Overheads and Activity Based Costing Contents


So far we have examined two of the components of cost, namely labour and material costs.  The third cost element is expenses, which comprises all items not falling within the other two categories.  Examples therefore include rent, rates, telephone charges, power, royalties payable to an inventor, depreciation of equipment, etc.

Direct and Indirect Expenses

We saw with both material and labour that such costs could be direct or indirect.  For instance, the wages of a skilled carpenter in a furniture factory are a direct cost, but the wages of a foreman or of a clerk in the cost office are normally indirect.  The distinction is that the carpenter’s wages can be identified with particular products, whereas the others cannot.

The same distinction applies in the case of expenses, although there are in fact very few examples of direct expenses.  Royalties payable to the inventor of a product are clearly a direct expense.  Another example would be the running cost of a machine used entirely for one particular product; in practice, however, most machines are used for a variety of products so their associated costs are indirect expenses.



If a business rents its factory, the rent payable is, of course, an expense.  Often, even if the premises are owned and no rent is paid, a notional charge in lieu of rent is included in the cost accounts.  This allows for the fact that the real cost of premises is not only the depreciation of those premises but also the interest on the capital which is tied up (which a landlord would allow for in fixing the rent).  This permits direct comparison of costs of production between different sites.

Interest on Capital

It may similarly be argued that the expenses in the cost accounts should include a notional charge for interest on capital in respect of all manufacturing equipment (regardless of whether money was in fact borrowed to purchase that equipment).  Arguments for and against this approach are as follows:

  In Favour of Including Interest on Capital
  • Just as wages are the reward for labour, interest is the reward for capital. Therefore an economist would argue that interest, as well as wages and other costs, ought to be taken into account in calculating profit.
  • False conclusions may be drawn from comparisons if interest is not taken into account. If one manufacturer makes his own sub-assemblies while another buys them ready-made, interest on the additional capital which the first manufacturer has tied up must be taken into account in deciding which of them has taken the more economical option.
  • Interest takes account of the time factor, which is of prime importance in production.
Against Including Interest on Capital
  • Interest payments depend on the manner in which the business is financed. One manufacturer may provide his own capital, while another may decide to raise loans.  The manner of financing does not affect the manufacturing cost but only the way in which the ultimate profit is distributed (whether used to pay interest on loans or available for the owner).
  • How should interest be calculated? Should the cost of fixed assets alone be used, or should capital tied up in stocks also be taken into account?  What rate of interest should be used?  Problems arise when comparisons are required between firms in the same industry and in many cases production costs may be widely different.
  • Inclusion will complicate the cost accounts and, if interest is included in stock valuations in the cost accounts, an adjustment would be required in order to arrive at stock valuations for the financial accounts.


The arguments against often outweigh the arguments in favour of inclusion of this interest as an expense.  However, when pricing a large order which the manufacturer will have to finance for a long period before receiving payment, it is reasonable to include an amount to cover interest on capital.



Depreciation is charged in order to apportion the capital cost of a fixed asset over its working life.  Depreciation is often a major part of the total overhead expense, so it is worth looking in some detail at the methods which are used to calculate it.

There are at least two methods of calculating an annual depreciation charge in common use:  i.e. the straight line method, whereby the capital cost of the machine, less any estimated residual value at the end of its life, is spread equally over the estimated number of years of life; and the reducing balance method, in which a percentage of the remaining book value of the machine is written off each year, so that the charge declines as the asset gets older.

In costing, we want to arrive at a level of annual charge for depreciation and find a means of apportioning it (along with other costs) to the individual products or jobs.  This is done by:

  • Estimating the number of hours to be worked by the machine per year and dividing the annual depreciation by this estimated number of hours, to arrive at a machine-hour rate.
  • Estimating the number of hours to be worked by the machine throughout its life, and dividing the capital cost, less any estimated residual value, by this number of hours, to arrive at a machine-hour rate.
  • Calculating a combined charge for depreciation and repairs, by dividing the capital cost less residual value plus the total expected repair bill over the asset’s life, by the estimated number of hours of use. The advantage of this method is that the cost charged in each year of the asset’s life is the same – the rate does not rise with the higher repair bills which will arise in the asset’s later years.  However, this method may be impractical, since it is difficult to estimate the total repair bill.

