AccountingAccounting Explanation

What is Activity-Based-Costing (ABC) & How Does It Work?

ABC full form is Activity Based Costing

The ABC method of cost accounting is use to give costs to specific activities that a company carries out, such as services, projects, products, or tasks. It uses physical, monetary, and non-monetary indicators to measure these costs and distributes them among the company’s products, based on their resource consumption. 

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This method is more accurate than traditional methods of cost assignment. And it helps companies identify and assign indirect costs to products and services. In short, it’s a way of allocating a company’s costs of operations to the activities that create them. By tracing the costs of specific activities to the products and services that cause them to be incurred.

Meaning of ABC (Activity-based costing)

Activity-based costing (ABC) is an accounting method that traces overhead and indirect costs to the products and services. It is a more accurate method of assigning overhead and indirect costs to products and services than traditional methods of cost assignment.


Activity-based costing (ABC) is a method of assigning costs to products and services by tracing the costs of activities that caused them, more accurate than traditional methods.


How does Activity-Based Costing Work? 

ABC is a way for companies to understand how much it costs to perform different activities and how those costs are relate to the products and services they offer. It pays special attention to product planning and design costs and looks at factors like quality, delivery times, flexibility, innovation, and after-sales service. This method provides a more detailed and big-picture analysis of the cost-basis of activities than traditional systems.

When using ABC, a company first identifies the main activities. That are integral to its purpose and the secondary activities that add value for customers but are usually subcontract. Then it determines how costs are distribute among the activities. By analyzing factors that influence how much time, money, and resources the activities consume. These factors are called inductors.

Inductors are of 3 types:

Transaction inductors: which consider how often an activity is repeat

Inductors of duration: which measure how long it takes to perform each activity

Inductors of intensity: these measure resource consumption each time an activity is perform.

ABC is superior to traditional cost quantification systems that focus on materials. Because it highlights activity costs and the added value activities bring to company products. It helps companies to identify and assign the costs of activities to the products and services that cause those costs to be generated. It is a more accurate way of understanding the cost of a company’s operations.

For example, if a company makes two products, A and B, and product A uses more machine time than product B, then more of the costs of the machine activity will be assigned to product A than to product B.


  • ABC provides a more accurate picture of the costs of products and services.
  • It helps in identifying the areas where costs can be reduce.
  • It provides useful information for pricing decisions. And for identifying and targeting cost-reduction opportunities.
  • It helps in making better decisions about product and service mix, facility expansion, and other strategic issues.


  • ABC can be complex and time-consuming to implement.
  • It requires significant data collection and analysis.
  • It can be expensive to install, particularly for small and medium-sized companies.

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