Activity-Based Costing (ABC) & Overhead Analysis

TAKEAWAYS:

• ABC assigns overhead costs based on activities, not just volume, improving cost accuracy for products/services.
• Traditional costing uses direct labor hours, while ABC uses cost drivers linked to activities.
• Overhead analysis helps identify cost-saving opportunities and pricing strategies.
• ABC is widely used in service industries (e.g., banks, hospitals) and complex manufacturing.
• Worked examples include Nepali businesses like Daraz (inventory handling costs) and Pathao (driver dispatch overheads).
• Exam questions often require ABC cost allocations, variance analysis, and cost driver identification.

Activity-Based Costing (ABC): Core Concepts

ABC is a costing method that assigns overhead costs to products/services based on the activities that drive those costs. Unlike traditional costing (which uses direct labor hours), ABC traces costs to cost drivers (e.g., machine setups, inspections, customer orders).

Why ABC?

Traditional costing distorts product costs because it assumes overheads are driven by volume alone. ABC reveals hidden inefficiencies by linking costs to specific activities.

Key Terms

How ABC Works: Step-by-Step

1. Identify Cost Pools (e.g., Machine Maintenance, Order Processing).
2. Select Cost Drivers (e.g., "Number of Setups" for Machine Maintenance).
3. Calculate Activity Rates (Cost Pool ÷ Total Cost Driver Units).
4. Allocate Overheads to products/services based on activity usage.

Example: Kathmandu Bike Shop (ABC vs. Traditional Costing)

Scenario: A bike shop produces two models—Mountain Bikes (MB) and City Bikes (CB). Overheads include:

• Machine Maintenance: Rs. 120,000 (Cost Driver: Setups)
• Quality Inspection: Rs. 80,000 (Cost Driver: Number of Bikes Inspected)

ABC Allocation

1. Machine Maintenance Rate: $\frac{120,000}{100\text{ setups}}=\text{Rs. }1,200\text{ per setup}$

   • MB: $60\times 1,200=\text{Rs. }72,000$
   • CB: $40\times 1,200=\text{Rs. }48,000$

2. Quality Inspection Rate: $\frac{80,000}{500\text{ bikes}}=\text{Rs. }160\text{ per bike}$

   • MB: $300\times 160=\text{Rs. }48,000$
   • CB: $200\times 160=\text{Rs. }32,000$

Total Overhead Allocated:

• MB: Rs. 120,000
• CB: Rs. 80,000

Traditional Costing (Assuming 1,000 Labor Hours Total)

• MB: 600 hours → $\frac{200,000}{1,000}\times 600=\text{Rs. }120,000$
• CB: 400 hours → $\frac{200,000}{1,000}\times 400=\text{Rs. }80,000$

Result: Same in this case, but ABC would differ if activities varied widely!

Overhead Analysis: Fixed vs. Variable

Overheads can be fixed (unchanged with production) or variable (changes with volume). ABC helps classify them accurately.

Visual:

graph TD
    A["Total Overheads"] --> B["Fixed Overheads"]
    A --> C["Variable Overheads"]
    B --> D["Rent, Salaries"]
    C --> E["Utilities, Materials"]

Advantages & Disadvantages of ABC

✅ Advantages

• More Accurate Costing: Links costs to real activities, not just labor.
• Better Pricing: Helps set competitive prices by revealing true costs.
• Cost Control: Identifies inefficient activities (e.g., excessive inspections).
• Service Industry Useful: Banks (loan processing), hospitals (patient care activities).

❌ Disadvantages

• Complexity: Requires detailed activity tracking (high setup cost).
• Time-Consuming: More data collection than traditional methods.
• Overhead for Small Firms: Not cost-effective for tiny businesses.

Real-World Applications in Nepal

1. Daraz (Inventory Handling Costs)

• ABC Use: Daraz allocates warehouse costs (e.g., picking, packing) based on number of orders per product.
• Why? Helps price items accurately and identify slow-moving stock.

