ABC: cost flows and product costing
Cost flows in Activity-Based Costing
In an Activity-Based Costing (ABC) system, the flow of costs differs significantly from traditional costing. Rather than assigning overhead directly to products based on a single driver like direct labor hours, ABC traces costs more accurately by linking resources (the costs a company incurs) to activities through resource drivers, and then linking those activities to cost objects such as products, services, or customers through activity drivers.
This multi-stage allocation provides a clearer picture of how and why overhead costs are incurred, enabling more accurate product costing, better pricing decisions, and enhanced cost control.
Step-by-Step flow of costs in ABC
ABC cost flow consists of two stages of allocation:
Stage 1: Assign Resource Costs to Activities (Resource Drivers)
Costs such as salaries, rent, utilities, and depreciation are first accumulated into activity cost pools. These are grouped by activity type (e.g., machine setups, inspections, order processing). Allocation is based on resource drivers, which measure how much of each resource is consumed by an activity.
Example:
- Factory rent is assigned to the “Machine Operation” pool based on square footage occupied, and maintenance staff salaries are assigned based on the share of labor time spent on machine upkeep.
- HR salaries are assigned to the “Employee Training” pool based on number of hours devoted.
- To see the resource-driver math directly: if $100,000 of factory rent is split by square footage, with 60% of the floor used for machine operation and 40% for training, $60,000 goes to the Machine Operation pool and $40,000 goes to the Employee Training pool.
Stage 2: Assign Activity Costs to Cost Objects (Activity Drivers)
Once activity cost pools are established, costs are assigned to specific cost objects (such as products, services, or customers) using activity drivers that best represent consumption.
Example:
- Setup costs are allocated based on number of setups per product
- Inspection costs are allocated based on number of batches inspected
- Customer support costs may be allocated based on number of service calls
ABC activity pools generally fall into a cost hierarchy, which explains why some overhead is easier to trace accurately than others:
- Unit-level activities: vary with each unit produced, such as machine hours consumed per unit.
- Batch-level activities: vary with each batch processed rather than each unit, such as setups and inspections performed per batch.
- Product-sustaining activities: support a specific product line regardless of how many units or batches are produced, such as engineering changes for that line.
- Facility-level activities: support the overall production process and can’t be traced to any specific product, batch, or line, such as plant rent and the plant manager’s salary.
Facility-level costs have no causal driver linking them to specific cost objects, which is why they’re still allocated somewhat arbitrarily even under ABC.
Comparison to traditional cost flow
The following table compares ABC with the traditional costing discussed so far:
| Step | Traditional Costing | Activity-Based Costing (ABC) |
| Overhead Pool | Usually single or few pools | Multiple activity-based pools |
| Allocation Base | Typically volume-based (e.g., labor hours) | Activity-based (e.g., # of setups, # of orders) |
| Accuracy of Allocation | Less accurate, may distort product costs | Generally more accurate, especially for complex product lines |
| Flexibility | Rigid, less adaptable to change | Flexible, accommodates diverse operations and services |
| Cost to implement | Low; simple to maintain | High; needs detailed activity data and judgment in choosing drivers.
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ABC can also be applied outside manufacturing - a hospital, for example, might assign overhead to patient visits using activity drivers like number of lab tests or minutes of nursing care.
Strategic insight
ABC reveals which activities drive costs and which products or services consume the most resources. This visibility supports decisions such as identifying non-value-added activities and re-evaluating customer or channel profitability.
A value-added activity directly contributes to the value a customer perceives in a product or service, such as machining or assembly. A non-value-added activity consumes resources without adding that value, such as inspection or rework; ABC’s activity pools make these costs visible so managers can target them for reduction.
ABC product costing calculations
Direct materials and direct labor continue to be traced directly to products even under ABC. The main distinction lies in the way indirect (overhead) costs are allocated.
Below is a comprehensive example showing how overhead is assigned to two products using ABC:
The Company produces two types of products
- Product A
- Product B
Overhead Cost Pools and Activity Drivers are as follows:
| Cost Pool | Total Overhead | Activity Driver | Product A Usage | Product B Usage |
| Machine | $60,000 | Machine hours | 1,200 hours | 800 hours |
| Assembly | $40,000 | Direct labor hours | 500 hours | 1,000 hours |
| Dispatch | $30,000 | Number of orders | 150 orders | 150 orders |
| Inspection | $20,000 | Number of inspections | 100 inspections | 300 inspections |
Step 1: calculate activity rates
| Cost Pool | Total Overhead | Total Activity | Activity Rate |
| Machine | $60,000 | 2,000 machine hours | $30 per machine hour |
| Assembly | $40,000 | 1,500 labor hours | $26.667 per labor hour |
| Dispatch | $30,000 | 300 orders | $100 per order |
| Inspection | $20,000 | 400 inspections | $50 per inspection |
Note: the assembly rate is carried unrounded ($40,000 ÷ 1,500 = $26⅔ per hour, shown rounded as $26.667) when it’s applied below, so the overhead assigned across both products adds back up to the full $150,000 pool total.
Step 2: assign overhead to products
| Cost Pool | Product A Usage | Rate | Overhead for A | Product B Usage | Overhead for B |
| Machine | 1,200 hours | $30/hour | $36,000 | 800 hours | $24,000 |
| Assembly | 500 hours | $26.667/hour | $13,333 | 1,000 hours | $26,667 |
| Dispatch | 150 orders | $100/order | $15,000 | 150 orders | $15,000 |
| Inspection | 100 inspections | $50/inspection | $5,000 | 300 inspections | $15,000 |
Step 3: Total overhead allocation
| Product | Total Overhead Assigned |
| Product A | $36,000 + $13,333 + $15,000 + $5,000 = $69,333 |
| Product B | $24,000 + $26,667 + $15,000 + $15,000 = $80,667 |
This example illustrates how ABC allocates overhead more accurately by associating it with actual activities and resource consumption.
To see the effect of this concretely, compare these ABC results to a traditional, volume-based allocation that uses direct labor hours as the single overhead driver. The plantwide rate would be $150,000 total overhead ÷ 1,500 total direct labor hours = $100 per direct labor hour. That assigns $50,000 of overhead to Product A (500 hours × $100) and $100,000 to Product B (1,000 hours × $100).
Compared with the ABC results of $69,333 for Product A and $80,667 for Product B, traditional costing undercosts Product A by $19,333 and overcosts Product B by that same $19,333. Total overhead allocated is unchanged either way - only how it’s divided between the two products differs. That shift is exactly the cross-subsidization ABC is designed to correct.