ACCT20001 Chap.7 Activity Based Costing and the Cost Hierarchy
Activity Based Costing and the Cost Hierarchy
A single overhead pool with a single base is common and often reasonable, but one base cannot drive every indirect cost a firm incurs. The moment the pool contains something driven by anything else, the allocation stops tracking cause.
Machine set-up is the standard demonstration: the work happens once per batch and costs much the same whether the batch holds a hundred units or a hundred thousand, so allocating it on machine hours loads it onto the high-volume product that runs in a few long batches and takes it away from the low-volume product that triggers most of the set-ups.
The subject states the general result plainly: single-base systems tend to over-cost standard products and under-cost specialty ones, and the damage lands on prices in both directions. Activity based costing replaces one pool with several, each holding the cost of an activity and each spread on the driver of that activity.
Its underlying claim is a chain: resources generate costs, activities consume resources, and products consume activities. The cost hierarchy then sorts activities into five levels, unit, batch, product-sustaining, facility-sustaining and organisation-sustaining, and the level tells you which base is legitimate. Total cost is unchanged by the switch; everything ABC is worth comes from the decisions the better split supports.
What this chapter covers
- 01
Why one rate cannot be the driver of every indirect cost
- 02
The set-up cost that breaks a single-rate system, and how the damage lands on price
- 03
Symptoms of a costing system that needs redesigning, visible without opening the ledger
- 04
What an activity cost pool is, and how it differs from a departmental pool
- 05
Resources, activities and products: the chain and its implication for fixed cost
- 06
The five levels of the cost hierarchy, and the trigger test that identifies each
- 07
Why the top two levels are where honest systems often stop allocating
- 08
The six steps of building an activity based system
- 09
Reading a cross-subsidy: same pool, two systems, two unit costs
- 10
Who benefits from ABC, what it costs, and its three limitations
Sort four activities into the cost hierarchy using the trigger test
- 1Running the machine recurs with each unit made, so it is unit-level and machine hours or units are the natural base.
- 1Setting up recurs once per batch regardless of batch size, so it is batch-level and the number of set-ups is the base.
- 1Designing and certifying a variant recurs only because that product exists in the range, so it is product-sustaining and the number of products or design hours is the base.
- 1Insuring the building supports the facility rather than any product, so it is facility-sustaining and is often left unallocated.
Key terms
- Activity cost pool
- The costs of one activity collected together so they can be spread on the driver of that activity rather than on a facility-wide base.
- Activity cost driver
- The measure of how much of an activity a cost object demands, such as the number of set-ups, orders, letters or inspections.
- Cost hierarchy
- The classification of activities into unit, batch, product-sustaining, facility-sustaining and organisation-sustaining levels.
- Unit-level cost
- A cost driven by work done on every single unit made, such as machine power, machine maintenance and indirect materials.
- Batch-level cost
- A cost triggered once for a whole group of units, such as a machine set-up, a shipment or a purchase order.
- Product-sustaining cost
- A cost that exists because a particular product is in the range at all, such as its design work or its own advertising.
- Facility-sustaining cost
- A cost that supports the facility as a whole, such as rent, insurance, security and the plant manager's salary.
- Cross-subsidy
- The effect of a single unit-based rate charging a high-volume product for resources that a low-volume product actually consumed.
- Over-costing
- Reporting a product as consuming more indirect resource than it caused, which typically raises its price and reduces its volume.
- Under-costing
- Reporting a product as consuming less indirect resource than it caused, which typically lowers its price and attracts unprofitable volume.
Activity Based Costing and the Cost Hierarchy FAQ
Does activity based costing make a company more profitable?
Not by itself, and saying so is a trap. The subject is explicit that total cost is unchanged under both systems and so is the year's profit; only the split between products moves.
The value comes from the decisions the better split enables, such as repricing a line that was quietly loss making, redesigning a product to demand fewer expensive activities, or planning capacity from activity forecasts rather than from a growth rate.
How can I tell from the outside that a costing system needs redesigning?
The subject lists symptoms that need no access to the ledger. Managers want to drop products the system calls profitable. Margins are hard to explain product by product. Difficult products carry suspiciously high margins. Competitors price below what looks possible. The firm keeps winning complex bids and losing simple ones. Staff build their own spreadsheets.
Each of these points at complex work being under-costed and simple work over-costed.
When is building an activity based system not worth it?
When output is uniform, when indirect costs are a small share of total cost, or when products consume resources roughly in proportion to volume, because a single base is then already reasonably accurate. The subject also lists real costs on the other side: designing the system, winning employee acceptance, training, and then tracking multiple bases every period.
In a fast-changing environment the driver data goes stale, and outdated drivers produce worse decisions than a simple system honestly labelled.
Exam move
Learn the hierarchy first and the arithmetic second, because the hierarchy is what stops you inventing a base. For every activity you meet, ask what has to happen for the cost to be incurred once more, and say the level aloud before choosing a driver.
Then practise the comparison shape, since almost every assessed question here runs one pool through two systems: compute the conventional unit cost, compute the activity based unit cost, and finish by explaining which product was over-costed and why, naming the batch-level or product-level activity responsible. Always convert to a per-unit figure before commenting, because the cross-subsidy is invisible in the line totals.
Finally, be ready to argue against building the system, since the limitations and the implementation costs are examinable in their own right.
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