ACCA Articles

Activity Based Costing (ABC)

Organisations best suited for the use of Activity Based Costing (ABC)

In this article, Muhammad Assad Niazi takes a look at the organisations which may benefit from Activity Based Costing (ABC).  It is relevant to ACCA papers F5 and P5.

Organisations which are best suited to use Activity Based Costing (ABC) are those which usually have a broad customer base, a variety of products and lots of overheads.

ABC aims to provide more accurate costing information but it is not feasible for all types of businesses.  Businesses operate in different environments with differing product ranges and various levels of complexity.

ABC would be particularly useful to entities with the following characteristics:

1. High ratio of overheads:Traditionally, standard costing was used to apportion overheads on direct material or direct labour hours.  However this was more relevant for the ‘classical manufacturing environment’ and with technological evolution, standard costing no longer provides accurate costing information.

Illustration

A bank may have overheads consisting of telephone calls made for marketing new credit cards.  The bank may apportion these overhead costs to the staff working in the credit department increasing the cost of the credit department. Such an apportionment would be misleading because the overhead costs are incurred for marketing purposes rather than for credit granting.

2. Broad product mix: If a business has many product lines then it would become difficult to apportion cost overheads to different products as this would require a level of arbitration which can distort actual cost information.

3. Wide customer base: Analysis of activities involved in reaching the customer can enhance the understanding of the business processes and activities involved in reaching the customer.

4. Competitive environment: In a competitive environment, where the market is profitable attracting potential businesses into the market, it is important to have highly accurate cost information which will affect pricing and marketing strategies to maintain or improve market share in the growing market.

Muhammad Assad Niazi is a student of ACCA P5 ‘Advanced Performance Management’