what do you mean by activity based costing

Activity-based costing (ABC) is a cost accounting method that finds the activities a business performs and then assigns costs to products or services based on how much they actually use those activities. It gives a more accurate picture of overhead and indirect costs than traditional methods that spread costs using just one factor like labour hours or machine hours.

Quick Scoop

What do you mean by activity based costing?

Activity-based costing means you:

• Identify all the key activities that create costs (e.g., machine setups, quality inspections, order processing, customer service).

• Group the costs of each activity into cost pools (a separate “bucket” of costs for setups, for inspections, for dispatching, etc.).

• Find cost drivers for each activity (e.g., number of setups, number of inspections, hours of design time).

• Assign activity costs to products or services based on how much they actually consume those activities.

So instead of saying “spread all overhead based on labour hours,” ABC says “see which activities cause the overhead, then charge products for the activities they really use.”

Mini example (simple story)

Imagine a factory making:

• Product A: simple, large batches, few machine setups.
• Product B: complex, many small batches, lots of setups and inspections.

Traditional costing:

• Allocates overhead using only labour hours or machine hours, so A and B may look similar in cost per unit.

Activity-based costing:

• Creates a setup cost pool (e.g., 50,000 currency units total; 100 setups → 500 per setup).

• If Product B uses 60 setups and Product A uses 40, B gets 30,000 of setup costs, A gets 20,000.

• Do the same for inspections, material handling, etc., and you often discover Product B is much more expensive than you thought.

That insight helps management adjust pricing, product mix, or processes.

Why is activity based costing used?

Common reasons companies adopt ABC include:

• More accurate product and service costing, especially when overheads are high and operations are complex.

• Better pricing decisions, because management can see the true cost per product, customer, or project.

• Identifying unprofitable products, services, or customers that consume a lot of costly activities.

• Improving processes by spotlighting activities that are wasteful or unnecessarily expensive.

It is especially popular in:

• Manufacturing businesses with multiple product lines and shared facilities.

• Service and project-based organizations where indirect costs form a big part of total cost.

Key features at a glance

• Focuses on activities , not just departments.

• Uses multiple cost drivers (setups, inspections, orders, design hours), not a single one like labour hours.

• Moves many indirect overhead costs into more precise, activity-based assignments.

• Gives clearer visibility into which products or services are truly profitable.

• Usually more complex and data-heavy than traditional costing, so not every small or simple business needs it.

Simple step view (how ABC works)

1. Identify activities that consume resources (e.g., purchasing, setup, machining, packaging, delivery).

2. Group costs into activity cost pools (setup costs, inspection costs, material handling costs, etc.).

3. Choose cost drivers for each pool (number of setups, inspection hours, orders processed, etc.).

4. Compute a rate for each cost driver (e.g., total setup cost ÷ total number of setups).

5. Assign costs to products or services by multiplying the activity rate by the amount of that driver used by each product.

In short, when you ask “what do you mean by activity based costing,” you’re asking about a modern way of costing that follows the path: resources → activities → cost objects (products/services/customers) instead of directly spreading costs with one broad measure.

Information gathered from public forums or data available on the internet and portrayed here.