Definition
Activity-based costing (ABC) is a costing method that assigns overhead to products, services or customers through the activities that consume it, such as machine setups, quality inspections or order handling. Each activity has its own cost pool and cost driver, so products that need many setups or inspections carry the overhead they actually cause.
How it works
ABC works in four steps: identify the main support activities, assign overhead to an activity cost pool for each, choose a cost driver that measures how much each product uses the activity, and divide each pool by its total driver volume to get an activity rate. Products are then charged rate times usage.
A single plant-wide rate based on labour or machine hours spreads overhead in proportion to volume. That overcosts high-volume, simple products and undercosts low-volume, complex ones, which can lead to underpricing the products that actually consume the most support.
ABC costs more to run, so it pays off when overhead is large and products differ a lot in complexity. Ledgeriano lets you build activity-based costing models and compare them with a plant-wide rate; the management accounting guide has a worked case, and overhead absorption explains the traditional method.
Formula
Activity rate = Activity cost pool ÷ Total cost driver volume
Overhead charged = Σ (Activity rate × Driver units used by the product)
Example: standard vs custom product
Overhead is 100,000: setups 60,000 (100 setups, 600 each) and inspections 40,000 (1,000 inspections, 40 each). Standard: 10,000 units, 20 setups, 400 inspections. Custom: 1,000 units, 80 setups, 600 inspections. Each unit takes one machine hour.
| Standard | Custom | |
|---|---|---|
| Plant-wide rate (100,000 ÷ 11,000 machine hours) | 9.09 per unit | 9.09 per unit |
| ABC overhead | 20 × 600 + 400 × 40 = 28,000 | 80 × 600 + 600 × 40 = 72,000 |
| ABC overhead per unit | 2.80 | 72.00 |