A better approach here is to use the reducing balance method.  Indeed, some would argue that this is one advantage of using the reducing balance method.  Consider the case of a company with only one large machine.  It can use either the straight line or the reducing balance method for depreciation.  It is known that with each year of usage, repair and maintenance costs will increase.



An overhead cost is defined in the CIMA Terminology as:

“The total cost of indirect materials, indirect labour, and indirect expenses”.

This means those items of material, wages or expense which, because of their general nature, cannot be charged direct to a particular job or process but have to be spread in some way over the various jobs or processes.

Identification of Overhead Costs

In considering what is a direct charge and what is an indirect charge, i.e. overhead, regard must be paid to the type of industry, the method of production and the organisation of the firm concerned.  For instance, in a general machine shop making a variety of products, the foreman’s wages would be an indirect or overhead charge, as there is no obvious method of identifying the cost of the foreman’s wages with a particular job; on a building site, the foreman’s wages would be a direct expense, as they can only relate to the contract in hand.

The Changing Problem of Overhead Costs

50 years ago most labour was manual, and such overhead expense as existed was a comparatively small proportion of total cost; today the position has changed radically.  Direct labour, as such, becomes an increasingly small proportion of total cost, and overhead expenses very much larger.  This tendency will undoubtedly continue as mechanisation and automation develop; and the cost accountant must always move with the times, developing and rearranging information to suit requirements.

We said earlier that a costing system must suit the business; it must suit not only the kind of business but also the stage of development of the business.  A costing system which was suitable for a car manufacturer 20 years ago is probably not suitable now – because of the changing relationship between direct labour and overheads and the enhanced information demands to manage the business.

With automation becoming increasingly important, there is a tendency for overheads to increase and for prime costs to decrease.  The installation of new machines will increase the depreciation charges and such items as service labour, while fewer workers will be needed to operate them (direct labour).

Classification by Function

There are three main classifications of overhead:  production, administration and selling, and distribution overhead.  These headings are associated with the three main functions of the business organisation and we should, as a first step, attempt to classify overhead expenditure into the appropriate categories.  Clearly, there are certain items of cost which appertain to all three, such as electricity, rent and rates, and it will be necessary to break these individual charges down to the shares appropriate to the main headings.

 Production Overhead

Before any business can start producing goods, it must have a building, which has to be heated, lit, ventilated and provided with energy to operate the machines.  The building must be kept clean and will need repair and redecoration from time to time, and in addition rent and rates will have to be paid.  The products will have to be designed and production must be planned, supervised and checked.  Records have to be kept, wages calculated, some form of stores must be operated and materials must be conveyed from point to point within the building.

These functions, and others, are not directly concerned with actual production, but are nonetheless essential and may be looked upon as services to the actual job of production.  It is the cost of providing these services which constitutes the production overhead.

Specific examples of this type of overhead are as follows:

  • Rent and rates of factories and land.
  • Insurance and depreciation of plant and machinery, and buildings. (iii) Salaries of the technical staff.
  • Repairs and maintenance of plant and machinery.
  • Consumable stores used in the factory.
  • Holidays, paid sick leave and idle time of factory employees.
  • Factory heating and lighting.
  • Internal transport expenses.

(The above is not intended to be an exhaustive list.)

Selling and Distribution Overhead

The dividing line between production overhead and selling and distribution overhead comes when the finished goods are delivered to the finished goods store.

Examples of selling and distribution overhead are:

−          Salesmen’s salaries

−          Salesmen’s expenses

−          Salesmen’s commission

−          Advertising

−          Samples

−          Depreciation of delivery vehicles

−          Carriage outwards

−                Vehicle drivers’ wages −    Warehouse charges


 Administration Overhead Examples are:

−          Office repairs

−          Office salaries

−          Depreciation of office machinery

−          Office heating and lighting

−          Postal charges

−    Stationery −    Share of rates.

