Activity based costing (ABC) is a costing approach that assists in the recognition of the actual cost of products based on their associated overheads. In start-ups just like in established businesses, it is important to allocate the true cost to the different products or services in order to evaluate their value to the business.
Activity based costing in this regard, factors all activities and their related costs, which are involved in the production and provision of products and services. For instance, product A may require few machine hours but plenty of machine setups. Product B on the other hand, requires more machine hours but few machine setups. In calculating the cost based on machine hours the cost of product B will be higher than actual because the overhead caused by the machine setup will not be factored in. The use of machine hours will result in a lower than actual cost for product A based on the same reason.
ABC can be used to effectively allocate costs on products and services based on the actual activities employed instead of liberally spreading out the total costs among the products produced. ABC offers insights into the actual value of producing a certain product over another and helps with decisions regarding the opportunity cost of production.