Activity-based costing

A plant-wide overhead rate spreads all overhead using one volume-based measure, such as machine hours or labour hours. That works when overhead really does rise with volume. But in most modern plants a big share of overhead is caused by complexity — set-ups, inspections, engineering changes, purchase orders — that has little to do with how many units are made.

When that happens, a single rate cross-subsidises: high-volume, simple products are charged for costs actually caused by low-volume, complex ones. The complex product looks cheaper than it is, gets underpriced, and the business wins exactly the work it makes least money on.

Activity-based costing (ABC) fixes this in four steps: 1. Identify activities that consume overhead and gather their cost into activity cost pools (machining, set-ups, inspections…). 2. Choose a cost driver for each pool — the factor that causes the cost (number of set-ups, number of inspections). 3. Compute an activity rate: pool cost ÷ total driver quantity. 4. Allocate to products: driver units used × activity rate.

The cost hierarchy helps choose drivers: - Unit-level — performed for every unit (machine running power, per-unit inspection). - Batch-level — performed per batch, whatever its size (set-ups, purchase orders, batch inspections). - Product-sustaining — support a product line (engineering changes, product design, maintaining a bill of materials). - Facility-level — sustain the whole site (factory rent, plant manager). These have no product-specific driver; many companies leave them unallocated in decision analysis because no product decision changes them.

ABC costs more to run — it needs driver data — so it pays off where overhead is large, products differ widely in complexity, and decisions (pricing, mix, dropping lines) depend on product cost.