Collection of Overhead

All expenditure as it is incurred is allocated its appropriate code number and is accumulated against each cost centre.  (Remember the definition of “cost centre” given in Study Unit 2.)  This will comprise wages and payments which are incurred at irregular intervals.  For example, rates may be paid either half-yearly or yearly and it is, therefore, possible that during a shorter period of, for instance, three months, either no expenditure will be incurred, or, alternatively, a whole year’s expenditure may be included.

We must, therefore, prepare a periodical “expense summary”, which ascertains the total expenditure to be charged to costs of production in respect of each cost centre.  It is necessary to improve the simple figures of payments made, by providing for expenditure incurred but not yet paid and for expenditure paid in advance.


 Allocation and Apportionment

You should learn the following CIMA definitions of cost allocation and cost apportionm

   Cost Allocation

“The charging of discrete identifiable items of cost to cost centres or cost units.”

 Cost Apportionment

“The division of costs among two or more cost centres in proportion to the estimated benefit received, using a proxy, e.g. square feet.”

As an example of cost allocation, repairs to the building housing the raw materials store could be allocated directly to the stores department cost centre.

Those items which cannot be allocated must be apportioned.  As the definition implies, there is no single correct way to apportion costs.  We have to use the most logical basis possible with the data at our disposal.


Cost Allocation



Cost Apportionment

You will find the following methods of cost apportionment among those used in practice:

Capital Value of Cost Centre

Where cost is increased by reference to the capital value of the cost centre it should be apportioned in the same way, e.g. fire insurance premium charged by reference to capital value.

Cost Centre Labour Cost

Where the cost depends on the extent of labour cost of the centre, such as in the case of employers’ liability insurance premiums, this should also form the basis for the apportionment of the premium paid.

Cost Centre Area

Where cost depends on the floor area, it should be apportioned in the same way, e.g. rent and rates.

Cost Centre Cubic Capacity

Where cost is incurred in phase with cubic capacity, it should be spread back on this basis, e.g. lighting.

Number of Employees at Cost Centre

The cost of providing a canteen service is generally proportional to the numbers employed, so it is reasonable to apportion it by reference to the number of employees at each cost centre.

  Technical Estimate

The chief engineer of a factory is in a position to estimate how the cost of certain expenses should be apportioned between the various cost centres of the factory.  Examples of this type of expense are as follows:


The wattage used in each department can be calculated and the cost of lighting apportioned to each cost centre accordingly.


The horsepower of machines in each cost centre can be established and the cost of power apportioned on this basis.

 Proportionate to Materials Issued

The expenses of operating the stores department, and “normal” stores losses, may be apportioned by this method, measuring materials by value, weight or volume, as appropriate.

 Proportionate to Production Hours

There are many items of expenditure which can be apportioned on this basis, although the figures are usually available only where a fairly comprehensive costing system is in operation.  Either labour hours or machine hours may be used.  Items which may be apportioned on this basis are:

  • Overtime wages (where not allocated direct).
  • Machine maintenance (where not chargeable direct).
Examples Example 1

Here is an example of overhead allotment.

A company has two production departments, X and Y and three service departments, stores, maintenance and production control.

We have now arrived at an estimate of the overhead appropriate to each department or cost centre.  However, we really need to express all overhead costs as being appropriate to one or other of the two production departments, for instance, so that we can include in the price of our products an element to cover overhead – for it is only in this way that costs incurred will be recovered.  Although costs have been incurred by the service departments, they have really in the end been incurred for the production departments.  The next step is therefore to re-apportion the costs of the service departments.  We do this in a similar way to that used in the original apportionment.

Additional data is provided:  the total number of material requisitions was 1,750, of which 175 were for maintenance department, 1,000 for Department X and 575 for Department Y.  This data will be used to apportion the cost of the stores department to these three departments.  Maintenance costs will be directly allocated to production control and Departments X and Y.  (In practice, a record may be kept of the number of maintenance hours needed in each department to provide data for cost apportionment.)  Production control costs will be apportioned between Departments X and Y according to the number of employees in those departments (already given).

