ABC divides activities into four categories:

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Unit level activities which arise each time a product is manufactured eg. machine power, depreciation of machinery etc.

Transaction level activities which arise each time a transaction happens eg. quality control, inspection costs, set-up costs etc.

Plant level activities which relate to costs arising from the maintenance and operation of the business facilities.

 

In absorption costing overheads are assigned to cost centres and charged to cost units by usually a volume-based measure such as machine or labour hours whereas ABC uses a two-fold approach by locating costs in cost pools and identifying cost drivers to facilitate assigning costs to cost units.

 

In product costing it is relatively easy to charge direct costs to cost units but the problem arises in relation to indirect costs(overheads). Overhead costs(resource costs) such as rent, rates, maintenance costs, cleaning materials etc. which can be identified with a particular cost pool are located there. Other overheads which cannot be identified with a cost pool are apportioned to the cost pools by means of cost drivers which are the main determinants of the cost of activities. These overheads are pre-determined in that they are part of the budgeting process. These cost drivers might include the number of production runs, the number of customer orders received, the number of quality control tests, etc.

 

Activity cost pool Activity cost driver
Advertising The value of sales in each sales area
Quality control The number of quality tests
Purchasing The number of purchase orders
Set-up costs The number of set-ups/production runs
Stores The number of material requisitions
Despatch The number of despatch notes

 

When the overheads are located in the cost pools an average cost per transaction is calculated by dividing the total cost of an activity by the number of transactions performed. This average cost is then used to charge each product with the amount of service demanded from each activity cost pool. Consequently, products are charged with a fairer share of the overheads they have helped to create. The result is more accurate product costing, better decision-making in respect to the product output mix and product pricing.

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