Activity-Based Costing
AdvancedActivity-based costing (ABC) is a method of assigning overhead costs to products or services based on the activities they actually use, such as machine setups, inspections or orders processed, rather than a single broad measure such as labour hours.
Traditional costing often spreads overheads across products using one allocation base, such as direct labour hours. This can distort costs when products use overhead resources very differently.
ABC first identifies the main activities that create overhead costs, groups the costs by activity, and then assigns them to products based on cost drivers, the measures of how much of each activity a product uses.
For example, machine setups cost 50,000 a year and there are 100 setups, so each setup costs 500. A specialist product needing 10 setups is assigned 5,000 of setup cost, even if it uses few labour hours. Under traditional costing, high-volume products would have absorbed much of this cost instead.
ABC often reveals that low-volume, complex products are more expensive to make than traditional methods suggest, while high-volume simple products are cheaper. This helps with pricing and product decisions. The drawback is that ABC requires more data and effort to set up and maintain.
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