What would be a brief description of activity based costing?

Activity based costing (ABC) is a more sophisticated and logical way to allocate a company’s costs to its products (or other objects) than traditional costing. (Traditional costing might allocate all of the overhead costs solely on the basis of machine hours.) Activity based costing identifies the many activities that actually cause the company to consume resources. Next, it calculates the cost of each of the activities. Then it assigns each activity’s cost only to the products that actually use the activities. Obviously this is important when some products require few activities, and other products require many activities.

In the case of a manufacturer, some products may require special engineering, sophisticated testing, unique storage arrangements, and are low-volume items. Other products might be high-volume items that run continuously and require no special attention. In other words, some products require lots of activities (engineering, testing, storing, many machine setups, and running the production machine), while some products require just one activity–running the production machine. Under activity based costing, the products that require the activities mentioned above will be assigned the costs of engineering, testing, storing, setups, and producing activities. The products that run continuously will not be assigned costs for engineering, etc. These products will only be assigned the cost of the production activity. (If activities were not considered, and all costs were allocated solely on machine hours, the high-volume, easy-to-manufacture products would be assigned an enormous amount of overhead, and the low-volume, activity-intensive products would be assigned too little overhead cost.)

Activity based costing is useful for service businesses as well as manufacturers. The process of identifying and determining the cost of activities can lead to improvements in a company’s operations.

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