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Management Accounting · Activity Based Costing

Steps in Implementing ABC and Overhead Allocation

Updated 10 October 2026 · Fact-checked

ABC assigns overheads to products in stages. You identify activities, group their costs into cost pools, pick a cost driver for each pool, compute a cost driver rate (pool cost ÷ total driver volume), and charge each product rate × the driver units it consumes. Add direct costs to get total product cost.

Understand Steps in Implementing ABC and Overhead Allocation

Traditional costing spreads all factory overhead using one rate, usually direct labour hours or machine hours. This can distort product cost because many overheads, such as set-ups or inspections, do not move with labour hours. ABC fixes this by tracing overheads to the activities that cause them.

An activity is a task that consumes resources, for example machine set-up, material handling, quality inspection or order processing. You list the main activities, then collect the overhead cost of each into a cost pool. If several activities share the same driver and behave alike, you may combine them into one pool.

A cost driver is the factor that causes the cost of an activity to rise or fall. For set-ups it may be the number of set-ups. For inspection it may be the number of inspections. For material handling it may be the number of material movements. Choose a driver that has a real cause-and-effect link with the cost.

Next you compute the cost driver rate for each pool: the pool cost divided by the total driver units in the period. Then each product is charged the rate multiplied by the driver units it uses. Divide the total overhead assigned by the number of units produced to get overhead per unit.

The final product cost is direct material + direct labour + assigned overheads. Low-volume, complex products usually show higher cost under ABC than under traditional costing, and high-volume simple products show lower cost.

Key rules to remember

Cost driver rate
Cost driver rate = Total cost of the activity pool ÷ Total quantity of the cost driver
Use the total driver units for all products in the period, not for one product.
Overhead assigned to a product
Overhead assigned = Cost driver rate × Driver units consumed by the product
Do this for every pool, then add the amounts.
Overhead per unit
Overhead per unit = Total overhead assigned to the product ÷ Units produced
Use units produced or units of the batch costed, as the question requires.
Total product cost
Total cost = Direct material + Direct labour + Other direct costs + ABC overheads
Selling price or profit comparison needs this full cost.
Check on allocation
Σ overhead assigned to all products = Total overhead of all pools
If it does not tie, a driver total or a rate is wrong.

How to solve Steps in Implementing ABC and Overhead Allocation questions

Follow the same order for every ABC question. Show each stage on paper so you earn step marks even if one figure goes wrong.

  1. 1List the activities and the overhead cost given for each. Group them into cost pools if the question says they share a driver.
  2. 2Write down the cost driver for each pool, using the one given or the most logical one.
  3. 3Add up the total driver units across all products for each pool.
  4. 4Compute the cost driver rate for each pool: pool cost ÷ total driver units.
  5. 5Multiply each rate by the driver units used by each product to get overhead by activity.
  6. 6Add the pool-wise overhead for each product, then divide by units produced for overhead per unit.
  7. 7Add direct costs to get total cost and cost per unit. Do the requested comparison, profit or pricing.
  8. 8Cross-check that total assigned overhead equals total overhead given.

Quickest way: Table method for ABC overhead absorption

When to use it: Use it when a question gives several activities and products with driver data in a table and you have limited time.

  1. Draw a table with one row per activity and columns: cost, driver total, rate, then one column per product.
  2. Fill the rate first. Calculate it once per row.
  3. Fill each product column as rate × that product's driver units.
  4. Total each product column, divide by its units for per-unit overhead.
  5. Tick the cross-check: the sum of all product columns must equal the total overhead.

Common mistakes in Steps in Implementing ABC and Overhead Allocation

  • Dividing the pool cost by the driver units of only one product

    Students read the product data and forget the rate needs all products' units.

    Fix: Always total the driver units across every product before computing the rate.

  • Choosing a volume-based driver for every activity

    Habit from traditional costing with labour or machine hours.

    Fix: Match the driver to the cause: set-ups for set-up cost, inspections for inspection cost, orders for order processing.

  • Forgetting to divide by units produced

    The overhead total for the product looks like the final answer.

    Fix: Check whether the question asks for per-unit cost and divide by the units of that product.

  • Leaving out direct costs in total cost

    Focus on overhead makes students stop at the assigned overhead.

    Fix: Add direct material and direct labour whenever cost per unit or profit is asked.

  • Not showing the cost driver rate

    Students jump straight to product overhead using mental division.

