by Activity Based Costing (ABC) is a modern costing technique that allocates overhead costs to products and services based on the activities that generate those costs. Traditional costing methods usually allocate overheads using broad measures such as direct labour hours or machine hours, which may produce inaccurate product costs. ABC recognizes that activities consume resources and products consume activities. Therefore, costs are assigned according to the actual consumption of activities. ABC provides more accurate cost information and helps organizations improve pricing, profitability analysis, cost control, and strategic decision-making.
Meaning of Activity Based Costing
Activity Based Costing is a costing method that identifies activities within an organization and assigns the cost of each activity to products or services based on their consumption of those activities.
Allocation of Overheads under ABC
Stage 1. Identification of Overhead Costs
The first stage in allocating overheads under Activity Based Costing is identifying all indirect costs incurred by the organization. These costs include factory rent, maintenance expenses, supervision costs, electricity, inspection expenses, and administrative overheads. Unlike traditional costing, ABC does not allocate all overheads together. Instead, it studies the nature of each overhead and determines the activities responsible for generating those costs. Proper identification of overhead costs ensures that every expense is assigned to the correct activity. Therefore, identifying overhead costs is the foundation of ABC because accurate cost allocation depends upon complete and correct identification of indirect expenses.
Stage 2. Identification of Activities
After identifying overhead costs, the organization determines the activities that consume resources and generate those costs. Activities may include machine setup, purchasing, inspection, material handling, packaging, and maintenance. Each activity represents a specific task performed within the organization. ABC assumes that products consume activities and activities consume resources. Therefore, proper identification of activities is essential for allocating overhead costs accurately. For example, inspection costs are related to quality control activities, while maintenance costs are related to equipment servicing activities. Identifying activities helps managers understand cost behaviour and provides the basis for creating activity cost pools under Activity Based Costing.
Stage 3. Creation of Activity Cost Pools
Once activities are identified, overhead costs related to similar activities are grouped into activity cost pools. A cost pool is a collection of costs associated with a particular activity. For example, all costs related to purchasing activities are placed in the purchasing cost pool, while setup expenses are placed in the setup cost pool. Creating separate cost pools improves cost accuracy because each pool reflects a specific activity. This process avoids the use of broad overhead rates and enables organizations to trace costs more precisely. Therefore, activity cost pools are essential because they organize overhead costs before assigning them to products.
Stage 4. Identification of Cost Drivers
After creating cost pools, the next step is identifying cost drivers for each activity. Cost drivers are the factors that cause activity costs to occur and determine how costs are allocated to products. Examples include the number of purchase orders, machine hours, number of setups, and inspection hours. Every activity has an appropriate driver that measures its consumption by products or services. Selecting suitable cost drivers is important because inaccurate drivers may distort product costs. Therefore, identifying cost drivers is a critical stage in overhead allocation because it establishes the relationship between activities and products under Activity Based Costing.
Stage 5. Calculation of Cost Driver Rates
The next step involves calculating the cost driver rate for each activity. The cost driver rate is obtained by dividing the total cost of an activity cost pool by the total quantity of its cost driver. For example, if setup costs amount to ₹2,00,000 and there are 100 machine setups, the cost driver rate becomes ₹2,000 per setup. This rate represents the cost of performing one unit of the activity. Cost driver rates provide the basis for assigning activity costs to products according to their actual consumption of activities. Therefore, calculating cost driver rates improves the accuracy and fairness of overhead allocation.
Stage 6. Allocation of Costs to Products
Once cost driver rates are determined, overhead costs are assigned to products or services based on the amount of activities consumed. Products requiring more activities receive a larger share of overhead costs. For example, if Product A requires ten machine setups and the setup rate is ₹2,000 per setup, Product A receives ₹20,000 of setup costs. This approach ensures that overhead costs are allocated according to actual resource consumption rather than broad averages. Therefore, allocating costs to products using activity information provides accurate product costing and improves managerial decisions regarding pricing and profitability.
