What it means
Traditional costing spreads overhead (rent, supervision, equipment and other indirect costs) across products using one simple yardstick, such as direct labour hours or units made. That works when all products consume overhead in similar proportions.
It fails when a complex, low-volume product needs far more support than a simple, high-volume one. Activity based costing, often shortened to ABC, fixes this in stages.
The business groups overhead into cost pools, each linked to an activity such as setting up machines, inspecting goods or handling orders. It then picks a cost driver for each pool, which is the measure that makes the cost rise, such as the number of setups or inspections.
Dividing each pool by its total driver volume gives a rate per driver unit. A product is charged that rate for each unit of the driver it uses, so a product needing 200 setups bears far more setup cost than one needing 100.
Adding these charges to direct costs gives the full cost of each product. ABC often reveals surprises.
Products that looked profitable under traditional costing may turn out to be unprofitable once their true overhead is counted, while simple products may have been over-charged and undersold. These insights guide pricing, product range decisions and customer negotiations.
The drawback is effort. Gathering activity data takes time and the system needs regular updating, so ABC suits businesses with large overheads and varied products or customers.
Some firms use a lighter version, called time-driven ABC, that estimates the time each activity takes.
In practice
Real-world examples
Example 1
A precision engineering firm discovers that custom orders need ten times as many machine setups as standard orders. Under ABC, custom products carry a much higher overhead charge. The firm raises its custom prices and shifts sales effort toward standard lines.
Example 2
A bank uses ABC to cost its customer segments. Customers who rely on branch visits and phone calls cost far more to serve than those who bank online. The bank introduces fees for high-touch services and promotes its app.
Example 3
A hospital assigns costs to activities such as admission, theatre preparation and recovery. It finds that one procedure consumes far more nursing time than its payment covers. The hospital renegotiates its contract with the insurer.
Think of it
ABC assigns costs based on what activities products actually require-more accurate than spreading costs evenly.
Formula
Calculation
Activity rate = Cost pool / Total driver volume
Overhead charged to a product = Sum of (Activity rate x Driver units used by the product)
A factory has $120,000 of setup costs and 300 setups, so the setup rate is $120,000 / 300 = $400 per setup. It has $80,000 of inspection costs and 1,000 inspections, so the inspection rate is $80,000 / 1,000 = $80 per inspection. Product Alpha uses 200 setups and 700 inspections, so its overhead is (200 x $400) + (700 x $80) = $80,000 + $56,000 = $136,000. Product Beta uses 100 setups and 300 inspections, so its overhead is $40,000 + $24,000 = $64,000. If Alpha makes 4,000 units its overhead is $136,000 / 4,000 = $34 per unit, and if Beta makes 16,000 units its overhead is $64,000 / 16,000 = $4 per unit. Spreading the $200,000 evenly over 20,000 units would have charged both products $10.Case study
Seen in the real world
Marlow Plastics is a fictional moulding company that, in this illustrative story, sold two product lines, standard bottle caps and custom medical housings. Using direct labour hours, its accountant spread overhead evenly and concluded that both lines earned a 15% margin.
A consultant recommended activity based costing. The analysis showed that the medical housings required about 70% of the machine setups and 70% of the quality inspections, even though they made up only 20% of units sold.
With overhead traced properly, the housings earned a margin close to zero while the caps earned about 22%. Marlow raised the housing price by 12% and offered caps customers volume discounts, and total profit improved within two quarters.
Watch out
Common mistakes
- Choosing too many activities. A long list adds cost and complexity without improving decisions.
- Using drivers that are easy to measure but unrelated to cost. The driver must genuinely explain why the cost rises.
- Treating ABC as a one-off project. Rates become stale as costs and volumes change.
Questions
People also ask
How is activity based costing different from traditional costing?
Traditional costing spreads overhead using one broad base such as labour hours, whereas ABC uses several drivers tied to specific activities. This gives more accurate product costs.
When is ABC worth the effort?
It is most useful when overhead is high and products or customers consume support services very differently. For simple businesses, a traditional method may be enough.
Can service businesses use it?
Yes. Banks, hospitals, logistics firms and consultancies all use it to cost services and customers.
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