Note that when a department’s costs are re-apportioned, the cost is credited to that department.

Having completed the re-apportionment, you will see that the total of overhead now attributed to Departments X and Y is, of course, equal to the original total of overhead.  This is something you should always check in doing examination questions of this type.

Examiners have been known to include direct costs in the list of costs, to trap the unwary, e.g. costs such as direct material and production wages.  If you are asked to allocate overheads, ignore direct costs.

In the above example, some of the stores department’s cost was incurred on behalf of the maintenance department, but not the other way round.  When service departments serve each other as well as the production departments (sometimes called reciprocal services), we must use repeated distribution to apportion their costs to the production cost centres.  An example follows.



Overhead absorption is the allotment of overhead to cost units by means of rates separately calculated for each cost centre.

In other words, when we talk about the amount of overhead absorbed by a product, we mean the proportion of the total overhead which we estimate is appropriate to that product.

If all items produced by a department were identical, there would be no problem.  We should simply take the total overhead incurred by each productive department (determined by the methods already described) and divide it by the number of products made, to arrive at an overhead rate for the product.  In practice, it is rarely as simple as that, for units are not identical.

The following are methods of overhead absorption found in practice.


Percentage on Prime Cost

This system is still, unfortunately, in widespread use where costing is fragmentary, and it must not be dismissed until you are quite clear why it is inadequate.

Imagine, a manufacturer asked to make a million pairs of army boots.  If the boots cost him RWF1 to make they would be sold to the government for RWF1.10, so he would have an income of RWF0.10 per pair to meet general overheads and profits.  If, however, he was a very inefficient manufacturer, so that his boots cost him RWF2 per pair to make, they would be sold to the government for RWF2.20 and he would have a sum of RWF0.20 to meet overheads and profits.  He had thus a very direct incentive to inefficiency and it is probably true to say that the need to remedy this abuse was one of the powerful factors contributing to the development of the cost accounting profession.

The only thing that can be said in favour of this percentage on prime cost is that it is simple and requires little clerical work, but it would only be approximately true when materials used on every job were equal in price, wages were uniform throughout (both for skilled and unskilled labour) and any equipment used was employed equally on all jobs.  As these conditions virtually never apply, the system should virtually never be used.



Overhead for the period  ×  100

Prime cost for the period

=  Percentage of prime cost

 Percentage on Direct Wages

This is a slight improvement on “percentage on prime cost”, because fluctuations due to the varying prices of direct materials are eliminated and, furthermore, there are a few items of expenditure which can, in fact, be reasonably absorbed on the basis of direct wages.  It is still very unsatisfactory in general, however, and the criticisms against it may be summarised as follows:

  • The ratio of wages cost to total hours spent on production may vary considerably where on one job skilled men are using expensive machines, and on others a large number of unskilled men are employed without much equipment.
  • The slower, and therefore usually the more inefficient, worker attracts a larger burden of overheads.
  • Where piece rates are used, the overhead recovered per piece will be constant, although much of this may have been done quickly by expert workers and the other part slowly by beginners.


Formula: Overhead for the period  ×  100

Wages for the period

=  Wages percentage rate


Points in its favour are:

  • It is simple and easy to calculate, especially where the costing system is rough and ready. • More consideration is given to the time factor.

Percentage on Direct Material

This method has the worst features of the previous two.  Only rarely is it found in practice that overhead is proportionate to material used.




Overhead for the period  ×  100

Direct materials used

=  Material percentage rate


 Absorption on Basis of Time

Anyone who has had any experience of costing will have concluded that much overhead expenditure is, above all else, subject to the time factor in its relation to output.  If one article takes twice as long to go through the factory as another, it should attract to itself twice the charge for lighting the factory as the other product, and this is only one example which you can probably multiply many times out of your own experience.  It is generally true, therefore, that by far the most valuable method of apportioning overhead is on a time basis, and this is usually of one of two kinds, a direct labour-hour rate and a machine-hour rate.