Stage 7. Preparation of Product Cost Information
After overhead costs are allocated, organizations prepare detailed product cost information. This information includes direct materials, direct labour, and activity-based overhead costs assigned to each product. Accurate product cost information helps managers determine the profitability of individual products and evaluate their contribution to organizational performance. Products consuming excessive resources can be identified and improved or discontinued if necessary. Detailed cost information also supports pricing decisions and strategic planning. Therefore, preparing product cost information is an important stage in overhead allocation because it converts activity data into meaningful managerial information for decision-making and performance evaluation.
Stage 8. Review and Continuous Improvement
The final stage in overhead allocation under ABC is reviewing the system and continuously improving it. Business operations and activities change over time because of technological developments and market conditions. Consequently, activity cost pools and cost drivers may need revision. Regular review ensures that cost allocation remains accurate and relevant. Organizations can also identify non-value-added activities and eliminate unnecessary costs through continuous improvement. This process increases efficiency and strengthens cost management practices. Therefore, continuous review and improvement are important because they ensure the long-term effectiveness of Activity Based Costing and maintain the reliability of overhead allocation systems.
Methods of Allocation of Overheads under ABC
1. Transaction Driver Method
The Transaction Driver Method allocates overhead costs based on the number of times an activity is performed. It assumes that every occurrence of an activity consumes approximately the same amount of resources. This method is simple, inexpensive, and easy to implement because it uses measurable factors such as the number of purchase orders, number of inspections, number of machine setups, and number of customer orders.
For example, if purchasing costs amount to ₹1,00,000 and the company processes 500 purchase orders, the cost driver rate becomes ₹200 per purchase order. Products requiring more purchase orders receive a larger share of purchasing costs.
This method is widely used because it reduces administrative effort and provides a practical way of allocating overhead expenses. However, it may not always be completely accurate because different transactions may consume different amounts of resources. Despite this limitation, the transaction driver method remains useful for organizations where activities are relatively uniform and the cost of collecting detailed information is not economically justified by additional accuracy.
2. Duration Driver Method
The Duration Driver Method allocates overhead costs according to the amount of time consumed by an activity. It recognizes that different activities may require different amounts of time and therefore consume different levels of resources. Common duration drivers include machine hours, labour hours, inspection hours, and setup hours.
For example, if maintenance costs amount to ₹2,00,000 and machines operate for 4,000 hours, the cost driver rate becomes ₹50 per machine hour. Products consuming more machine hours receive a larger allocation of maintenance costs.
This method is more accurate than the transaction driver method because it considers the time spent performing activities. It is particularly useful when the duration of activities varies significantly among products or customers. However, collecting and maintaining time-related information can be costly and time-consuming. Despite this limitation, the duration driver method provides more reliable cost information and helps organizations improve cost allocation, pricing decisions, and profitability analysis through better measurement of resource consumption.
3. Intensity Driver Method
The Intensity Driver Method allocates overhead costs according to the actual resources consumed by an activity. It provides the highest level of accuracy because costs are assigned based on the specific amount of labour, materials, equipment, and other resources used for a particular activity. Examples include engineering services, product design costs, technical support expenses, and consulting services.
For instance, if Product A requires special engineering assistance costing ₹30,000, that exact amount is allocated directly to Product A.
This method is particularly useful for complex activities where resource consumption differs significantly between products or customers. Since it measures actual consumption rather than averages, it provides highly accurate cost information and supports better managerial decision-making. However, the intensity driver method is expensive and difficult to implement because it requires detailed data collection and continuous monitoring of resource usage. Despite these challenges, it is extremely valuable for organizations requiring precise cost allocation and detailed profitability analysis.
4. Direct Tracing Method
The Direct Tracing Method allocates overhead costs directly to products or services whenever a clear relationship exists between the cost and the cost object. Under ABC, some activity costs can be directly assigned without using allocation bases because the organization can identify exactly which product or customer consumed the resources. Examples include special product design costs, customized packaging costs, and specific customer support expenses.
For instance, if a company spends ₹50,000 to design a customized product for a particular customer, the entire amount is charged directly to that product.
This method provides highly accurate cost information because it eliminates arbitrary allocation and ensures that costs are assigned to the actual users of resources. However, direct tracing can only be applied when a clear and measurable relationship exists between the cost and the cost object. Despite its limited applicability, this method improves cost accuracy and supports effective pricing and profitability analysis.
