This article intends to demonstrate the characteristics of Activity-based costing and how is it
different from the traditional cost accounting approaches.
The traditional approach assumes that fixed overhead production costs should be summed up
to derive a single overhead absorption rate which shall then be added in the cost of the
product. But with the introduction of modern manufacturing, this traditional approach is no
longer considered reliable as firms now need to know what are the actual causes of overheads
and that costs should be assigned to products on the basis of the resources they devour.
Activity-based costing (ABC) is a modern approach to cost accounting according to which there
exists a relationship between the cost of a product and its activities/events/tasks (also referred
to as ‘cost pools’). The ABC analysis recognizes that the special engineering, special testing,
machine setups, and others are the activities that cause costs and cause the company to
The ABC process inculcates the following steps:
1. The first step requires that the total fixed overheads should be bifurcated into major
2. Once cost pools have been identified, the second step involves identifying the cost
drivers. Thereby, all cost pools shall be driven on the basis of these cost drivers.
3. Compute cost per unit of the cost driver.
4. Finally, apportion product cost on the basis of the proportion of the cost driver
By pursuing the ABC system, firms can not only estimate true costs of production more
accurately but can identify opportunities of cost savings, which is one of the essential
requirements of modern accounting.
Firms are now applying ABC system extensively as it provides a clear picture of which business
process are performing well and which ones require enhancements. It is a useful tool in
identifying non-valued added activities in a firm’s value chain analysis which in turn assists in
saving unnecessary costs being incurred.
Moreover, the ABC approach also contributes in detecting wasteful products and superfluous
activities that ultimately results in improved product quality.
One hitch of the ABC system, however, can be its setup cost which is both expensive and time
consuming. As ABC system demands that business activities need to be scrutinized, they must
be broken down into each activity’s individual constituents. This process uses valuable
resources since data will be sorted, composed, measured and entered into the new system.
Additional expenses would involve hiring a management consultant who specializes in the
setup of the system and acquiring a software for its implementation.
The analysis made above concludes that the ABC approach provides better results than the
traditional approaches to cost accounting, especially in the manufacturing sector. It is a helpful
tool for management accountants to remain proactive in refining performance rather than
passively measuring costs.
Written and Compiled by : Asfand Sikandar