Cost and Management Accounting · Activity Based Costing

Concept and Key Terms of Activity Based Costing (ABC)

Updated 4 October 2026 · Fact-checked

Activity Based Costing assigns overheads to products in two stages: first to activity cost pools using resource drivers, then to products using activity cost drivers. It traces cost to the activities that cause it, so product costs reflect actual resource use rather than a blanket volume-based rate.

Understand Concept and Key Terms of Activity Based Costing

Traditional costing spreads overheads over products using one base, such as direct labour hours or machine hours. This works when overheads are small and products use resources in proportion to volume. Today overheads are large, and many of them have nothing to do with volume.

Activity Based Costing (ABC) starts from a different idea: products do not consume overheads directly. Products consume activities, and activities consume resources. So you first find what activities the business performs, then cost each activity, then charge products for the activities they use.

Key terms you must know:

Activity: a task or process that consumes resources, such as machine setup, material handling, inspection or purchase ordering.
Cost pool (activity cost pool): a collection of the costs of related activities, grouped so that one driver can be used to charge them.
Cost driver: the factor that causes the cost of an activity to change. It is the basis for charging the pool to products.
Resource driver: measures how much of a resource (e.g. salaries, power, rent) is used by each activity. It is used in stage one, to assign resource cost to activity pools.
Activity driver: measures how much of an activity a product or job uses (e.g. number of setups, number of inspections). It is used in stage two, to assign pool cost to products.

Activities are classified by the level at which they occur, following the Cooper hierarchy:

Unit level activities: performed every time a unit is produced. Cost varies with units. Examples: machine running, direct power.
Batch level activities: performed every time a batch is processed, whatever the batch size. Examples: setups, batch inspection, material ordering and handling per batch.
Product (product-sustaining) level activities: performed to support a product line, whatever the units or batches. Examples: product design, engineering change orders, product testing.
Facility (organisation-sustaining) level activities: support the whole plant and cannot be traced sensibly to any product. Examples: factory rent, plant management, security.

Facility level costs are hard to link to products with any driver. Under ABC they are usually kept separate or spread on a broad base such as total cost or labour hours. This is a weak point of ABC, and the exam may ask about it.

Key rules to remember

Cost driver rate: Cost driver rate = Total cost of the activity cost pool ÷ Total quantity of the cost driver; Use the total expected driver volume across all products. This is the stage-two rate.
Overhead assigned to a product: Overhead charged = Cost driver rate × Quantity of driver used by the product; Repeat for each pool and add the results. Then divide by units produced for overhead per unit.
Two-stage ABC flow: Resources → (resource drivers) → Activity cost pools → (activity drivers) → Products; Stage one assigns resource cost to activities. Stage two assigns activity cost to products.
Activity hierarchy: Unit level → Batch level → Product level → Facility level; Unit varies with units, batch varies with batches, product varies with product lines, facility does not vary with any of them.

How to solve Concept and Key Terms of Activity Based Costing questions

Use this method for theory questions and for short numerical questions on the concept of ABC.

1Read what is asked: a definition, a classification of given activities, or a choice of cost driver.
2For a definition, write ABC as a system that traces overheads to activities first and then to products using cost drivers.
3For classification, ask one question per activity: does it happen per unit, per batch, per product line, or for the whole plant?
4For choosing a cost driver, pick the factor whose change causes the activity cost to change, such as setups for set-up cost.
5Group related activities that share a driver into one cost pool.
6Compute the driver rate as pool cost ÷ total driver quantity, then multiply by each product's driver usage.
7Add the charges from all pools and state the overhead per unit. Add a line of interpretation if marks are allotted.

Quickest way: Level and driver shortcut

When to use it: Use for MCQs on activity levels and drivers, and for the first lines of a written answer.

MCQ: look for the trigger word. Per unit means unit level, per batch or setup means batch level, design or product line means product level, rent or plant management means facility level.
If the options mix up resource driver and activity driver, remember: resource driver feeds pools, activity driver feeds products.
Written: define, list the key terms in bullets, then give one example for each. Examiners give step marks for each term covered.
Numerical: write the rate as a one-line formula, show the division and show the multiplication. Show each pool separately so that partial marks are secured.

