Activity-Based Costing

Activity-based costing or ABC assigns indirect costs to products by identifying production activities, creating cost pools, selecting appropriate cost drivers, measuring usage, and allocating overhead based on actual usage.
For instance, consider a beverage company that produces Classic Cola and Diet Cola. Both are made in the same factory but consume different amounts and types of resources.
The company begins by identifying three key activities that create overhead, namely machine setup, quality control, and packaging. These are grouped into activity cost pools, each with its own total overhead cost.
Next, it selects a cost driver for each activity, such as the number of setups, quality tests, or packaging types.
Since Diet Cola requires more setups, stricter testing, and more complex packaging than Classic Cola, it receives a higher share of overhead.
Using ABC, overhead is allocated in proportion to each product’s actual use of activities, rather than being spread based on the number of units produced.
Overall, ABC helps managers make better pricing and profitability decisions.