Activity Based Costing: Cost Pools, Cost Drivers and Calculations for Skills Level

A factory makes three products on the same machines. One sells in thousands, one in hundreds, and one is a special order made a few at a time. The accountant adds the factory’s overhead to each product by machine hours, and the special order looks cheap to make and profitable to sell.

Yet the special order needs its own set-up, its own inspection, its own paperwork and its own delivery, every time. Nothing in the machine-hour rate shows it. Activity based costing (ABC) was developed to fix this. It finds what activities cause overhead cost, measures how often each product uses them, and charges the cost accordingly.

This topic explains the ideas behind ABC, how to choose cost pools and cost drivers, how to calculate the cost per driver and the cost per unit, and how to use the result. It builds on the big data analytics topic, whose methods can supply the activity data ABC needs. The next topic compares ABC with traditional absorption costing and weighs its advantages and disadvantages.

The ideas behind ABC, and what it is used for

ABC is based on three ideas. In a modern factory a large part of total cost is overhead, and direct labour is relatively small. Because overhead is large, it is worth tracing it to the products that cause it as accurately as possible. And the traditional methods of charging overhead by direct labour hours or machine hours have no sound basis, because many overheads do not depend on production hours:

• Quality control and inspection depend on the quality standards and inspection methods, not on hours worked.
• Processing and chasing customer orders depends on the number of orders, not on the hours spent on each job.
• Storing materials depends on the volume of materials handled.
• Production planning depends on the number and complexity of orders or batches.

Uses of ABC

• More accurate product costs, and so better pricing decisions.
• Profitability analysis of products, customers and services, showing which to keep, improve or drop.
• Better resource allocation and cost control, by showing where overhead arises.
• Process improvement, by identifying inefficiencies and activities that add no value.
• Strategic decisions on product mix, outsourcing and customer segments, and more accurate budgets.

Cost pools and cost drivers

A cost pool is the overhead allocated and apportioned to an activity. A cost driver is the factor that determines the cost of the activity: something that makes the cost rise as more of the activity is done. Each driver must be measurable, so that the number of units of the driver in the period can be counted. Typical pairs:

• Processing customer orders: number of customer orders.
• Purchasing materials: number of purchase orders.
• Quality control and inspection: number of inspections.
• Production planning and set-ups: number of production runs or batches (set-ups).
• Repairs and maintenance: number of machines or machine hours.
• Selling: number of sales orders.
• Warehousing and despatch: number of deliveries.

Machine hours remain the right driver for costs that really vary with machine use, such as power and depreciation. ABC does not abandon volume-based charges. It uses them only for the costs they explain.

The steps

1. Group the overhead into cost pools by activity.
2. Choose a cost driver for each pool.
3. Calculate the cost per unit of driver = pool ÷ total driver units.
4. Charge each product: rate × driver units used by that product, for every pool.
5. Add the pools to get the overhead per product; divide by units made for the overhead per unit.
6. Add direct materials and direct labour for the full cost per unit, and compare with the selling price.
7. Check that the overhead charged to all products equals the total overhead.

Applying ABC well

• Suitable circumstances. A manufacturer needing full cost for inventory valuation; overhead a large share of cost and direct labour small; complex products; products made to customer specification; very different order sizes, so that order handling and despatch are significant.
• Selecting drivers. Choose the driver that best explains the cost, and that can be measured at reasonable cost. Many activities have more than one possible driver, so a judgement is needed, and it should be reviewed.
• Number of pools. Few enough to be affordable, many enough to separate costs that behave differently.
• Services. ABC works in service businesses such as a laboratory, a bank or a firm of accountants, where nearly all cost is overhead and the cost drivers are things like samples, tests, transactions or reports.
• Long-term view. ABC reflects the idea that in the long run all overhead is variable, so that the cost of an activity falls if the activity is reduced. In the short run most of the cost is fixed, so ABC product costs are not the same as relevant costs for a short-term decision.

ABC and financial reporting

ABC is a management accounting method, and no Nigerian statute requires it. When a manufacturer also uses ABC for inventory valuation, IAS 2 Inventories applies. It requires the cost of inventory to include a systematic allocation of production overhead, with fixed production overhead allocated on the basis of the normal capacity of the production facilities. It requires unallocated overhead to be recognised as an expense.

An ABC allocation can satisfy this if the drivers are reasonable, applied consistently and not inflated by idle capacity. Abnormal waste and idle capacity costs are not added to inventory. Selling and general administration costs are not part of inventory cost either.

Sources and references

• IAS 2 Inventories, paragraphs on costs of conversion and allocation of production overheads.

These points are stated as at 6 November 2026.

