ABC: impact on inventory, COGS, and decision-making

Impact on inventory and COGS

In an Activity-Based Costing (ABC) system, the effect on inventory valuation and cost of goods sold (COGS) stems from how overhead is assigned to products. Even though direct materials and direct labor are treated the same as in traditional costing, the change in overhead allocation can significantly alter the reported cost per unit.

Inventory valuation

Under ABC, overhead allocated through activity-based drivers flows into work-in-process and finished goods inventory, not raw materials, which are carried at purchase cost regardless of costing method.

• More complex or resource-intensive products will have higher inventory values, as they consume more costly activities.
• Conversely, simpler products will no longer be overburdened with indirect costs they do not truly consume.

This leads to a more accurate representation of inventory value on the balance sheet and aligns better with managerial insights about product complexity and resource usage.

Example: Traditional vs. ABC product cost

A company makes $8,000$ units of simple product A and $2,000$ units of complex product B; total overhead is $100,000. A traditional single rate assigns $10 per unit to both: A totals $80,000, B totals $20,000. ABC traces overhead to machine hours and setups - B needs far more setups, since it’s produced in small, complex batches - and instead assigns A $52,000 ($6.50/unit) and B $48,000 ($24/unit), shifting $28,000 from A to B.

Answer: Total overhead is still $100,000 either way - ABC just reallocates it, raising B’s cost and the overhead carried in B’s ending inventory and COGS while lowering A’s.

Watch out: ABC reallocates total overhead - it doesn’t create or destroy it. A single volume-based rate overcosts high-volume simple products and undercosts complex ones (cross-subsidization); ABC fixes that split, not the total.

Cost of goods sold (COGS)

Since COGS is directly derived from inventory costs, any difference in the way overhead is applied will also affect COGS.

• If ABC assigns more overhead to high-activity products, their COGS will increase.
• If simpler products receive less overhead, their COGS will decrease relative to traditional costing.

This shift can affect gross margin, product profitability analysis, and strategic decisions about product pricing and discontinuation.

Benefits and limitations of ABC

Benefits

• ABC provides more precise product costing by tracing overhead based on actual activity consumption.
• Supports better pricing, product mix, and discontinuation decisions by identifying true profitability - ABC helps managers avoid underpricing complex products or overpricing simple ones.
• Helps managers understand cost drivers and reduce or eliminate non-value-added activities.
• Particularly effective in multi-product or service firms with diverse overhead structures.

Limitations

• Implementing and maintaining an ABC system can require significant resources and data tracking.
• ABC involves multiple stages of cost allocation, which may be challenging for smaller organizations.
• Activity rates and drivers need ongoing review to remain relevant and accurate.
• ABC systems built for internal decisions often include nonmanufacturing costs (not allowed in GAAP inventory) and facility-sustaining costs with no clear activity driver - both need adjustment before the numbers feed external reporting.