Activity-based costing (ABC)

Activity-based costing (ABC) is a cost-accounting tool that attempts to determine the cost of each activity in the production or service process. Traditional cost accounting focuses on accumulating the total cost of the item produced by cost inputs (i.e., salaries, materials, overhead). ABC overcomes the deficiencies in this process by looking at the cost from an activity perspective instead of an inputs perspective. For example, a traditional cost-accounting system may say the painting department had the following costs for painting one appliance: direct labor, $20; direct materials, $10; assigned overhead, $20. An activity-based cost system would show the cost by activities: sanding, $5; cleaning, $5; spraying, $25; drying, $10; inspection, $5.
At the heart of this concept is the handling of overhead. Traditional cost accounting incorrectly assigns overhead based on some other cost such as direct labor. This often causes erroneous management data that assigns too much overhead to large jobs and too little to small jobs. It may allocate too much overhead to departments with less machinery and too little overhead to departments with more machinery.
Activity-based accounting tries to address this shortfall by allocating cost based on what it calls "cost drivers." Cost drivers are the items in the business that create overhead. Examples of cost drivers include number of production runs, number of engineering change orders, number of purchase orders, number of vendors, and number of parts. Activity-based costing requires the additional effort needed to determine what cost drivers are producing the overhead, and then it allocates the overhead to the activities based on the driver. This gives a much more accurate total cost calculation.