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        1.2 ABC and cost drivers
　　ABC is an alternative approach to the traditional method of absorption costing outlined above.
　　The traditional method of overhead absorption effectively absorbs on a production volume basis and may be misleading for costs where the * is not directly related to production volume.
　　For example, the cost of quality control may be driven more by the number of inspections made rather than the overall volume of units manufactured.
　　The ABC approach is to link overhead costs to the products or services that cause them by absorbing overhead costs on the basis of activities that ‘drive’ costs (costs drivers) rather than on the basis of production volume.
　　Overhead expenses incurred
　　Step 1: Overheads allocated or apportioned to cost pools using suitable bases
　　Cost pools (usually activities)
　　Step 2: Overheads absorbed into units of production using cost drivers
　　§ A cost pool is an activity that consumes resources and for which overhead costs are identified and allocated. For each cost pool, there should be a cost driver.
　　§ A cost driver is a unit of activity that consumes resources. An alternative definition of a cost driver is a factor influencing the level of cost.
　　Expandable text
　　The concepts or assumptions underlying ABC are:
　　§ In the long run, all overhead costs are variable. Some overheads are variable in the short run. However, overhead costs do not necessarily vary with production volume or service level.
　　§ Activities consume resources.
　　§ The consumption of resources drives cost.
　　Products incur overhead costs because of the activities that go into providing the products or services, and these activities are not necessarily related to the volumes of the product that are manufactured. Direct labour hours and machine hours are not the drivers of cost in many modern business environments.
　　Understanding the relationship between overhead costs, activities and products (or services) is essential for managing overhead costs and product or service profitability.
　　Absorption of overheads into unit costs on a volume basis may be misleading, particularly in a modern manufacturing environment where overhead costs are influenced by the diversity and complexity of output rather than volume.
　　Illustration 1 – ABC
　　A company manufactures two products, X and Y. The company uses absorption costing and fixed production costs and absorbed into production costs on a direct labour hour basis.
　　The budgeted information for the next financial year is as follows:
　　Product XProduct YTotal
　　Production and sales2,000 units5,000 units
　　Direct labour hours per unit32
　　Budgeted direct labour hours6,00010,00016,000
　　Fixed production costs$48,000
　　Absorption rate per direct labour hour
　　Fixed overheads absorbed$18,000$30,000
　　Using ABC
　　A review of the incidence of costs has established that the number of setups is the driver of the fixed production costs. Using ABC the fixed production costs would be allocated as follows:
　　No. of setups per 1,000 units81.6
　　Budgeted setups16824
　　Cost per setup$2,000
　　Fixed overheads allocated$32,000$16,000
　　This difference in costing could have significant implications for pricing, especially if a cost-based approach is used for profit calculation. These, and other implications are discussed in more detail below.
　　Activity-based costing could provide much more meaningful information about product costs and profits when:
　　§ indirect costs are high relative to direct costs
　　§ products or services are complex
　　§ products or services are tailored to customer specifications
　　§ some products are sold in large numbers and others in small numbers.