Costing, Activity Based

Activity-based costing is an alternative approach to the allocation of overheads that recognises that traditional approaches such as allocating a ‘standard’ percentage are inaccurate and lead to incorrect understanding of actual costs and profitability. As an example, let’s say two products each require one hour’s labour and the same material cost, but product A requires 60 minutes of processing by an expensive machine, whereas product B requires 6 minutes processing by the same machine. If the overhead apportionment is based on labour hours and a standard percentage is added, both products will be costed the same, and product B will subsidise product A. Under activity-based costing a cost driver will be used to apply the overhead cost of the expensive machine, for example, hours for processing, so that the true cost of product A - and hence its real profitability - will be measured. See also Cost Driver and Total Absorption Costing.