Activity-Based Costing
A costing method that assigns overhead costs to products based on the specific activities that consume resources.
What is ABC Costing?
Activity-based costing (ABC) is an accounting method that identifies the activities a company performs and assigns overhead costs to products or services based on the actual consumption of those activities. Traditional costing spreads overhead uniformly — typically by direct labor hours — which can distort product profitability when products differ significantly in complexity. ABC traces costs through cost pools and cost drivers (e.g., number of setups, machine hours, orders processed) to allocate expenses more accurately. While ABC provides better insight for pricing and make-or-buy decisions, it is more complex to implement than traditional costing and is typically used as a supplement to GAAP reporting for internal management purposes.
Example
A manufacturer produces two products: a standard widget and a custom widget. Traditional costing allocates overhead equally per labor hour. Under ABC, the custom widget triggers far more engineering changes, quality inspections, and machine setups — so it receives a significantly higher overhead allocation, revealing that it is actually unprofitable at its current price.