In our example, Product 124 will be assigned some of the company's costs of special engineering, special testing, and machine setup. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. Under ABC, the company will calculate the cost of the resources used in each of these activities. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine.Īctivity based costing recognizes that the special engineering, special testing, machine setups, and others are activities that cause costs-they cause the company to consume resources. The result will be a miscalculation of each product's true cost of manufacturing overhead. In contrast, Product 366 will be allocated an enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. However, it did demand lots of engineering, testing, and setup activities. This will result in little overhead cost allocated to Product 124, because it did not have many machine hours. If this company used traditional costing, it might allocate or 'spread' all of its overhead to products based on the number of machine hours. A similar product, Product 366, is a high volume product-running continuously-and requires little attention and no special activities. Product 124 is a low volume item which requires certain activities such as special engineering, additional testing, and many machine setups because it is ordered in small quantities. Let's discuss activity based costing by looking at two products manufactured by the same company. It then assigns the cost of those activities only to the products that are actually demanding the activities. Activity based costing first assigns costs to the activities that are the real cause of the overhead. Activity Based Costing with Four ActivitiesĪctivity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours.