# Activity Based Costing (ABC)
## Core Principle
ABC is a modern overhead allocation method that traces costs to activities rather than departments. The logic flows in two stages:
> Resources → Activities → Products/Services
Products do not consume costs directly. Money is spent on activities, and activities are consumed by products.
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## ABC vs Traditional Absorption Costing
| Dimension | Traditional Absorption Costing | Activity Based Costing |
|---|---|---|
| Cost flow | Overheads → Departments → Products | Overheads → Activities → Products |
| Realism | Less realistic | More accurate |
| Allocation bases | Direct labour hours, machine hours, prime cost, direct material/labour cost | Activities involved in production |
| Rate formula | Total Overheads ÷ Chosen basis | Total Overheads ÷ Related activities |
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## Types of Activities — Manufacturing Cost Hierarchy (Cooper, 1990)
| Level | Driven by | Example |
|---|---|---|
| Unit level | Number of units produced | Use of indirect materials |
| Batch level | Number of batches | Material ordering in batches; production run setup |
| Product level | Creation of a new product | Designing a new product |
| Facility level | Existence of the facility (not tied to individual products) | Production manager's salary |
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## Objectives of ABC
1. Improve accuracy of product costing
2. Identify and eliminate non-value-adding activities
3. Provide information for managerial decision making
4. Reduce non-essential use of common resources
5. Help managers evaluate efficiency of internally provided services
6. Calculate full cost for financial reporting and cost-based pricing
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## Importance of ABC
- Links cost to its causal factor — the Cost Driver
- Overcomes the limitations of blanket overhead rates used in traditional costing
- Assists in budgeting and performance measurement
- Supports cost control, cost reduction, and improved profitability
- Delivers: accurate product cost data, comprehensive performance information, relevant decision-making data
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## Uses of ABC
| Use Area | How ABC Helps |
|---|---|
| Activity costs | Track and benchmark activity costs; feedback tool for cost reduction |
| Customer profitability | Identify which customers yield real profit after overhead (service levels, returns, marketing agreements) |
| Distribution channel cost | Allocate overhead to channels; drop unprofitable channels |
| Make or buy | Compare in-house overhead vs outsourcer's cost |
| Margins | Determine margins across products, product lines, subsidiaries |
| Minimum price | Identify relevant overhead for floor pricing; avoid loss-making sales |
| Production facility cost | Compare costs across facilities for operational decisions |
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## Limitations of ABC
1. Costly and resource-intensive to implement and maintain
2. Complex — requires extensive record-keeping
3. Small organisations tend to resist change from familiar traditional systems
4. ABC data can be misinterpreted; managers must judge what is relevant for each decision
5. Reports do not conform to GAAP — organisations must maintain two parallel cost systems (one internal, one for external reporting)