Activity based costing is a method of identifying and costing activities, services, and products based on frequency. It is used to allocate manufacturing overhead costs in a more thorough and detailed manner than methods based on direct hours or machine hours. Activities are costed when they contribute to the overhead and are then directly allocated to products which utilize those activities.
Activity based costing takes into account costs associated with the operation of equipment which consume business time and resources such as setup, testing, and maintenance. Activity based costing has become the prime method of determining cost of manufacturing overhead because manufacturing costs have increased in recent years, may be unrelated to direct labor hours or machine hours, there are more products and more demand for products, and products may be high or low volume.
Activity based costing is effective because it can identify inefficiencies in activities, products, and even departments. For example, by comparing setup costs for a piece of machinery with costs in other factories, it can be determined if the setup process is wasteful and must be adjusted. If any extraneous costs are found, these can be eliminated. When the efficiency of an activity, product, or department is determined, more resources can be allocated to it. Finally, activity based costing can help adjust prices of services or products to a more appropriate amount.