Occasionally a combination of both these will be in operation and a composite rate per production hour may be used.

 Direct Labour-Hour Rate

Where this system is used, the number of hours of direct labour worked at a production centre is estimated, and the number divided into the total figure shown in the expense summary for that production centre (or costing department) for the corresponding period.  The resultant figure gives an amount to be added to the direct cost of the output for every hour of the direct labour used throughout.


Hours may be either the number of hours expected to be worked, or the number of hours which would relate to working at normal capacity.


This is a very satisfactory method, particularly where a production centre uses little elaborate or expensive machinery, and when it may reasonably be said that every hour of direct labour absorbs the same amount of expense.  You must remember, however, that separate direct labour-hour rates should be calculated for each production centre and that holidays should be excluded, as should overtime hours, except when this is a regular recurring feature.


The advantages of this system are as follows:

  • The result is not invalidated by use of skilled and unskilled labour.
  • Proper provision is made to deal with fast and slow workers who are paid piece rates.
  • The figure of labour hours is a more useful guide to the management than the value of wages paid, because fluctuations due to varying overtime rates and wages increases are avoided.


Formula: Overhead for the period

Direct labour hours worked or budgeted to be worked in the period


=  Direct labour-hour rate



Machine-Hour Rate

Where machinery rather than labour is the dominant feature of a production centre, a rate of overhead per hour of machine time should be substituted for a rate per direct labour hour.

The “machine-hour rate” is defined as:

“A rate calculated by dividing the budgeted or estimated overhead or labour, and the overhead cost, attributable to a machine or group of similar machines by the appropriate number of machine hours.

The hours may be the number of hours for which the machine or group is expected to be operated, the number of hours which would relate to normal working for the factory, or full capacity.”

To find this machine-hour rate, it is necessary to estimate the number of hours of operation of the machine or machines in the cost centre during the period under consideration.  Allowance must be made for idle time and for cleaning and setting-up time.  The total expense is then divided by the number of working machine hours.

Machine-Hour Rate Where Machines Are Not Identical

In the above illustration the department operated identical machines.  Where the machines are not identical, however, it is necessary to calculate the rate for each machine separately.  You can apply the following principles:

  • Some expenditure can be directly allocated to the particular machine, e.g. power, cost of repairs, depreciation.

Overhead chargeable to the production centre in which the machine is located, and not to the individual machine, e.g. rent, rates, heating, is apportioned on the basis of area occupied.



In the examples considered so far, we have been dealing with a known total of overhead which we have allocated or apportioned to cost centres and hence to cost units.  In practice, of course, costs are being incurred while production is taking place, so that total costs are not known until the end of the period.  But management needs timely information on product costs as they are being incurred.  To overcome this problem, predetermined overhead rates are used.  These are based on estimated overheads and estimated production levels.  Each job then absorbs overhead at the predetermined rate.

Overhead Adjustment Account

At the end of each period it is necessary to compare the overhead which has been absorbed with that actually incurred.  Almost certainly there will be differences.  Overhead will have been over-absorbed if the production level was greater than anticipated, or if overhead costs were lower than anticipated.  Conversely, overhead will have been under-absorbed if the production level was lower than anticipated or overhead costs were greater.

The overhead over- or under-absorbed each month is transferred to an overhead adjustment account, and at the end of the year the net amount over- or under-absorbed is transferred to profit and loss account.  This method is preferable to the alternative of carrying forward a balance on the overhead account each month, although this alternative method is acceptable if the under- or over-absorption is caused purely by seasonal fluctuations where an average annual rate of overhead absorption is in use.  In this case, there will be under-absorption in some periods and over-absorption in other periods because of the seasonal factors, but the net effect over a year will be nil.  Nevertheless, since a cost accountant will rarely be in a position to say that all under- or over-absorption is due to seasonable factors, it is still considered preferable to operate an overhead adjustment account.