Layouts for ABC calculations

1. Cost per driver = cost pool ÷ total driver units. Write the rate with its unit: ₦ per set-up, ₦ per inspection.
2. Overhead charged to a product = Σ (rate × driver units used by the product).
3. Overhead per unit = overhead charged ÷ units produced.
4. Full cost per unit = direct materials + direct labour + overhead per unit.
5. Profit per unit = selling price − full cost per unit; total profit = profit per unit × units.
6. Foot check. Σ overhead charged = total overhead. Always show it.

Money is in naira, per-unit figures are rounded once to the nearest naira, and totals are exact.

Worked examples

1. Rates.
   Machining 8,400,000 ÷ 7,000 = ₦1,200 per machine hour.
   Set-ups 3,150,000 ÷ 105 = ₦30,000 per set-up.
   Inspection 2,640,000 ÷ 220 = ₦12,000 per inspection.
   Despatch 1,980,000 ÷ 330 = ₦6,000 per delivery.
2. P overhead.
   3,000 × 1,200 = 3,600,000
   20 × 30,000 = 600,000
   40 × 12,000 = 480,000
   60 × 6,000 = 360,000.
   Total ₦5,040,000; per unit ÷ 6,000 = ₦840.
3. Q overhead.
   3,000,000 + 1,350,000 + 960,000 + 540,000 = ₦5,850,000
   per unit ÷ 2,500 = ₦2,340.
4. R overhead.
   1,800,000 + 1,200,000 + 1,200,000 + 1,080,000 = ₦5,280,000
   per unit ÷ 1,000 = ₦5,280.
5. Foot check.
   5,040,000 + 5,850,000 + 5,280,000 = 16,170,000, which equals the total overhead (8,400,000 + 3,150,000 + 2,640,000 + 1,980,000).
6. Full cost per unit.
   P 900 + 300 + 840 = ₦2,040.
   Q 1,400 + 450 + 2,340 = ₦4,190.
   R 2,200 + 700 + 5,280 = ₦8,180.
7. Profit per unit.
   P 2,600 − 2,040 = ₦560.
   Q 4,000 − 4,190 = −₦190.
   R 7,500 − 8,180 = −₦680.
8. Total profit.
   P 6,000 × 560 = ₦3,360,000
   Q 2,500 × −190 = −₦475,000
   R 1,000 × −680 = −₦680,000.
   Total ₦2,205,000.
9. Comment. Q and R lose money once the set-ups, inspections and deliveries they cause are charged to them. Management should review their prices, their batch sizes and the cost of their activities before deciding to drop them, because overhead that is fixed in the short run will not disappear if they are dropped.

1. Rates.
   Reception 2,400,000 ÷ 6,000 = ₦400 per sample.
   Analysis 9,000,000 ÷ 1,500 = ₦6,000 per test hour.
   Reporting 1,800,000 ÷ 1,200 = ₦1,500 per report.
2. Hospitals.
   3,500 × 400 = 1,400,000
   800 × 6,000 = 4,800,000
   600 × 1,500 = 900,000.
   Total ₦7,100,000; per sample ÷ 3,500 = ₦2,029.
3. Clinics.
   800,000 + 3,000,000 + 675,000 = ₦4,475,000
   per sample ÷ 2,000 = ₦2,238.
4. Corporate.
   200,000 + 1,200,000 + 225,000 = ₦1,625,000
   per sample ÷ 500 = ₦3,250.
5. Foot check.
   7,100,000 + 4,475,000 + 1,625,000 = ₦13,200,000, equal to the total overhead.
6. Comment. The corporate group looks cheap on a per-sample volume basis but costs most per sample because its work is analysis-heavy. A single rate per sample would have under-priced it.

Expect variants: a volume-based comparison in the same question, a driver rate that must be found from a total, products that use some pools but not others, or a request for the effect of a change in batch size.

Common mistakes

• Using one driver for every pool. That is traditional costing.
• Choosing a driver that does not cause the cost. It must be measurable and causal.
• Dividing by units produced instead of driver units when finding the rate.
• Forgetting the foot check. Overhead charged must equal overhead incurred.
• Treating ABC cost as relevant cost. Much of it is fixed in the short run.
• Leaving out direct costs when asked for full cost or profit.
• Rounding rates early. Carry full figures, round the answer once.

Quick revision

• ABC: overhead traced by activities. Cost pool per activity; cost driver per pool; rate = pool ÷ driver units.
• Product overhead = Σ rate × driver units used. Add direct costs for full cost.
• Drivers: orders, purchase orders, inspections, set-ups or batches, machine hours, sales orders, deliveries.
• Suitable where overhead is high, products complex, orders differ in size; works in services.
• IAS 2 governs overhead in inventory; abnormal waste and idle capacity are expensed.
• Foot check: total charged = total incurred.

How the marks are earned

• Explain ABC: the ideas, with one point for each reason the traditional method fails.
• Suggest drivers: one mark for each sensible activity and driver pair.
• Calculate: a mark for each rate, each product’s overhead, the per-unit cost and the foot check.
• Comment: link the result to a decision such as price or batch size.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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