Activity-Based Costing Explainer
Activity-based costing, or ABC, assigns indirect costs to products, services, or customers through the activities that consume resources. Instead of applying all overhead with one broad measure, it creates activity cost pools and uses drivers linked to the work performed.
A business identifies important activities, groups related costs, selects measurable drivers, calculates rates, and applies them based on actual or expected usage. Setup hours, purchase orders, inspections, support calls, or machine time may be more informative than production volume alone.
ABC can reveal cross-subsidies hidden by simple allocation. A low-volume customized product may consume far more scheduling and support than a high-volume standard item. Managers can use the insight for pricing, process improvement, product design, and customer profitability analysis.
The method is not automatically more accurate. Too many pools create costly data collection, while weak drivers create false precision. Allocated cost is not always avoidable cash cost, so decisions still require incremental analysis. Review the model as processes, technology, and product mix change.
Group overhead into activity pools and identify drivers of each pool.
Drivers should have a credible relationship with resource use.
Custom work, small batches, or frequent support may consume disproportionate overhead.
ABC can reveal subsidies between products or customers.
More detail increases effort and does not guarantee better decisions.
Keep material activities and update the model when operations change.
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