    Fix: Write each rate on its own line with its unit, such as ₹ per set-up. Examiners award marks for it.

  • Ignoring the check that total assigned overhead equals total given

    Time pressure and no habit of verifying.

    Fix: Add the product overheads at the end and compare with the total overhead. Fix any gap before moving on.

Worked examples

Example 1

Sundaram Auto Parts has two products, A and B. Overheads for the month: Set-up ₹1,20,000; Inspection ₹80,000; Material handling ₹1,00,000. Drivers: Set-ups: A 10, B 30. Inspections: A 100, B 300. Material movements: A 150, B 350. Units produced: A 1,000, B 4,000. Compute the overhead per unit for each product under ABC.

Show the solution
  1. Total set-ups = 10 + 30 = 40. Rate = ₹1,20,000 ÷ 40 = ₹3,000 per set-up.
  2. Total inspections = 100 + 300 = 400. Rate = ₹80,000 ÷ 400 = ₹200 per inspection.
  3. Total movements = 150 + 350 = 500. Rate = ₹1,00,000 ÷ 500 = ₹200 per movement.
  4. Product A: set-up 10 × 3,000 = ₹30,000; inspection 100 × 200 = ₹20,000; handling 150 × 200 = ₹30,000. Total = ₹80,000.
  5. Product B: set-up 30 × 3,000 = ₹90,000; inspection 300 × 200 = ₹60,000; handling 350 × 200 = ₹70,000. Total = ₹2,20,000.
  6. Check: 80,000 + 2,20,000 = ₹3,00,000 = 1,20,000 + 80,000 + 1,00,000.
  7. Per unit: A = ₹80,000 ÷ 1,000 = ₹80. B = ₹2,20,000 ÷ 4,000 = ₹55.

Answer: Overhead per unit under ABC: Product A ₹80 and Product B ₹55.

Example 2

Using the data of Sundaram Auto Parts, the company's traditional system absorbs total overhead of ₹3,00,000 on units produced. Compute the overhead per unit under the traditional method using units produced as the base, and state the effect on each product compared with ABC.

Show the solution
  1. Total units = 1,000 + 4,000 = 5,000.
  2. Traditional rate = ₹3,00,000 ÷ 5,000 = ₹60 per unit.
  3. Under traditional costing, A = ₹60 per unit and B = ₹60 per unit.
  4. ABC: A = ₹80 and B = ₹55.
  5. Difference for A: 80 − 60 = ₹20 per unit higher under ABC. Difference for B: 60 − 55 = ₹5 per unit lower under ABC.
  6. Check: 20 × 1,000 = ₹20,000 under-costed for A; 5 × 4,000 = ₹20,000 over-costed for B. They offset.

Answer: Traditional overhead is ₹60 per unit for both. ABC shows A at ₹80 (under-costed by ₹20 traditionally) and B at ₹55 (over-costed by ₹5 traditionally). Product A, the low-volume product with more set-up and inspection effort per unit, was subsidised by B.

Exam tips

  • Write the cost driver rate with its unit, such as ₹3,000 per set-up, on its own line.
  • Always do the final tie-out of total assigned overhead to total overhead given.
  • Read whether the question asks for total overhead, per-unit overhead or total cost. Do the extra division or addition required.
  • Where the question gives no driver, name a logical one and state why it matches the activity.
  • In MCQs, test the rate first. Most wrong options come from dividing by one product's driver units.

Practice questions from Activity Based Costing

Steps in Implementing ABC and Overhead Allocation in other exams

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

Steps in Implementing ABC and Overhead Allocation: frequently asked questions

What are the steps in an ABC system?

Identify activities, assign resource costs to activities and group them into cost pools, select a cost driver for each pool, compute the cost driver rate, and assign overhead to products by driver usage. Then add direct costs for total product cost.

How do you calculate the cost driver rate in ABC?

Divide the total cost of the activity pool by the total number of driver units for all products in the period. For example, ₹1,20,000 of set-up cost over 40 set-ups gives ₹3,000 per set-up.

Can several activities be put in one cost pool?

Yes. Activities that use the same cost driver and are similar in nature can be combined into one pool. This reduces the number of rates to calculate without losing accuracy.

Why does ABC change product costs compared with traditional costing?

Traditional costing spreads overhead on a volume base, while ABC charges it by activity usage. Products that use more activities per unit, such as small batches, get a higher overhead under ABC.