Activity based costing is a system of allocating overheads to jobs, processes or products on
the basis of activities responsible for such expenses, instead of the traditional system, so that
true and logical cost is obtained. According to traditional system, firstly the overheads are
apportioned over various departments on some basis and then they are absorbed to the
individual product on the basis of direct wages or direct labour hours or direct machine
hours etc. Suppose factory overheads are absorbed on the basis of machine hours, this is not
logical, because all factory overheads are not dependent on machine hours and so the
overheads allocated are incorrect and consequently the total cost and selling price based on
such costs are all incorrect and illogical, which may put business into trouble. The overheads
are absorbed under Activity Based Costing on the basis of activities giving rise to overheads,
e.g. to allocate the expenses of procurement of goods, it can be divided into three activities
like placing an order, receipts and inspection, storage etc. The total overheads of all three
activities are ascertained and are absorbed to various jobs, processes or products in
proportion to the services which they received from these activities, e.g. the inspection cost
is absorbed on the basis of number of times the product is inspected, cost of placing an order
is allocated on the basis of number of times the orders were placed etc.