4.1 Activity Based Costing (ABC)

2026 Syllabus Objectives

By the end of this topic, you should be able to:

  1. Explain the application of Activity Based Costing (ABC)
  2. Describe the uses and limitations of ABC
  3. Explain what is meant by a cost driver
  4. Use ABC to: identify the appropriate cost driver, apportion and allocate overheads, and calculate the total cost and selling price of a unit
  5. Explain the effect of different methods of overhead absorption on cost and profit
  6. Apply ABC costing techniques to make business decisions and recommendations using supporting data

1. What is Activity Based Costing (ABC)?

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Before understanding ABC, you need to understand the problem it was designed to solve.

The Problem with Traditional Overhead Absorption

In traditional costing, a business adds up all its overhead costs (indirect costs — things like factory rent, electricity, and machine maintenance that cannot be directly traced to a single product) and then spreads them across products using a single measurement, such as labour hours or machine hours. This is called overhead absorption.

The problem: Modern businesses often make many different products. Some products are simple and quick to make. Others are complex and require lots of special attention, setups, inspections, or orders. If you spread all overheads using just one measure (like labour hours), you end up over-charging some products and under-charging others. This gives you an inaccurate picture of what each product actually costs.

Example: Imagine a factory that makes two products — plain wooden chairs (simple, high volume) and custom carved chairs (complex, low volume). If overheads are spread using labour hours alone, the plain chairs absorb a huge chunk of overhead simply because more of them are made. But the custom chairs actually cause more overhead activity (more setups, more quality checks, more supplier orders). Traditional costing gets this wrong.

The ABC Solution

Activity Based Costing (ABC) is a more accurate method of sharing out overhead costs. Instead of using just one measure to spread all overheads, ABC:

  1. Identifies the main activities in the business that cause overhead costs (e.g., setting up machines, placing purchase orders, inspecting products).
  2. Groups overhead costs into cost pools — one pool for each activity.
  3. Finds a cost driver for each activity — a measure of what causes that activity's cost to increase.
  4. Uses those cost drivers to charge overhead costs to products in proportion to how much each product actually uses each activity.

This gives a much more accurate cost per product.

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