What is the main principle behind activity-based costing (ABC)?

The main principle of activity-based costing (ABC) is that it attributes overhead costs to products based on the activities that drive those costs. This approach enhances the accuracy of cost allocation by recognizing the specific activities that contribute to overhead expenditures.

In traditional costing methods, overhead costs are often allocated based on simplistic formulas such as machine hours or labor hours, which can lead to distorted product costs. ABC, however, identifies various activities that incur costs (such as machine setups, inspections, and material handling) and assigns those costs to products based on their actual usage of those activities. This provides a more nuanced view of costs and helps businesses understand the true cost structure of their products or services.

Implementing ABC allows organizations to make more informed decisions about pricing, budgeting, and product profitability by providing clearer insights into where resources are being consumed and how overall costs can be better managed. This method is especially useful in environments with diverse products and complex processes, where understanding the actual cost drivers is crucial for strategic decision-making.