Blanket” Overhead Absorption Rates

Overhead absorption rates should preferably be calculated separately for each department.  However, a “blanket” rate for the whole factory may be acceptable in the following circumstances:

  • Where only one product is manufactured.
  • Where there are several products but they use approximately equal amounts of the services of all departments.
  • Where overhead forms a small proportion of total cost, and the extra work involved in calculating departmental absorption rates would not be worthwhile.


It is not generally worthwhile to attempt to be too scientific in apportioning administration costs to products.  For pricing purposes, the inclusion of an agreed percentage on production costs will generally be adequate.  For other purposes, there is no need to absorb administration costs into product costs:  instead they can be treated as period costs to be written off in the profit and loss account.


Variable Elements

Some elements of selling and distribution overhead vary directly with the quantities sold – for instance, commission of so much per unit paid to a salesman.  Such items can be charged directly to the product concerned in addition to the production cost.

Fixed Elements

Other items are incurred whether products are sold or not – for instance, rent of showrooms, salaries of salesmen.  Such items may be treated as period costs and written off in the profit and loss account or may be absorbed in one of three ways:

Percentage of

Selling overheads for the year RWF250,000

Estimated production cost of sales for year      RWF2,000,000


Absorption rate  =


Cost      ×  100  =  250 000,     ×  100  =  12½%

Activity                    2 000 000,  ,


12½% of production cost of each unit is calculated and added to that cost.

Care must be taken in applying this method.  For instance, suppose a company makes two products, A and B.  A costs twice as much as B to produce.  Therefore, a percentage on production cost basis would charge A with twice as much selling and distribution overhead as B.  However, it may very well be that there is a ready market for A, so there is no need to advertise it, whereas B is in competition with others and the company spends RWF10,000 on advertising B.  It is therefore clearly incorrect to charge A with twice the overhead which is charged to B.  Indeed, the advertising cost should have been charged directly to B.  The method is, however, acceptable if the costs involved are small, or if there is a limited range of products and those costs which do not vary with the cost of production can be charged direct.


What is Activity-Based Costing?

The two traditional costing methods are absorption costing and marginal costing, as we have seen.  Absorption costing allocates and apportions all overheads to products.  In order to do this, companies must allocate and apportion service overheads to the main production departments.  Direct labour and/or machine-hour rates are then derived, which are used to calculate the overheads attributable to each product.  The approach was developed in the early part of the 20th century and assumes that overheads directly relate to the level of production.  This is not always the case under current production methods, as factors such as sales mix, complexity, range and production techniques all influence overhead costs.  The method of apportionment can also seem arbitrary and the resulting product costs are sometimes difficult to interpret.

Marginal costing, on the other hand, makes no attempt to apportion overheads and a product’s marginal cost only includes direct material, direct labour and directly attributable overheads.  Sales less marginal cost establishes the company’s contribution, which should be managed in such a way that it covers all fixed overheads and generates the required level of profit.  Critics of this approach point to the danger of not apportioning all overheads to products and the possibility that these costs will not be recovered in selling prices.  As a result, the company may drift into loss and eventually go out of business.

Absorption costing requires a lot of time and energy put into the basis of overhead allocation and apportionment but often the factors leading to the generation of these costs are obscured.  Marginal costing tends to ignore these fixed overheads and relies on budgets to control cost levels.  Activity-based costing provides an alternative approach to the treatment of fixed overheads.  It focuses on the activities that generate overheads and the factors, or cost drivers, that cause costs to change.  These cost drivers are at the heart of ABC and are used to determine the basis of overheads attributable to each product.  Attention is focused on each activity and the factors that cause cost levels to change.  In consequence, the nature of each cost will be better understood and increased control and better decisions should result.


Terms used in Activity-Based Costing

⇒     Activity:         Discrete services or related tasks which are carried out repeatedly.

⇒     Cost Driver:       The factor or event which causes a cost to occur.

⇒      Cost Pool: All the costs incurred when an activity takes place.


  • Professors Kaplan and Cooper of Harvard University created the idea of activity based costing. It was designed to deal with the problem of allocating costs to output where such costs are not related to volume of production.
  • In the traditional methods overheads are apportioned to output using a basis such as machine hours.
  • For every cost driver the cost per unit of activity is calculated and this is then used to divide costs into individual cost units.


