## Activity Based Costing (ABC) – Definition
ABC is an accounting methodology that assigns costs to activities rather than products or services, enabling overhead costs to be assigned more accurately to the products and services that actually consume them.
> ABC identifies the cost of each cost-driving activity and uses it as the basis for apportioning costs to different cost objects (jobs, products, customers, or services).
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## Why ABC Was Developed – Key Triggers
1. Growing overhead costs due to increasingly automated production – traditional volume-based methods became distorting
2. Intense market competition requiring more accurate product costs for pricing
3. Increasing product diversity – a single overhead rate misrepresents cost when products have very different complexity
4. Falling IT costs – made detailed activity tracking economically viable
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## When is ABC Suitable?
| Condition | Why ABC Helps |
|---|---|
| High overhead costs | Overheads form a significant share of total cost – accuracy matters |
| Wide product range / diversity | Different products consume activities in different proportions |
| Significant non-volume-related activities | E.g., material handling, inspections, set-ups – traditional costing can't handle these well |
| Stiff competition | Accurate costs enable better pricing and cost reduction decisions |
ABC also identifies non-value-adding activities that can be targeted for elimination, enabling cost reduction beyond just better measurement.
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## Key Terms in ABC
| Term | Definition |
|---|---|
| Activity | An event that incurs cost (e.g., machine set-up, inspection, material handling) |
| Cost Object | An item for which cost measurement is required – a product, service, or customer |
| Cost Driver | A factor that causes a change in the cost of an activity |
| Cost Pool | A group of cost items that share the same cause-and-effect relationship (e.g., all machine set-up costs) |
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## Types of Cost Drivers
### Resource Cost Driver
- Measures the quantity of resources consumed by an activity
- Used to assign resource cost → activity / cost pool
- Example: Square footage used by an activity (to assign rent to the activity)
### Activity Cost Driver
- Measures the frequency and intensity of demand placed on activities by cost objects
- Used to assign activity cost → cost objects (products/customers)
- Example: Number of set-ups (to assign set-up cost to products)
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## Cost Drivers by Business Function
| Business Function | Typical Cost Drivers |
|---|---|
| Research & Development | No. of research projects; personnel hours on a project |
| Design of products/services | No. of products in design; design complexity index |