Cost Accounting — Activity-Based Costing (ABC): Activities, Cost Drivers and the Cost Hierarchy

Traditional costing allocates manufacturing overhead on a single volume-based measure such as direct labor hours or machine hours. Yet much of the overhead in today’s factories arises not from output but from the number of batches, setups and product types. Activity-based costing (ABC) gathers overhead by the activities that cause it and allocates it to products according to how much of each activity they consume.

1. The ABC procedure

Identify the main activities (setups, purchase orders, quality inspection, machine operation).
Gather manufacturing overhead into a cost pool for each activity.
Choose the cost driver that causes each activity’s costs (number of setups, number of orders, inspection hours, machine hours).
Calculate each activity’s rate: activity cost ÷ total quantity of the cost driver.
Allocate by multiplying the rate by the quantity of the driver each product consumed.

2. The cost hierarchy

The cost hierarchy of activities
Level	What causes the cost	Examples	Cost drivers
Unit level	Producing one unit	Power for running machines, supplies	Machine hours, units produced
Batch level	Processing one batch	Setups, purchase orders, first-item inspection	Number of setups, number of orders
Product level	Sustaining one product line	Product design, parts administration, engineering changes	Number of products, number of engineering changes
Facility level	Sustaining the whole plant	Plant administration, building depreciation, insurance	Weak allocation bases (floor space, etc.)

Batch-level and product-level costs are not proportional to output. Setup cost is the same whether a batch has 100 units or 10,000. So volume-based allocation loads too much of these costs onto high-volume products and too little onto low-volume ones.

3. Worked example

Company AB makes a high-volume standard product S and a low-volume custom product C. Manufacturing overhead totals ₩120 million.

Product data
Item	Standard S	Custom C	Total
Units produced	10,000	1,000
Direct labor hours	20,000	4,000	24,000
Number of setups	20	80	100
Inspection hours	300	700	1,000
Machine hours	30,000	10,000	40,000

Activity costs are ₩40 million for setups, ₩30 million for quality inspection and ₩50 million for machine operation.

A. Traditional allocation (direct labor hours)

The rate is $12{,}000 / 24{,}000 = 0.5$ (₩5,000 per hour). S is allocated ₩100 million and C ₩20 million, so overhead per unit is ₩10,000 for S and ₩20,000 for C.

B. ABC allocation

Allocation by activity (unit: ₩10,000)
Activity	Rate	S	C
Setups	4,000 ÷ 100 setups = 40	20 × 40 = 800	80 × 40 = 3,200
Quality inspection	3,000 ÷ 1,000 hours = 3	300 × 3 = 900	700 × 3 = 2,100
Machine operation	5,000 ÷ 40,000 hours = 0.125	30,000 × 0.125 = 3,750	10,000 × 0.125 = 1,250
Total		5,450	6,550
Overhead per unit		0.545	6.55

Size of the cost distortion

\text{Overhead per unit of C}: \underbrace{2}_{\text{traditional}} \rightarrow \underbrace{6.55}_{\text{ABC}}, \qquad \text{S}: 1 \rightarrow 0.545

In ₩10,000. The traditional method shifted the custom product's setup and inspection costs onto the standard product, undercosting C by about ₩45,500 and overcosting S by about ₩4,550.

4. Uses and limits of ABC

ABC information is used for pricing, product mix, customer profitability analysis and process improvement. If the cost of custom product C rises sharply, options appear: raise its price, cut setup time to lower the cost, or set a minimum order quantity. Managing to reduce activity costs is called activity-based management (ABM).

Check your understanding

Company AC makes two products, M (5,000 units, 50 orders) and N (500 units, 150 orders). What is N’s purchase-order processing cost per unit when ₩8 million of order processing cost is allocated on units produced, and when it is allocated on the number of orders (ABC)?

On units produced, the rate is $800 / 5{,}500 ≈ 0.145$ per unit (₩10,000), so N’s cost is about ₩1,455 per unit. On number of orders, the rate is $800 / 200 = 4$ (₩40,000) per order; N is allocated $150 \times 4 = 600$ (₩6 million), i.e. ₩12,000 per unit. The cost of N, a low-volume product ordered frequently, is badly undercosted on the volume basis.

References

Robert Kaplan and Robin Cooper, Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance
Charles Horngren, Srikant Datar and Madhav Rajan, Cost Accounting: A Managerial Emphasis, ch. 5
Robert Kaplan and Steven Anderson, “Time-Driven Activity-Based Costing,” Harvard Business Review (2004)