5. Resource Driver Method
The Resource Driver Method allocates resource costs to activities before assigning those activity costs to products or services. Resource drivers measure how activities consume organizational resources such as labour, machinery, floor space, and electricity.
Examples of resource drivers include machine hours, number of employees, floor area occupied, and energy consumption. For example, if electricity expenses amount to ₹3,00,000 and different departments consume electricity according to machine hours, the costs are allocated to activities based on those hours. After the costs are assigned to activities, they are further allocated to products using activity cost drivers.
This method provides a more systematic approach to overhead allocation because it recognizes the relationship between resources and activities. It also improves the understanding of resource utilization and helps managers identify inefficient activities. However, collecting information regarding resource consumption can be complex and expensive. Nevertheless, the resource driver method significantly enhances the accuracy of Activity Based Costing systems.
6. Activity Driver Method
The Activity Driver Method allocates costs from activity cost pools to products and services according to the extent to which products consume activities. Activity drivers are the measures that explain the frequency or intensity of activity usage by products. Examples include the number of setups, number of purchase orders, inspection hours, and material movements.
For example, if setup costs amount to ₹2,00,000 and there are 100 machine setups, the cost driver rate becomes ₹2,000 per setup. A product requiring ten setups receives ₹20,000 of setup costs.
This method is one of the most important methods under Activity Based Costing because it directly links activity consumption to product costs. It improves cost allocation accuracy and helps managers identify high-cost products and activities. However, selecting appropriate activity drivers requires careful analysis and regular updating. Despite this limitation, the activity driver method provides valuable information for pricing, cost control, and profitability analysis.
7. Multiple Cost Driver Method
The Multiple Cost Driver Method uses several cost drivers instead of a single allocation base for assigning overhead costs. Traditional costing systems often allocate all overhead expenses using one basis such as labour hours or machine hours, resulting in distorted product costs. ABC recognizes that different activities have different causes of costs and therefore uses multiple cost drivers for greater accuracy.
For example, purchasing costs may be allocated using the number of purchase orders, setup costs by the number of setups, and maintenance costs by machine hours.
This method reflects the complexity of modern manufacturing and service environments and provides more realistic cost information. It helps organizations understand the true cost of products, customers, and processes. However, implementing multiple cost drivers requires detailed information and sophisticated information systems. Despite these challenges, the method significantly improves the accuracy of overhead allocation and supports better strategic and operational decision-making.
8. Hierarchical Cost Allocation Method
The Hierarchical Cost Allocation Method classifies activities into different levels and allocates costs according to the nature of each activity. ABC generally recognizes four activity levels: unit-level activities, batch-level activities, product-level activities, and facility-level activities. Each level has its own cost drivers and cost behaviour.
For example, machine operation costs may be allocated using units produced, setup costs using the number of batches, product design costs using the number of products, and factory rent as a facility-level cost.
This method recognizes that not all overhead costs behave in the same way and therefore improves the accuracy of cost assignment. It also helps managers understand how different activities contribute to overall costs and profitability. However, classifying activities into different levels requires detailed analysis and can increase system complexity. Nevertheless, the hierarchical allocation method is extremely useful in providing a comprehensive and accurate approach to overhead allocation under Activity Based Costing.
Process of Allocation of Overheads under Activity Based Costing (ABC)
Step 1. Identification of Overhead Costs
The first step in the ABC process is identifying all overhead or indirect costs incurred by the organization. Overhead costs include factory rent, maintenance expenses, supervision costs, electricity, inspection expenses, insurance, and administrative costs. Unlike direct costs, these expenses cannot be directly traced to individual products and therefore require systematic allocation. Management must carefully analyze financial records and classify expenses according to their nature. Proper identification of overhead costs is essential because any omission may lead to inaccurate product costing and distorted profitability analysis.
For example, a manufacturing company may identify overhead costs such as machine maintenance of ₹5,00,000, inspection expenses of ₹2,00,000, and purchasing expenses of ₹1,50,000. These costs become the starting point for Activity Based Costing. Therefore, identifying overhead costs is the foundation of the entire ABC process because accurate cost allocation depends upon complete and correct identification of all indirect expenses incurred by the organization.
