Traditionally, manufacturers used the absorption cost method of allocating costs. This approach calculates the full amount of manufacturing overhead costs and spreads it evenly across the volume of all products. However, this method doesn’t consider that the production of some products may not necessarily be related to some activities. Activity-based costing (ABC) solves this problem.
Let’s illustrate with an example. Company XY Shoes is launching two lines of running shoes. Shoe A is cheaper to manufacture than shoe B but requires extra time from factory supervisors. If we do full costing, the total cost of overhead will be divided equally between both and shoe B will end up absorbing costs from shoe A. Activity-based costing addresses this issue by allocating the relevant costs to shoe A and not to shoe B, therefore revealing realistic production costs.
Ensuring that all lines are accounted for can be very time-consuming and practically impossible for medium and large manufacturers. Manual processes also increase the risk of human errors. This is why activity-based costing software is so helpful.