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Definition: Activity Based Costing
In a traditional system, there is a lot of debate on how the indirect costs be allocated to products. Activity based costing solves this by measuring the activities performed in order to make the final product and costs are allocated to each of the activities. The indirect costs are then allocated based on the usage of the respective activities to produce the product.
The activities used to allocate the costs are also referred to as “cost-base”. This method converts more of the indirect costs into direct costs.
Let’s suppose that a factory produces 2 products A & B. Now, if A is a customized product which takes a lot of R&D, is produced very rarely and needs some special engineering while B is a product which is in continuous production with a large amount of machine hours.
Now, as per the traditional costing system Product B will be allocated most of the indirect cost due to the no. of machine hours while Product A might have cost more due to the special engineering etc. Activity based costing thus takes various activities to be the cost base and allocates costs accordingly.