confusing batch-level and unit-level: dividing machine set-up cost by total units produced instead of number of batches.
Treating facility-level (sustaining) costs as if they have a meaningful per-unit driver — they should be absorbed using an arbitrary base or excluded from product cost.
Assuming ABC always gives a lower product cost than traditional — it reallocates cost, so some products go up and some go down.
Using a single overhead recovery rate in ABC problems — ABC requires a separate rate for each activity cost pool.

Reference:

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ABC vs Traditional Costing & Levels of Activities

Worked example

⚠️ Common exam mistakes