Activity-based costing (ABC)
Also known as: ABC costing
Activity-based costing (ABC) is a method of assigning overhead costs to products based on the activities each product actually consumes. It replaces a single plantwide overhead rate with multiple cost pools, each allocated using its own cost driver.
Activity-based costing (ABC) is a costing system that assigns overhead to products or services based on the activities required to produce them. Traditional costing spreads all overhead using one broad measure, such as direct labor hours or machine hours. ABC instead identifies the distinct activities that generate overhead — machine setups, quality inspections, material handling, purchase orders — and traces costs to products according to how much of each activity they use.
The mechanics follow a two-stage pattern. First, overhead costs are grouped into cost pools, one for each major activity. Second, each pool is assigned to products using a cost driver — a measure of activity consumption, such as number of setups or inspection hours. For example, if a setup cost pool totals $100,000 and the factory performs 500 setups, each setup costs $200. A low-volume specialty product requiring 50 setups absorbs $10,000 of setup cost, even if it accounts for a tiny share of total labor hours.
ABC matters because a single plantwide rate tends to overcost high-volume, simple products and undercost low-volume, complex ones. More accurate product costs lead to better pricing, product-mix, and outsourcing decisions. The tradeoff is that ABC is more expensive to design and maintain, so it delivers the most value when overhead is large and products differ significantly in complexity.
Activity-based costing is tested on the CMA Part 1 exam, which covers cost pool construction, driver selection, and product costing under ABC.
Key takeaways
- ABC assigns overhead based on the activities each product consumes, rather than a single plantwide rate.
- Costs are grouped into activity cost pools and allocated using cost drivers such as setups or inspection hours.
- ABC typically shifts cost from high-volume, simple products to low-volume, complex products.
- It improves pricing and product-mix decisions but costs more to implement than traditional costing.
- The CMA Part 1 exam tests ABC in depth.