What activity-based costing is
Activity-based costing (ABC) assigns overhead to products according to the real consumption of activities, instead of a single allocation base such as direct labor hours. Products that demand more setups, inspections and orders carry more cost.
Under traditional costing, a simple high-volume product often subsidizes a complex low-volume one. ABC exposes that subsidy and shows which product, customer or order actually makes money. The basics of unit cost are in production cost and unit cost; this article focuses on how overhead is allocated.
Visual map of activity-based costing
The map shows the chain from resources to activities, cost drivers and cost objects, with the 2-product example.
The logic in 4 stages
- Resources: what the company spends (indirect salaries, energy, depreciation, rent).
- Activities: what the company does with those resources (set up machines, machine, inspect, ship).
- Cost drivers: the measure that explains how much of each activity a product uses (number of setups, machine hours, number of inspections, number of orders).
- Cost objects: products, customers or orders that receive the cost.
Driver rate = activity cost ÷ total driver volume
Cost assigned to product = rate × driver volume consumed by the product
Direct costs (material and direct labor) are still traced directly; ABC deals only with overhead.
Worked example: two metal brackets
Fictional example: a metalworking plant makes P1 (standard bracket, 10,000 units/year) and P2 (special bracket, 2,000 units/year). Overhead totals $360,000 per year. Each product uses 0.5 machine hours per unit, i.e. 5,000 h for P1 and 1,000 h for P2.
Stage 1: cost and rate per activity.
| Activity | Annual cost | Driver | Total volume | Rate per driver |
|---|---|---|---|---|
| Setup | $90,000 | no. of setups | 60 | $1,500 |
| Machining | $150,000 | machine hours | 6,000 | $25 |
| Inspection | $60,000 | no. of inspections | 250 | $240 |
| Orders and shipping | $60,000 | no. of orders | 300 | $200 |
| Total | $360,000 |
Stage 2: cost assigned to each product.
| Activity | P1 | P2 |
|---|---|---|
| Setup | 20 × $1,500 = $30,000 | 40 × $1,500 = $60,000 |
| Machining | 5,000 × $25 = $125,000 | 1,000 × $25 = $25,000 |
| Inspection | 100 × $240 = $24,000 | 150 × $240 = $36,000 |
| Orders and shipping | 200 × $200 = $40,000 | 100 × $200 = $20,000 |
| Total overhead | $219,000 | $141,000 |
| Overhead per unit | $21.90 | $70.50 |
Check: $219,000 + $141,000 = $360,000. Overhead per unit is $219,000 ÷ 10,000 = $21.90 for P1 and $141,000 ÷ 2,000 = $70.50 for P2.
ABC versus traditional allocation
Under the traditional method, overhead would be spread by machine hours: $360,000 ÷ 6,000 h = $60 per hour. Since each unit uses 0.5 h, both products receive $30.00 of overhead per unit. Here is the effect on results:
| Per unit | P1 | P2 |
|---|---|---|
| Selling price | $80.00 | $100.00 |
| Direct cost (material + labor) | $50.00 | $60.00 |
| Overhead, traditional allocation | $30.00 | $30.00 |
| Margin, traditional | $0.00 | $10.00 |
| Overhead, ABC | $21.90 | $70.50 |
| Margin, ABC | $8.10 | $-30.50 |
| Annual result, ABC | $81,000 | −$61,000 |
Total profit is the same ($20,000), but its distribution changes: under the traditional method P1 shows a zero margin and P2 shows $10 per unit. Under ABC, P1 earns $8.10 per unit and P2 loses $30.50 on every piece. P2 triggers 40 of the 60 setups and 150 of the 250 inspections, which the hours-based allocation hid.
With ABC the decisions change: reprice P2, cut setups with SMED, combine batches or review the mix using contribution margin. Before dropping a product, confirm which overhead really disappears; part of it is fixed.
Step by step to implement
- Define the purpose: pricing, product mix, customer profitability or cost reduction.
- List the activities through interviews and process mapping; start with 5 to 15 activities, not hundreds.
- Assign resources (payroll, energy, depreciation) to each activity, using measured time or consumption percentages.
- Choose a measurable driver for each activity, using data your system already records.
- Calculate each driver rate and assign costs to the cost objects.
- Compare with the current method, explain the differences to management and review the model once a year.
When it pays off, and the TDABC variant
- Worth it with a high share of overhead, a varied mix, and different batch sizes and complexity across products or customers.
- Of little use when overhead is small and products are alike: simple allocation is enough.
- TDABC (time-driven ABC), by Kaplan and Anderson, simplifies the model: it uses the cost per minute of capacity and the time each activity takes, with no long interviews.
For equipment purchase decisions, combine ABC with TCO; to see what poor quality costs, use the cost of quality.
Common mistakes and limits
- Too many activities: a model with hundreds of activities costs more to maintain than it returns.
- Drivers that do not explain consumption: using labor hours for everything reproduces traditional allocation.
- Treating the result as avoidable cost: ABC allocates costs; they only go away if capacity is actually reduced.
- Eyeballed data: time percentages without measurement undermine trust in the model.
- Doing it once and abandoning it: rates change with prices, volumes and processes.
- Ignoring management support: if it is not used in decisions, the model becomes an accounting report.
Frequently asked questions
What is activity-based costing?
A method that assigns overhead to products, customers or orders according to the consumption of activities, measured by cost drivers.
What are cost drivers?
The measures that explain how much of an activity is consumed, such as number of setups, machine hours, number of inspections or orders.
How does ABC differ from traditional costing?
Traditional costing spreads overhead over a single base (hours, material); ABC uses several bases, one per activity, and reveals cross-subsidies between products.
How do you calculate a driver rate?
Divide the activity cost by the total driver volume. In the example: $90,000 ÷ 60 setups = $1,500 per setup.
Does ABC work for services?
Yes. Banks, hospitals and administrative areas use it to cost processes, customers and services.
Is ABC accepted for tax and statutory reporting?
It is usually a management tool. For financial statements and tax filing, check the applicable accounting rules and your accountant.
Sources
- COOPER, R.; KAPLAN, R. S. Measure Costs Right: Make the Right Decisions. Harvard Business Review, 1988.
- KAPLAN, R. S.; COOPER, R. Cost & Effect: Using Integrated Cost Systems to Drive Profitability and Performance. Harvard Business School Press, 1998.
- KAPLAN, R. S.; ANDERSON, S. R. Time-Driven Activity-Based Costing. Harvard Business School Press, 2007.
- HORNGREN, C. T. et al. Cost Accounting: A Managerial Emphasis. Pearson.
Keep studying: trusted sources and links
- Sebrae: gestão, custos e finanças para empresas (in Portuguese)
- CFC: Conselho Federal de Contabilidade (in Portuguese)
- Wikipedia: Cost accounting
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About the author
Lean Manufacturing & Behavioral Management Specialist
Over 20 years in the automotive and metalworking industries (GM and Dana), Lean Manufacturing practitioner since 2006. SENAI instructor and mentor in Brazil’s Brasil Mais Produtivo program, delivering consulting, training and audits for 50+ companies, combining quality, productivity and people development.
