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Performance Management · Activity-based costing

Merits, Demerits and Uses of Activity-Based Costing

Updated 11 October 2026 · Fact-checked

Activity-based costing (ABC) assigns overheads to products using the activities that cause them. Its merits are more accurate product costs and better insight into overhead behaviour. Its demerits are cost, complexity and arbitrary cost pools. In exams, you must discuss both sides and link each point to the scenario.

Understand Merits, Demerits and Uses of ABC

Traditional absorption costing spreads overheads using a volume measure, such as labour hours or machine hours. This works if overheads rise and fall with volume. In many firms they do not. Overheads often come from activities such as set-ups, inspections, order handling and design.

Activity-based costing (ABC) identifies these activities, groups their costs into cost pools, and charges them to products using cost drivers. A product that needs many set-ups takes more of the set-up pool. Low-volume, complex products usually receive more cost than under traditional methods. High-volume, simple products usually receive less.

The main merits follow from this. Product costs are usually more accurate. Pricing and profitability decisions improve. Managers see what drives overheads and can target those drivers. Overheads are less hidden in a single absorption rate.

The main demerits are practical. ABC takes time and money to set up and maintain. Many costs, such as head office or factory rent, have no clear driver, so they still need arbitrary apportionment. Choosing activities and drivers needs judgement. The data may not be available. The result is not suitable if overheads are small or products are very similar.

Activity-based management (ABM) uses ABC information to manage the business. Examples are cutting non-value-added activities, redesigning processes, controlling cost drivers, setting prices, reviewing product ranges and supporting budgeting. ABC can also suit service organisations. They often have high overheads, little direct material and varied customers or services. Cost drivers there might be number of client visits, transactions or enquiries. The drawback is that service output is intangible and activities are harder to measure.

Key rules to remember

Cost driver rate
Cost per driver unit = Total cost of the activity pool ÷ Total number of driver units
Use the expected level of the driver for the period, for example set-ups or inspections.
Overhead charged to a product under ABC
Overhead = Σ (cost driver rate × driver units used by the product)
Add the charge from each pool, then divide by units produced for cost per unit.
Cost hierarchy
Unit-level, batch-level, product-level, facility-level
Facility-level costs have no sensible driver, so they are often absorbed on a volume basis or left out of unit cost.

How to solve Merits, Demerits and Uses of ABC questions

Use this method for any question that asks you to discuss, evaluate or advise on ABC.

  1. 1Read the requirement. Note whether it asks for merits, demerits, uses or suitability, and who the reader is.
  2. 2Scan the scenario for clues: overhead level, product range, volume and complexity, service or manufacturing, data available.
  3. 3State briefly what ABC does: overheads traced via activities and cost drivers.
  4. 4Give merits and demerits that fit the clues. Make each point a full sentence with a reason.
  5. 5Link each point to the scenario with a number, product or activity from the question.
  6. 6Add uses where relevant: pricing, product mix, cost control through ABM, budgeting, performance review.
  7. 7Finish with a reasoned conclusion on whether ABC is worth adopting in this case.

Quickest way: Point, reason, scenario

When to use it: Use this for Section C discussion parts and for choosing between statements in objective questions.

  1. Check the overhead share of total cost. High means ABC is more useful.
  2. Check product diversity. Varied volumes, sizes and complexity favour ABC.
  3. Check the cost of the system against the likely benefit.
  4. Write each point as: point, reason, scenario link.
  5. In objective questions, reject absolute words such as always, eliminates or guarantees.

Common mistakes in Merits, Demerits and Uses of ABC

  • Listing advantages and disadvantages with no link to the scenario.

    Students memorise a generic list.

    Fix: Tie every point to a fact in the question, such as high overheads or similar products.

  • Saying ABC removes all arbitrary apportionment.

    Students overstate the accuracy of ABC.

    Fix: State that facility-level costs and the choice of pools and drivers still need judgement.

  • Saying ABC reduces costs by itself.

    ABC is confused with ABM.

    Fix: Say ABC gives information. Action on the activities and drivers (ABM) is what controls cost.

