Activity based costing is a costing technique that is based on the cost calculations of all the activities that happen while running a business operation. The activity based costing use an approach of costing where cost of all the activities is assigned to all the products that are produced as a result of those activities. The activity based costing also calculates the overhead cost and adds that cost in the actual cost of the process and assign that cost to each and every unit produced under that process.
With the help of activity based costing a company can easily identify the processes and the overheads that are resulting in an additional cost of that process however these activities and overheads are difficult to identify in traditional costing approach. For example in a manufacturing process activities that can result in addition in cost can be machine testing, machine maintenance, equipment setups and other related activities. All these activities consume the additional resources of the business that result in increase the cost of production. Businesses use activity based costing approach as in these days manufacturing overheads are increasingly becoming common as well the cost involve in manufacturing overheads is important to identify as this cost is not related to the number of labor hours and number of machine hours. Moreover some products are produced in small batches where as other are produced in larger batches but the overhead activities of both the process are same.
The goal of activity based costing is to identify those products and processes that are unprofitable for the business and involve more overhead costs.