Common mistakes in Concept and Key Terms of Activity Based Costing

Mixing up resource drivers and activity drivers.
Both are called cost drivers and both appear in the same two-stage flow.
Fix: Resource driver: resources to activities. Activity driver: activities to products. Remember the order of the flow.
Classifying setup cost as unit level.
Students link all production costs with units made.
Fix: A setup happens once per batch whatever the batch size, so it is batch level.
Saying facility level costs are traced to products by an accurate driver.
Students assume ABC removes all arbitrary allocation.
Fix: Facility costs are common to all products. They are not caused by any product, so any charge to products is arbitrary.
Choosing a volume measure as the driver for every pool.
Habit from traditional costing with labour or machine hours.
Fix: Choose the cause of the cost. Inspection cost is driven by the number of inspections, not machine hours.
Dividing pool cost by units produced instead of total driver quantity.
Confusing the driver rate with cost per unit.
Fix: First divide by total driver quantity to get the rate. Divide by units only at the end to get cost per unit.

Worked examples

Example 1

Classify each of the following activities of a manufacturing company as unit, batch, product or facility level: (a) machine setup before each production run, (b) redesign of a product to reduce defects, (c) payment of factory rent, (d) machining of each unit.

Show the solution

(a) Setup is done once for every production run, whatever the number of units in the run. It is batch level.
(b) Redesign supports one product line and does not depend on units or batches. It is product level.
(c) Factory rent supports the whole plant and is not caused by any product. It is facility level.
(d) Machining occurs for each unit made, so cost varies with units. It is unit level.

Answer: (a) Batch level, (b) Product level, (c) Facility level, (d) Unit level.

Example 2

A company makes products X and Y. Setup cost for the period is ₹1,20,000. X needs 30 setups and Y needs 90 setups. Inspection cost is ₹80,000. X needs 100 inspections and Y needs 300 inspections. X is 2,000 units and Y is 6,000 units. Find overhead per unit for each product using ABC.

Show the solution

Setup driver rate = ₹1,20,000 ÷ (30 + 90) setups = ₹1,20,000 ÷ 120 = ₹1,000 per setup.
Inspection driver rate = ₹80,000 ÷ (100 + 300) inspections = ₹80,000 ÷ 400 = ₹200 per inspection.
Product X: setup = 30 × ₹1,000 = ₹30,000. Inspection = 100 × ₹200 = ₹20,000. Total = ₹50,000.
Product Y: setup = 90 × ₹1,000 = ₹90,000. Inspection = 300 × ₹200 = ₹60,000. Total = ₹1,50,000.
Check: ₹50,000 + ₹1,50,000 = ₹2,00,000, which equals ₹1,20,000 + ₹80,000.
Overhead per unit of X = ₹50,000 ÷ 2,000 = ₹25.
Overhead per unit of Y = ₹1,50,000 ÷ 6,000 = ₹25.

Answer: Overhead per unit is ₹25 for X and ₹25 for Y. Total overhead assigned is ₹50,000 to X and ₹1,50,000 to Y.

Exam tips

Learn the four activity levels with one example each. Questions often give a list of activities and ask you to classify them.
In definition answers, always mention the two stages and the word cost driver. These are the words examiners look for.
In numericals, show each pool's driver rate on its own line and cross-check that total assigned overhead equals total pool cost.
MCQs on this topic carry no reasoning marks and no negative marking, so attempt every one. Eliminate options that use volume bases for batch or product activities.

Practice questions from Activity Based Costing

Concept and Key Terms of Activity Based Costing in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Concept and Key Terms of Activity Based Costing: frequently asked questions

What is the difference between a cost pool and a cost driver?

A cost pool is a group of related activity costs collected together. A cost driver is the factor that causes those costs and is used to charge the pool to products. One pool normally has one driver.

What is the difference between resource driver and activity driver?

A resource driver assigns the cost of resources to activities, for example power cost by kilowatt hours used by each activity. An activity driver assigns the cost of an activity to products, for example setup cost by number of setups.

Why are facility level costs a problem in ABC?

They support the whole business and are not caused by any single product or batch. No true cause-and-effect driver exists, so any assignment to products is arbitrary. They are often shown separately or spread on a broad base.

Is ABC better than traditional costing?

ABC usually gives more accurate product costs when overheads are large and products consume activities differently. It takes more effort and cost to run. Traditional costing can be adequate where overheads are small and products are similar.