Examples of:               Activities                   & Cost Drivers Used
  − Purchasing Dept   −No. of Invoices
  − Accounting Dept Costs −No. of Accounting Reports
  −Set up Costs −No. of Manufacturing Set Ups
  −Engineering Dept. Costs −No. of Production Orders


Advantages of Activity-Based Costing (ABC)
  • Better basis for cost apportionment.
  • Overheads are traced to the product.
  • ABC brings attention to cost behaviour and helps in the reduction of costs.
  • ABC provides a useful means of getting financial and non financial data.
  • More realistic product costs.
  • Forces managers to consider the drivers of cost in their business. Disadvantages of Activity-Based Costing
  • Difficulty in picking cost drivers.
  • Very time consuming.
  • The problem of common costs.
  • A full ABC systems having numerous cost pools and cost drivers is more complex and more expensive to operate.


The stages involved in ABC are:

  • Identify the activities that cause overheads to be incurred.
  • Change the accounting system so that costs are collected by activity rather than by cost centre.
  • Identify the factors that cause each activity’s costs to change. These factors are the cost drivers.
  • Establish the volume of each cost driver.
  • Calculate the cost driver rates by dividing the activity’s cost by the volume of its cost driver.
  • Establish the volume of each cost driver required by each product.
  • Calculate overheads attributable to each product by multiplying (f) by (e).

ABC concentrates on the activities which are essential in order that services are provided or goods produced.  All related costs are charged to the activity and each activity is itself necessary for the final product to be produced.  Examples could be:

  • Personnel department costs
  • Material handling
  • Spare parts administration.

These activities are known as “cost drivers” (defined as “an activity that generates cost”).  Having separated expenses into these cost drivers, then the most appropriate method of allocation is determined for each cost driver and used.  For example, the total cost of the personnel department might well be allocated on the basis of numbers of personnel in each cost centre, etc.

By having different activity costs, each having different methods of allocation, it is argued that the allocation/apportionment task is refined and, being less arbitrary, more correctly reflects “true cost”.

The following example will illustrate how this works.

This example has been simplified but is not untypical of systems found in practice.  Overheads are apportioned to products based on a machine-hour rate, which in this example does not take into account the fact that Product Y is manufactured in small batches requiring additional tool-setting, production control and quality control effort.

Product Costs Calculated Using ABC

An activity-based costing method would regard these costs as activities that can be controlled, and seek to identify the cost drivers that determine the cost levels.  These cost drivers may not necessarily be the number of items produced and in this example we will assume they are as follows:

Activity Cost Driver
Purchasing Number of orders
Production control Number of components produced
Tool-setting Number of tool changes
Maintenance Machine-hours
Quality control Number of components inspected
Production Department A Machine-hours
Production Department B Machine-hours
Production Department C Machine-hours
Further Considerations

The ABC approach to ascertaining cost of production was introduced as an important innovation in management accounting in the 20th century.  It is a further development in relating overhead expenses to production.

Over recent years, rapid changes in methods of production have resulted in direct labour costs per unit of output being reduced.  More expenditure is now indirect overhead not directly related to units of production.

In marginal costing the only variable activity considered is volume of sales.  It is established that, at a certain level of production and sales, a breakeven point will be reached; the contribution per unit thereafter is related to profit.  In the case of absorption costing, overhead costs are absorbed in the most logical way by units of production.  Allocation and absorption is achieved arbitrarily but as logically as possible.  As overheads have become a greater proportion of total production cost, any arbitrariness in how they are charged to products becomes more significant.

In activity-based costing the overheads are considered to be related to the use made by production of the facilities (cost drivers) responsible for incurring them.  This is considered a more logical way to obtain accurate information on the cost of production.  The advocates of ABC consider the following points in promoting this approach:

  • It provides more accurate product costs, which should enable the management to make decisions on pricing, most profitable product mix etc. in a more logical manner.
  • It is argued that production resources are more efficiently utilised.
  • It extends the variable cost approach to short-term and long-term costs and volume changes. This is because these costs are related to the activities and not only to volume of production.
  • Costs are considered in more detail as to whether they add value to production or not. In this way management can achieve better cost control.
  • The management will have better understanding of the economics of production and of activities performed by the company.

