Activity Based Costing or ABC

Absorption costing shows to be relatively straightforward way of adding overhead costs to units of production utilizing, more often than not, a volume-related absorption basis as like direct machine hours or direct labour hours.  The assumption such all overheads are related primarily to production volume is implied in such system. Absorption costing was developed at a time while most organizations produced merely a narrow range of products and while overhead costs were only an extremely small fraction of net costs, direct material and direct labour costs accounting for the largest proportion of the costs. Therefore errors made in adding overheads to products were not extremely important.

However nowadays, along with the advent of advanced manufacturing technology, overheads are likely to be far more significant and in fact direct labour may account for as little 5 percent of a product's cost.  Furthermore, there has been a raise in the costs of non-volume related support activities, such as setting-up, production scheduling, inspection and data processing that assist the efficient manufacture of a wide range of products.  In general these overheads are not, affected via changes in production volume. They tend to vary in the long term according to the range and complexity of products manufactured quite than the volume of output.

Since traditional absorption costing methods tend to allocate extremely a great proportion of overheads to high-volume products that cause relatively little diversity, and also too small a proportion of overheads to low-volume products that cause greater diversity and hence employ more support services, other methods of costing have been developed.  Activity-based costing or ABC is one such development.