Activity based costing (ABC) assigns overheads to products by tracing them through the activities that cause them, such as machine setups, material handling or order processing, rather than spreading them on labour or machine hours. Each activity has a cost driver, and products are charged according to how much of each driver they use. It gives better product costs where overheads are large and products differ in complexity, batch size or support needs.
What problem does activity based costing solve?
Traditional absorption costing pools production overheads and spreads them using one measure of volume, usually direct labour hours or machine hours. That works when overheads are small and products are similar. ACCA’s technical article on ABC sets out the conditions in which the conventional approach is satisfactory: fixed costs are relatively immaterial compared with material and labour costs, most fixed costs accrue with time, and there are long production runs of identical products with little customisation.
Many businesses no longer fit that description. Automation has shrunk direct labour and grown overheads, and wider product ranges mean some items are made in small batches with frequent setups, special components or extra inspection. A volume based rate charges those low volume, complex products too little and charges high volume, simple products too much. The result can be prices that subsidise the wrong products. See absorption vs marginal costing for how the traditional method works.
How does ABC assign overheads?
ACCA describes the process in four steps:
- Split overheads into activities, called cost pools. Examples are machine setups, purchasing, receiving and handling materials, quality inspection, and despatch.
- Identify the cost driver for each pool, the factor that causes the cost to be incurred. ACCA suggests thinking of it as the cost causer. Setups are driven by the number of setups, purchasing by the number of purchase orders, handling by the number of components or movements.
- Calculate a cost per unit of driver: the cost pool divided by the total number of driver units.
- Charge products according to how many driver units each one uses.
Overheads with no identifiable activity driver, such as factory rent, are still spread on a volume basis. ABC refines the allocation; it does not require every pound to have a perfect driver.
Levels of activity
It helps to recognise that activities happen at different levels. Some occur for every unit (machine running time), some for every batch (setups, inspections of the first item), some for every product line (design changes, maintaining specifications) and some for the site as a whole. Batch and product level costs are the ones traditional methods most often misallocate, because they do not rise with the number of units.
What does a worked example look like?
Illustration only. A printer produces standard leaflets and short run bespoke brochures. Production overhead is £100,000 a year, previously absorbed on 10,000 machine hours at £10 an hour.
| Leaflets | Brochures | Total | |
|---|---|---|---|
| Jobs a year | 100 | 400 | 500 |
| Machine hours | 8,000 | 2,000 | 10,000 |
| Setups | 100 | 500 | 600 |
| Proof rounds | 50 | 950 | 1,000 |
Analysis shows the £100,000 is made up of £40,000 of machine running costs, £36,000 of setup costs and £24,000 of proofing and prepress costs. The driver rates are £4 per machine hour, £60 per setup and £24 per proof round.
| Overhead charged | Leaflets | Brochures |
|---|---|---|
| Traditional (machine hours at £10) | £80,000 | £20,000 |
| ABC: machine running | £32,000 | £8,000 |
| ABC: setups | £6,000 | £30,000 |
| ABC: proofing | £1,200 | £22,800 |
| ABC total | £39,200 | £60,800 |
The traditional method charged brochures £50 of overhead per job. ABC charges about £152. Leaflets fall from £800 to £392 a job. If the brochure price was set at traditional cost plus a mark up, the printer has been underpricing bespoke work and overpricing its standard work, exposing it to competitors on the leaflets it does efficiently. The total overhead is the same; only its distribution changes, which mirrors ACCA’s own example where total budgeted cost is unchanged under both methods.
When does ABC beat traditional methods?
- Overheads are a large share of total cost.
- Products or services differ widely in batch size, complexity or support needed.
- The business offers customisation or a wide range, so small volume items use disproportionate resources.
- Prices are set on cost, so misallocated overhead feeds directly into misjudged prices.
- Management wants to reduce overheads and needs to know what drives them.
ACCA’s article makes the last point directly: as well as producing better product costs, ABC shows where savings can be found. In its example, setup costs were a large part of the cost of a product made in small batches, which raised the obvious question of whether batches could be larger.
The same method extends beyond manufacturing. Accountancy and other professional practices can use activity costs to see what each client really costs to serve, for example counting bookkeeping queries, late records chasing or VAT return rework. That information supports value pricing and decisions about which clients to keep.
What are the drawbacks?
- Cost and effort. ACCA acknowledges that ABC requires time and effort to investigate what causes costs. Interviews, time studies and new data capture are needed.
- Judgement in drivers. Choosing drivers and splitting shared staff time between pools involves estimates. A poor driver gives a precise looking but wrong answer.
- Not every cost has a driver. Facility level costs are still allocated arbitrarily.
- Maintenance. Pools and rates need updating as processes change, or the model goes stale.
- Still full cost. ABC product costs include fixed costs that may not change with a single decision. For short run decisions, contribution analysis using only the costs that change remains the right tool.
Can ABC costs be used to value stock in the accounts?
ABC is a management technique, but the allocation it produces can feed stock valuation if it stays within FRS 102. Paragraph 13.8 requires a systematic allocation of fixed and variable production overheads to the costs of conversion, and paragraph 13.9 requires fixed production overheads to be allocated on the basis of normal capacity. Paragraph 13.13 excludes administrative overheads that do not help bring stock to its present location and condition, and selling costs.
That means any ABC pools for order taking, sales support, customer service or general administration must be stripped out before the rates are used for stock. Driver rates for production pools should be based on normal levels of activity, not on an unusually quiet period. For tax, HMRC’s Business Income Manual at BIM33115 says a stock valuation in accounts prepared under generally accepted accounting practice should be accepted provided it applies that practice correctly and pays sufficient regard to the facts. See stock valuation for the net realisable value test that follows.
What mistakes come up most often?
- Building too many cost pools. A handful of significant activities usually captures most of the benefit.
- Choosing drivers because the data is available rather than because they cause the cost.
- Carrying selling and admin pools into stock values.
- Treating ABC full cost as the minimum acceptable price for extra work.
- Running a one off ABC study and never updating it, so it drifts away from how the business now works. A standard costing system that uses ABC rates needs the same regular review as any other standard.
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Sources
Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.