Absorption Costing

ABC — The 4-Step Process and Worked Example

The 4 Steps of ABC

1. Identify the activities that cause overhead costs (e.g. machine set-ups, inspections)
2. Group costs into cost pools by activity and determine the cost driver for each pool
3. Calculate the cost driver rate for each pool: Pool total ÷ Total driver quantity
4. Charge overhead to products: Driver rate × Product's consumption of the driver ÷ Units produced

Worked Example — Hallford Instruments Ltd

Products: Standard (10 000 units, batch size 500) and Premium (2 000 units, batch size 100)

Premium has 2 quality checks per batch; Standard has 1.

Step 1 — Batches:

Step 2 — Quality checks:

Step 3 — Cost driver rates:

• Set-up rate: £96 000 ÷ 40 batches = £2 400 per batch
• Quality rate: £72 000 ÷ 60 checks = £1 200 per check

Step 4 — Overhead per unit:

Verification: £72 000 + £96 000 = £168 000 = £96 000 + £72 000 ✓

Note: Premium has the same number of batches as Standard but far fewer units per batch — so each Premium unit carries a much higher set-up cost. Traditional absorption costing would miss this entirely.