# Activity Based Costing (ABC)
## Definition
CIMA Definition: "Cost attribution to cost units on the basis of benefit received from indirect activities e.g. ordering, setting up, assuring quality."
ABC is a two-stage costing approach:
1. Stage 1: Assign costs to activities (create cost pools per activity)
2. Stage 2: Allocate activity costs to products based on each product's consumption of those activities
Core Principle: Products consume activities → Activities consume resources
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## Features of ABC
1. Two-stage approach: costs flow from resources → activities → products
2. The costs accumulated are called activity-related costs
3. An activity is any task an organization undertakes to deliver a product or service
4. Products are charged in proportion to the extent to which they use each activity
5. Applicable to any organization seeking more accurate overhead costs
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## Types of Activities (Cost Hierarchy)
| Level | Activity | Example |
|---|---|---|
| Unit-level | Performed for every unit produced | Machine running, direct labour |
| Batch-level | Performed for each batch | Machine set-ups, quality inspection per batch |
| Product-level | Supports a specific product line | Product design, product-specific advertising |
| Facility-level | Supports the overall facility | Factory rent, building security |
Only unit-level and batch-level costs are truly driven by product volume. Product-level and facility-level costs require care in allocation.
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## Benefits of ABC
1. Each product charged based on its actual consumption of activities — more accurate costs
2. Better identification of cost drivers — management understands what causes costs
3. Highlights non-value-added activities that can be eliminated
4. Supports better pricing decisions — especially for diverse product mixes
5. Improved cost control — managers accountable for activities they control
6. More relevant for organizations with diverse, complex product lines where traditional costing distorts costs
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## ABC vs. Traditional Absorption Costing
| Aspect | Absorption Costing | Activity Based Costing |
|---|---|---|
| Overhead basis | Volume-based (machine hrs, labour hrs) | Activity-based (cost drivers per activity) |
| Number of cost pools | Single or very few | Multiple (one per activity type) |
| Accuracy | Lower — distorts for diverse products | Higher — reflects actual resource consumption |
| Suitable for | Simple, homogeneous product lines | Complex, diverse product mixes |
| Cost driver | One (e.g., labour hours) | Many (set-ups, orders, inspections, etc.) |
Critical insight: Traditional costing over-costs high-volume, simple products and under-costs low-volume, complex products. ABC corrects this by linking overhead to the activities that actually drive it.
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## Objectives of ABC
- Provide accurate product cost information for pricing
- Identify profitable and unprofitable products
- Improve business processes by highlighting high-cost activities
- Support strategic decisions on product mix, outsourcing, and process improvement
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## Limitations of ABC
1. Costly and time-consuming to design and implement
2. Selection of cost drivers is complex — wrong drivers distort results
3. Not suitable for simple operations or homogeneous product lines
4. Requires significant ongoing data collection and maintenance effort
5. May create over-sophistication — the added accuracy may not always justify the cost