Activity Based Costing (ABC) is a two-stage product costing method that assigns costs first to activities and then to the products based on each product's use of activities. An activity is any discrete task that an organization undertakes to make or deliver a product or service. Activity-based costing is based on the concept that products consume activities and activities consume resources.

        Activity-based costing involves the following four steps:

            1.- Identify the activities -such as processing orders- that consume resources and assign costs to them.
            2.- Identify the cost driver(s) associated with each activity. A cost driver causes, or "drives" an activity's costs. For the order-processing activity, the cost driver could be the number of orders.
            3.- Compute a cost rate per cost driver unit or transaction. The cost driver rate could be the cost per order, for example.
            4.- Assign costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product. For example, the cost per order multiplied by the  number of orders processed for a particular song during the month of March measures the cost of the order processing activity for that song during March.

         Identifying activities that use resources. Often the most interesting and challenging part of the excercise is identifying activities that use resources because doing so requires understanding all activities required to make a product. In fact, much of the value of activity-based costing comes from this excercise even without changing the way product costs are computed. When managers step back and analize the processes (activities) they follow to produce a good or service, they often uncover many nonvalue-added steps, which they can eliminate.

         Choosing cost driver. The following table shows several examples of the types of cost drivers that companies use. Most are related either to the volume of production or to the complexity of the production or marketing process.
          

Machine-hours used	Computer time used
Labor-hours or labor cost incurred	Number of items produced or sold
Pounds of material handled	Customers served
Pages typed	Flight hours completed
Machine setups	Surgeries performed
Purchased orders completed	Scrap/rework orders completed
Quality inspections performed	Hours of testing time spent
Number of parts installed in a product	Number of different customers served
Miles driven

           The best cost driver is one that is causally related to the cost being allocated. Finding an allocation base that is causally related to the cost is often not possible.  With an ABC system, the selection of an allocation base, or cost driver, is often easier because we can use a measure of the activity volume. For example, a reasonable allocation base for machine set-up costs is machine set-up hours. Notice that many of the cost drivers in the previous table refer to an activity.

         Computing a Cost Rate per Cost Driver. In general, predetermined rates for allocating indirect costs to products are computed as follows:

                               Predetermined rate = Estimated indirect cost / Estimated volume of allocation base

          This formula applied to any indirect cost, wheter manufacturing overhead or administrative, distribution, selling, or any other indirect costs. Workers and machines peform activities on each product as it is produced. Costs are allocated to a product by multiplying each activity's predetermined rate by the volume of activity used in making it.
          In the two-stage cost system, the first stage consists of activities, not departments. Instead of a department rate, activity-based costing computes a cost driver rate for each activity center. This means that each activity has an associated cost pool. If the cost driver for material handling is the number of production runs, for example, the company must be able to estimate the costs of material handling before the period and, ideally, track the actual cost of material handling as it is incurred during the period.

         Assigning costs to products. The final step in the activity-based costing system is to assign the activity costs to products. We do this just as we have done for the other product costing systems we have considered. We multiply the cost driver rates by the number of units of the cost driver in each product. The following table shows a cost flow diagram with the four steps of developing activity-based costs graphically.