Activity Based Costing Compared with Traditional Absorption Costing

Two accountants cost the same factory. One divides all overhead by machine hours. The other traces each overhead to the activity that causes it. They use the same total cost, the same products and the same sales, and they report the same total profit. But they disagree about which products make money, and the manager who follows the first accountant may drop a profitable product and keep a loss-maker.

This topic compares activity based costing with the traditional method of absorbing overhead, shows the difference in numbers using one data set, and weighs the advantages and disadvantages of each. It builds on the activity based costing calculations topic. The next topic starts target costing.

Traditional absorption and ABC side by side

The traditional method spreads production overhead to products on the volume of production resources they consume, such as direct labour hours or machine hours. The overhead absorption rate is overhead divided by the volume of the chosen resource, and each product is charged rate times the hours it uses. It treats every overhead as if it varied with that one measure.

ABC splits the total overhead into pools and charges each pool according to what drives it.

• Cost driver. Traditional: a single driver. ABC: multiple drivers, one for each activity.
• Allocation. Traditional: on the total of one driver. ABC: on the activities each product uses.
• Accuracy. Traditional: less accurate, because it is an average. ABC: more accurate, because it reflects the activities actually used.
• Complexity. Traditional: simple and cheap to calculate. ABC: more complex and costly.
• Focus. Traditional: simple product cost for valuation. ABC: better information for decisions on pricing and product mix, and for cost control and cost reduction.
• Use. Traditional: external reporting and regulatory purposes. ABC: internal reporting and performance analysis.

The central difference is the effect of batch size and complexity. Where each product needs the same amount of activity per unit, the two methods give similar answers. Where a product is made in small batches, or needs many set-ups, inspections, orders and deliveries for its volume, the volume-based rate under-charges it and over-charges the simple, high-volume products that subsidise it.

When ABC is suitable

• A manufacturer that needs absorption costing for inventory valuation.
• Overhead is a large proportion of production cost and direct labour is small.
• Products are complex, or made to customer specification.
• Order sizes differ substantially, and order handling and despatch costs are significant.

Advantages and disadvantages

Advantages of ABC

• It gives information about the activities that drive overhead, which traditional absorption and marginal costing do not.
• It helps with long-term cost control, product selection and pricing.
• Each product carries a fair share of overhead based on the activities needed to make and sell it, so costs are more realistic. It can be argued, though, that full product cost has little practical meaning for management.
• In the long run all overhead is variable, so measuring costs by activity helps control the activities and long-term costs.

Disadvantages of ABC

• It is costly to design and use, and the cost may exceed the benefit.
• The analysis may rest on unreliable data and weak assumptions: wrong activities, wrong pools or wrong drivers.
• It analyses historical costs, but decisions should be based on expected future cash flows.
• A large amount of apportionment remains. General costs such as rent, insurance and lighting are apportioned between pools, which weakens the link between driver and cost.
• Systems often have few pools and drivers because more complex systems are hard to justify on cost.
• The best driver for a pool is hard to find, and many activities have more than one.
• Traditional systems may suit inventory valuation and financial reporting better.

The case against traditional costing, and the case for it

Traditional absorption costing is weak in a modern factory because production overhead is high compared with direct cost, so adding it by time spent in production is hard to defend, and because the full production cost it gives has limited value for management decisions.

It remains in use because it is a rational way of charging overhead to give a full cost of production for closing inventory, and because some argue that it helps in pricing.

Which method financial reporting allows

IAS 2 Inventories requires inventory to be measured at the lower of cost and net realisable value, with cost including a systematic allocation of fixed production overhead based on normal capacity, so absorption costing is needed for the financial statements. A traditional rate on normal capacity is the usual method.

An ABC allocation can also be used for reporting if it gives a systematic and reasonable allocation of production overhead and is applied consistently. Marginal costing, which excludes fixed production overhead, is not acceptable for inventory in published statements. Many businesses therefore keep a simple absorption system for the accounts and run ABC separately for management.

Sources and references

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

These points are stated as at 6 November 2026.

Comparing the two methods in figures

1. Traditional rate = total overhead ÷ total volume of the chosen resource (machine or labour hours).
2. Traditional overhead for a product = rate × the hours of the product; per unit = divide by units.
3. ABC overhead for a product = Σ (rate for each driver × driver units used), as in the previous topic.
4. Compare the overhead per unit, the full cost, the profit per unit and in total, under each method.
5. Check that total overhead and total profit are the same under both methods.

