What Is Activity-Based Costing (ABC)?

The activity-based costing (ABC) system is a method of accounting you can use to find the total
cost of activities necessary to make a product. The ABC system assigns costs to each activity
that goes into production, such as workers testing a product.
With activity-based costing, you take into consideration both the direct and overhead costs of
creating each product. You recognize that different products require different indirect expenses.
By assigning both direct and overhead expenses to each product, you can more accurately set
prices. And, the activity-based costing process shows you which overhead costs you might be
able to cut back on.
How Activity-Based Costing works?
Activity-based costing requires accountants to use the following four steps:

Step 1: Identify the activities that consume resources and assign costs to those activities. It
is often the most interesting and challenging part of the exercise. This step requires people to
understand all of the activities required to make the product. the more complex the business, the
higher the indirect costs

Step 2: Identify the cost drivers associated with each activity. A cost driver is an activity or
transaction that causes costs to be incurred. Each activity could have multiple cost drivers.
In deciding which cost drivers to use, managers consider these three factors:

 Causal relation. Choosing a cost driver that causes the cost is ideal
 Benefits received. Choose a cost driver so costs are assigned in proportion to benefits
received.
 Reasonableness. Some costs that cannot be linked to products based on causality or
benefits received are assigned on the basis of reasonableness.
Step 3: Compute a cost rate per cost driver unit. We need to calculate the activity rates. 
These are calculated using the same formula for predetermined overhead rate (POHR) that we
used for traditional costing.  In general, predetermined rates for allocating indirect costs to
products are computed as follows:

Predetermined Overhead Rate (POHR) = Estimated Overhead

Estimated Base (or cost driver)

This formula applies to all indirect costs, whether manufacturing overhead, administrative costs,
distribution costs, selling costs, or any other indirect cost
Step 4: Assign costs to products by multiplying the cost driver rate times the volume of cost
driver units consumed by the product. We first define the notion of an activity center.
An activity center is a unit of the organization that performs some activity.
Accountants allocate costs to products by multiplying each activity’s indirect cost rate by the
volume of activity used in making the product.  The formula we will use for each activity is
Applied Overhead = Actual amount of activity cost driver x activity POHR