2. Pathao (Driver Dispatch Overheads)

• ABC Use: Costs like driver training, vehicle maintenance are tied to number of rides dispatched.
• Why? Ensures pricing reflects true costs per ride.

3. NEPSE (Stock Exchange Transaction Costs)

• ABC Use: Brokerage fees and system maintenance are allocated per trade activity (not just volume).
• Why? Helps set fair transaction fees for different asset classes.

Worked Example: Nepali Hotel (ABC for Room Types)

Scenario: A Kathmandu hotel has Single Rooms (SR) and Double Rooms (DR). Overheads include:

• Housekeeping: Rs. 1,200,000 (Cost Driver: Cleaning Cycles)
• Laundry: Rs. 800,000 (Cost Driver: Laundry Loads)

ABC Allocation

1. Housekeeping Rate: $\frac{1,200,000}{2,000}=\text{Rs. }600\text{ per cycle}$

   • SR: $1,200\times 600=\text{Rs. }720,000$
   • DR: $800\times 600=\text{Rs. }480,000$

2. Laundry Rate: $\frac{800,000}{1,000}=\text{Rs. }800\text{ per load}$

   • SR: $600\times 800=\text{Rs. }480,000$
   • DR: $400\times 800=\text{Rs. }320,000$

Total Overhead Allocated:

• SR: Rs. 1,200,000
• DR: Rs. 800,000

Traditional Allocation (Assuming 500 Rooms):

• SR: $\frac{2,000,000}{500}\times 200=\text{Rs. }800,000$
• DR: $\frac{2,000,000}{500}\times 300=\text{Rs. }1,200,000$

Key Insight: ABC shows Double Rooms are actually cheaper to serve, helping pricing decisions!

ABC vs. Traditional Costing: Comparison Table

Exam Tip: How to Score Full Marks

1. Understand Cost Pools & Drivers:

   • Always identify cost pools (e.g., machine maintenance) and drivers (e.g., setups).
   • Example: "For a textile factory, ‘thread breaks’ could be a cost driver for ‘machine repairs.’"

2. Calculate Activity Rates Correctly:

   • Formula: $\text{Activity Rate}=\frac{\text{Cost Pool}}{\text{Total Driver Units}}$.
   • Show step-by-step calculations in exams.

3. Compare ABC & Traditional:

   • Highlight why ABC is better (e.g., "Traditional undercosts high-activity products").
   • Use real examples (e.g., Pathao’s ride dispatch costs).

4. Apply to Decision-Making:

   • Questions may ask: "Should the company discontinue a product?"
   • Use ABC to show true profitability (e.g., "Product X seems unprofitable under traditional costing but breaks even under ABC").

5. Show Worked Examples:

   • Always label tables (Cost Pool, Driver, Allocation).
   • Use Nepali businesses (e.g., Kathmandu hotels, Daraz) for context.

Common Exam Questions & Answers

Q1: Differentiate between ABC and Traditional Costing.

Answer:

Q2: A company has two products, A and B. Overheads are Rs. 500,000. Product A uses 300 machine setups, Product B uses 200. Allocate using ABC (Cost Driver: Setups).

Answer:

1. Activity Rate: $\frac{500,000}{500\text{ setups}}=\text{Rs. }1,000\text{ per setup}$
2. Allocation:
   • Product A: $300\times 1,000=\text{Rs. }300,000$
   • Product B: $200\times 1,000=\text{Rs. }200,000$

Final Summary

• ABC traces costs to activities, not just volume.
• Better for complex businesses (e.g., Daraz, Pathao).
• Traditional costing is simpler but less accurate.
• Exams test: Cost pools, drivers, activity rates, and comparisons.

Visual Recap:

graph TD
    A["ABC"] --> B["Identify Cost Pools"]
    A --> C["Select Cost Drivers"]
    A --> D["Calculate Activity Rates"]
    A --> E["Allocate Overheads"]
    E --> F["Better Decision-Making"]
    F --> G["Pricing, Cost Control, Profitability"]