Activity-based costing (ABC)

Welcome to this segment on activity based costing or ABC for short. Over the years, businesses have realized that traditional costing methods may not always accurately reflect the true resources consumed by their products or services, especially when overhead costs are significant, and production processes are complex. Activity based costing responds to this challenge by recognizing that activities drive costs, not just the amount of labor or machine time. In this system, costs are assigned to products based on the actual activities and resources they consume, giving managers a much clearer picture of profitability and cost drivers. To understand activity based costing, it's essential to grasp its main steps. First, a firm identifies major activities involved in producing goods or services. Each activity consumes resources, so costs are grouped into cost pools. Next, the organization determines cost drivers, factors that cause costs to rise or fall, such as the number of production setups or purchase orders processed. Finally, overhead is assigned to products based on their actual use of activities and cost drivers, instead of using a single measure like direct labor or machine hours. Adopting activity based costing offers substantial benefits, especially in environments with diverse products and complex processes. ABC provides more accurate product costing, helping managers identify high and low cost products precisely. It makes the real drivers of overhead visible,