Although ABC is a better approach in relating overheads to production, it is still an arbitrary method.  It is in a sense an extension of absorption costing, as ABC product costs are full absorption costs.  ABC can be applied to all costs incurred in an organisation, not only production costs.  It is being used increasingly in service organisations such as hotels, schools and hospitals.

ABC in Service Industries

The nature of the ‘product’ in service industries means that the cost structure typically differs from manufacturing industries.  Direct costs tend to be a smaller proportion of total cost, because the direct material content of a service is usually small.  The direct labour content of a service can, however, be significant.

The impetus for the application of ABC in service industries is mainly a desire for more understanding of the costs of providing services, as an aid to decision-making and cost control.  There may be a tendency in service industries to view all costs as overheads, bearing no direct relationship to the level of service provided.  This results in cost control being aimed at the inputs to the process rather than the outputs, so it will be relatively ineffective.  The application of ABC in service industries requires clear specification of what services are provided, so that the activities driven by and underpinning the services can be specified.

Examples of cost units used in service industries could include:

            Business                                                              Cost unit

Healthcare (hospitals)                                          (a)        Bed occupied              (b) Out-


Hotel & catering                                                  Room/cover

Professional services (accountants, architects, Chargeable hour lawyers)

Education                                                             (a)        Enrolled student          (b)

Successful student

(c)        School meal

These cost units could be refined to reflect significant differences in the activities and drivers relating to them.  One hospital changed its cost unit on adopting an ABC approach.  The initial unit was a patient-day, but analysis of the activities necessary to provide a patient-day revealed a range of activities falling into two broad categories:  those relating to the nursing care a patient received, and those relating to bed occupancy.  The latter category, such as the provision of ward cleaning services and patients’ meals was mainly driven by the number of beds, and these activities were largely independent of the specific types of patient occupying the beds.  The nursing care activities, however, were driven by the medical needs of particular types of patient.  On the change of cost unit, every ward’s head nurse rated each patient and arrived at a level of ‘acuity’ on a five-point scale.  The ‘acuity’ rating was the driver for the cost of nursing activity, and was used both in charging patients for their hospital stay, and in preparing a flexible budget for nursing costs in each ward.

The solution in this instance of the hospital is compatible with the approach of a traditional costing system – it equates to a manufacturing company changing from a plant-wide absorption rate to cost-centre absorption rates.  However, this does not indicate a general compatibility between the traditional and the ABC approach in service industries.

A key factor in the ABC approach is the recognition of cost at levels other than the unit level.  The cost of making a bed available is largely a facility-level cost, while the cost of providing nursing care to patients at a particular sickness level is a unit-level cost, i.e. it will increase as the number of patients with this level of sickness increases.  ABC and traditional costing result in the greatest differences when cost drivers are batch- and product-related, rather than unit- and facility-related.

In some service industries, e.g. public relations, the specific output may be difficult to identify and quantify.  Where there are multiple outputs, identifying support activities with particular outputs may be even more difficult.  Even strong advocates of ABC acknowledge that the costs of applying it in such circumstances may well outweigh the benefits.  For example, a hotel may incur significant costs in tending its gardens and maintaining communal areas.  Allocating these facility-sustaining common costs to particular ‘products’, such as overnight stays, must be largely arbitrary.

However, ABC can be very suitable for the service sector in identifying customer profitability rather than ‘product cost’.  Customer focus is vital in service industries – customers may make very different demands even when using the same ‘product’.  In some cases common costs may be more easily identified with customers than products; e.g. a hotel swimming pool may be used more by families than by business people, even though both types of guest are being provided with overnight accommodation.  An ABC analysis of customer profitability in service industries may yield valuable information to assist management in, for example, price-setting.

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