  • Claiming ABC is only for manufacturing firms.

    Textbook examples use products and factories.

    Fix: Explain that services have activities and overheads too, with drivers such as transactions or client visits.

  • Writing only demerits or only merits when asked to evaluate.

    Students run out of time or stop after the first list.

    Fix: Give balanced points and end with a conclusion.

  • Assuming ABC is always better than traditional costing.

    Students think newer means better.

    Fix: Say it depends on whether overheads are large, products are diverse and the benefits exceed the cost.

Worked examples

Example 1

A company makes two products, Standard and Deluxe, using labour hours to absorb overheads. Overheads are high and Deluxe is made in small batches with many set-ups. The finance director asks whether ABC would be useful. Discuss, in about six points.

Show the solution
  1. Open with the requirement: judge usefulness for this company.
  2. Merit 1: Deluxe uses many set-ups but low hours, so labour hours undercharge it. ABC would trace set-up costs to Deluxe.
  3. Merit 2: Better product costs improve pricing and the decision on whether to keep Deluxe.
  4. Merit 3: ABC shows set-ups as a cost driver, so managers can try to reduce set-up numbers or batch changes.
  5. Demerit 1: The system costs time and money to set up and keep updated.
  6. Demerit 2: Some overheads, such as factory rent, have no driver and still need apportionment.
  7. Demerit 3: Pools and drivers involve judgement, so costs are not perfectly accurate.
  8. Conclude: with high overheads and different batch patterns, ABC is likely to be worth adopting, if the data on set-ups can be collected at reasonable cost.

Answer: ABC is likely to be useful because overheads are high and the products consume overheads differently. It would improve costing and decisions, but it has costs and limits that should be weighed.

Example 2

A firm of accountants charges clients using a rate per chargeable hour that includes a flat overhead absorption. The managing partner says ABC is only for factories. Explain whether ABC could be used in the firm.

Show the solution
  1. Reject the claim: ABC depends on activities and overheads, not on making goods.
  2. Identify overheads in the firm: administration, compliance, client onboarding, software, training.
  3. Suggest activities and drivers: onboarding by number of new clients, queries by number of client contacts, tax returns by number of returns.
  4. Explain benefit: clients who need more support cost more to serve, and ABC shows this. Fees and client choices can be reviewed.
  5. Note limits: service output is intangible and varies by client, so measuring activity use is harder. Many costs are fixed and shared.
  6. Conclude: ABC can be used, mainly to understand client profitability, if the cost of collecting data is justified.

Answer: ABC is suitable for service organisations that have high overheads and varied customers. Drivers such as client contacts or transactions can be used. Measurement difficulties and system cost are the main drawbacks.

Exam tips

  • For discuss questions, aim for a balanced answer. One-sided answers rarely cover the full requirement.
  • Use scenario numbers and facts. Generic points earn less than applied points.
  • If asked about uses, include pricing, product mix, cost control through ABM, budgeting and service organisations.
  • In objective questions, watch for absolute wording. ABC improves accuracy but does not guarantee it.
  • Keep each written point to one or two sentences so you cover more points in the time.

Practice questions from Activity-based costing

Merits, Demerits and Uses of ABC: frequently asked questions

What are the main advantages of activity-based costing?

ABC usually gives more accurate product costs when overheads are not driven by volume. It shows what causes overheads and supports better pricing and product decisions. It also helps managers focus on cost drivers and activities that add no value.

What are the main disadvantages of ABC?

It is costly and time-consuming to set up and run. Some overheads cannot be linked to a driver, so arbitrary apportionment remains. It also needs judgement in choosing activities and drivers, and it may not be worth it if overheads are small.

Is ABC suitable for service organisations?

Yes, it can be. Service firms often have high overheads and varied customers, and drivers such as transactions or client visits can be used. Measurement is harder because services are intangible and many costs are fixed.

What is the difference between ABC and activity-based management?

ABC is a costing method that assigns overheads using activities and cost drivers. ABM uses that information to manage the business, for example by cutting non-value-added activities or redesigning processes. ABC supplies the data. ABM takes action.