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

Worked examples

1. Traditional rate.
   16,170,000 ÷ 7,000 = ₦2,310 per machine hour.
2. Overhead charged.
   P 3,000 × 2,310 = ₦6,930,000, per unit ₦1,155.
   Q 2,500 × 2,310 = ₦5,775,000, per unit ₦2,310.
   R 1,500 × 2,310 = ₦3,465,000, per unit ₦3,465.
   Total 16,170,000.
3. Full cost.
   P 1,200 + 1,155 = ₦2,355.
   Q 1,850 + 2,310 = ₦4,160.
   R 2,900 + 3,465 = ₦6,365.
4. Profit per unit.
   P 2,600 − 2,355 = ₦245.
   Q 4,000 − 4,160 = −₦160.
   R 7,500 − 6,365 = ₦1,135.
5. Total profit.
   P 6,000 × 245 = ₦1,470,000; Q −₦400,000; R ₦1,135,000.
   Total ₦2,205,000, the same as under ABC.
6. Comparison. Under ABC the profit per unit was P ₦560, Q −₦190 and R −₦680. The traditional method makes R look the best product at ₦1,135 a unit when it actually causes 40 set-ups, 100 inspections and 180 deliveries for only 1,000 units, and it understates the profit of P, the simple high-volume product. A manager who relied on the traditional figures would push sales of R and might drop P.

1. Volume basis.
   4,800,000 ÷ 100,000 units = ₦48 a unit.
   W ₦2,400,000; X ₦1,200,000; Y ₦720,000; Z ₦480,000.
2. ABC rate.
   4,800,000 ÷ 80 = ₦60,000 per order.
3. ABC charge.
   W 10 × 60,000 = ₦600,000; X 20 × 60,000 = ₦1,200,000; Y 40 × 60,000 = ₦2,400,000; Z ₦600,000.
   Total 4,800,000.
4. Per unit. W ₦12; X ₦48; Y ₦160; Z ₦60.
5. Comment. Y, with a small volume spread over many orders, costs ₦160 a unit to handle and is charged only ₦48 on a volume basis, so W subsidises it.

Expect variants: labour hours instead of machine hours, a different number of pools, an effect on selling price, or a question that asks only for the comparison in words.

Activity based costing in service organisations

Activity based costing suits large service organisations such as banks, hospitals and telecommunications companies.

Their features are:

• overheads are a large share of cost
• there is little direct material and the main cost, labour, is often salaried and fixed in the short term
• services are varied and vary by customer
• overheads are driven by activities such as the number of transactions, customer contacts, complaints handled and compliance checks, not by one volume measure

ABC groups the cost of each activity into a pool, assigns it to services and customers by a driver, and so shows which services and customers are unprofitable, supports pricing and highlights activities that add no value. Regulators may also be interested, because activity costs can show whether tariffs reflect cost.

Difficulties: defining outputs and activities, the cost of collecting data, joint costs that cannot be traced, and resistance from managers.

Problems of ABC in services, and what a regulator looks for

Problems. Facility-sustaining costs (property, for example) may be a large part of cost and avoidable only if the business stops, so there may be no suitable driver; services are intangible, so cost objects are hard to define; many service firms have no earlier costing system, so setting one up is costly; the choice of activities and drivers may be wrong; and the benefits may not justify the cost.

Uses. More accurate service and customer profitability, better pricing, understanding of what causes cost, process improvement and the elimination of non-value-adding activities.

A regulator of a privatised utility or telecommunications firm wants to know:

• the costing method used, to test that prices are fair and the monopoly is not abused
• whether joint and common costs are fairly allocated, so that one service does not cross-subsidise another
• consistency of method between periods, so that changes cannot be used to distort prices
• the return on investment of each service, including the depreciation policy and the allocation of shared assets such as head office

Pricing from a margin or a mark-up

A profit margin is a percentage of the selling price, so price = cost ÷ (1 − margin): cost ₦800 with a 20% margin gives ₦1,000. A mark-up is a percentage of cost: cost ₦800 with a 20% mark-up gives ₦960. Work out the price under each overhead method (traditional and ABC) and compare, as in a question asking for prices under both.

Common mistakes

• Saying ABC changes total profit. It changes only how overhead is spread; the total is the same.
• Calling ABC always better. It costs more and has limits, and the benefit must exceed the cost.
• Comparing only definitions. Compare driver, allocation, accuracy, complexity, focus and use, point against point.
• Ignoring the reporting position. Traditional absorption still serves the financial statements.
• Quoting ABC cost as a short-term relevant cost. Much of it is fixed in the short run.
• Failing to check that overhead charged equals overhead incurred under both methods.

Quick revision

• Traditional: rate = overhead ÷ machine or labour hours; single driver; average; simple; for reporting.
• ABC: several pools and drivers; accurate; complex; for decisions and cost control.
• Same total overhead and profit; different spread between products; high-volume simple products subsidise low-volume complex ones.
• Suitable: high overhead, complex or custom products, varied order sizes.
• Disadvantages: cost, weak assumptions, historical, apportionment remains, driver choice.
• IAS 2 requires absorption costing for inventory; marginal costing is not acceptable for published statements.

How the marks are earned

• Compare: a point for each side of each difference, about one mark per comparison.
• Advantages and disadvantages: one mark per developed point, with a business example.
• Calculate: each rate, each charge and a comparison with the foot check.
• Advise: say which method the business should use for which purpose.

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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