Step 2. Identification of Major Activities
After identifying overhead costs, the organization identifies the activities responsible for consuming resources and generating those costs. Activities are the operations performed within the organization, such as machine setup, purchasing, material handling, inspection, packaging, and maintenance. Management studies production and administrative processes to determine which activities significantly contribute to overhead costs.
For example, an automobile company may identify activities such as assembly, quality inspection, and machine setup, while a hospital may identify patient registration and laboratory testing. This step is important because Activity Based Costing allocates costs through activities rather than departments. Proper identification of activities helps managers understand how resources are consumed and where costs originate. It also provides the basis for creating activity cost pools and selecting cost drivers. Therefore, identifying major activities is an essential stage because all subsequent stages of overhead allocation depend upon accurate recognition of the activities performed within the organization and their contribution to total costs.
Step 3. Creation of Activity Cost Pools
Once activities are identified, costs associated with similar activities are grouped into activity cost pools. An activity cost pool is a collection of costs related to a particular activity. For example, all expenses associated with purchasing are placed in the purchasing cost pool, while all machine setup expenses are placed in the setup cost pool. This grouping process improves cost accuracy because each pool reflects a specific activity rather than combining all overhead expenses into a single category. Cost pools simplify cost allocation and enable organizations to assign costs according to the actual consumption of activities.
For instance, inspection costs, inspectors’ salaries, and testing equipment expenses may be grouped into an inspection cost pool. Creating separate cost pools also helps managers understand which activities generate the highest costs and where improvements are needed. Therefore, activity cost pools play an important role in Activity Based Costing because they organize overhead costs and prepare them for allocation to products and services.
Step 4. Identification of Cost Drivers
The next step in the process is identifying appropriate cost drivers for each activity. Cost drivers are the factors that cause activity costs to occur and determine how those costs are assigned to products. Examples include the number of machine setups, number of purchase orders, machine hours, and inspection hours. Every activity should have a driver that accurately reflects resource consumption.
For example, purchasing costs may be driven by the number of purchase orders, while maintenance costs may depend on machine hours. Selecting appropriate cost drivers is essential because inaccurate drivers can distort product costs and lead to poor managerial decisions. Management often studies operational records and historical data to determine the most suitable drivers. Properly selected cost drivers improve the reliability of cost allocation and provide better information for pricing and profitability analysis. Therefore, identifying cost drivers is one of the most critical stages in the ABC process because it establishes the relationship between activities and products.
Step 5. Calculation of Cost Driver Rates
After identifying cost drivers, organizations calculate cost driver rates for each activity cost pool. The cost driver rate is determined by dividing the total cost of an activity by the total quantity of its cost driver. This rate represents the cost of performing one unit of the activity.
For example, if setup costs amount to ₹2,00,000 and there are 100 machine setups, the cost driver rate becomes ₹2,000 per setup. Similarly, if purchasing costs amount to ₹1,50,000 and 750 purchase orders are processed, the purchasing rate becomes ₹200 per purchase order. Cost driver rates provide the basis for assigning activity costs to products according to their actual consumption of activities. Accurate calculation of these rates improves product costing and helps managers understand the true cost of operations. Therefore, calculating cost driver rates is an important step because it converts activity information into measurable rates that can be used for overhead allocation.
Step 6. Allocation of Costs to Products and Services
The final step in the ABC process is allocating activity costs to products and services according to the amount of activities consumed. Products requiring more activities receive a larger share of overhead costs.
For example, if Product A requires ten machine setups and the setup rate is ₹2,000 per setup, Product A receives ₹20,000 of setup costs. Similarly, if Product B requires only three setups, it receives ₹6,000 of setup costs.
This method ensures that costs are assigned according to actual resource consumption rather than broad averages. Accurate cost allocation helps managers determine product profitability, establish selling prices, and identify high-cost activities. It also supports strategic decisions regarding product design, outsourcing, and process improvement. Therefore, allocating costs to products and services is the most important stage of Activity Based Costing because it produces accurate product cost information and enables organizations to improve profitability and managerial decision-making.
