What Is Activity-Based Costing (ABC)?
Also known as: ABC costing, activity based costing, ABC accounting
Definition
Activity-based costing assigns overhead to products based on the activities that actually consume resources, such as setups, inspections or material handling, using a cost driver for each activity, instead of spreading all overhead on direct labor hours.
Activity-Based Costing (ABC) Explained
Traditional costing applies a single overhead rate, often per direct labor hour or machine hour. That works when every product consumes support activities in proportion to labor. In a modern plant with automation and many low volume parts, it distorts cost: high volume simple parts are over-costed and low volume complex parts are under-costed.
Activity-based costing first groups overhead into activity pools such as machine setup, quality inspection, engineering change handling, purchasing and receiving. Each pool gets a cost driver, for example number of setups, number of inspections or number of purchase order lines. The pool cost divided by total driver volume gives a rate, and each product is charged for the driver units it actually consumes.
ERP support varies. SAP offers activity-based costing capabilities in controlling, where process cost can be assigned through business processes. Most mid-market ERPs, including NetSuite, Business Central and SyteLine, do not run full ABC natively; companies instead model activities as work centers or cost centers with their own rates, or run ABC as an off-system analysis and load the resulting rates into overhead or routing setup.
ABC is mainly an analysis and pricing tool rather than a statutory accounting method, since financial reporting and tax usually still require absorption of overhead under a consistent policy.
Why It Matters
- It reveals unprofitable low volume, high complexity parts that standard overhead rates hide.
- It supports better make-versus-buy and pricing decisions for custom or small batch work.
- It points to activities worth reducing, such as setups, which ties directly to lean programs like SMED.
- It gives a defensible basis for cost allocation when customers or government contracting rules ask how overhead was derived.
In Practice
A plant has 1.2 million of annual setup and inspection cost and 600 setups. The ABC rate is 2,000 per setup. A part run in 20 batches of 500 units carries 40,000 of setup cost, while a part run in 2 batches of 5,000 units carries only 4,000, even though labor hours may be similar. A labor hour rate would have charged both almost identically.
Frequently Asked Questions
What is a cost driver?
A measurable factor that causes an activity cost, such as the number of setups, inspections or purchase order lines. Overhead for the activity is charged to products per unit of that driver.
Does my ERP support activity-based costing?
Some, like SAP, have dedicated capability. Many mid-market ERPs approximate it with detailed work centers and cost centers, or take rates calculated in a spreadsheet or BI tool.
Is ABC accepted for financial reporting?
It is mostly used for management decisions. Statutory inventory valuation still follows the company's chosen absorption method, though ABC derived rates can be used if applied consistently.
Related Terms
Standard Cost
Standard cost is a predetermined per-unit cost for material, labor, and overhead, set in advance and used to value inventory and transactions. Differences between standard and actual are captured as variances that isolate where cost deviated.
Actual Cost
Actual cost is the real cost incurred to produce or acquire an item, accumulated from the specific material prices paid, labor hours reported, and overhead applied, rather than from a predetermined standard.
Overhead Absorption (Applied Overhead)
Overhead absorption is the process of charging indirect manufacturing costs, such as factory rent, utilities and supervision, to products or jobs using a predetermined rate based on labor hours, machine hours or another base.
SMED (Single-Minute Exchange of Die)
SMED (Single-Minute Exchange of Die) is a structured method developed by Shigeo Shingo for reducing equipment changeover time to under ten minutes, primarily by converting setup steps that require the machine stopped into steps performed while it still runs.
Routing
A routing is the ERP record that defines the ordered sequence of operations required to manufacture an item, specifying for each step the work center or machine, setup time, run time per unit, move and queue time, and any outside processing.
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