Activity based costing is one of the most important used method for overhead allocation in cost accounting. ABC (Activity based costing) method aids in identification of activities involved in entire manufacturing process of organization and then assignment of the cost to each individual activities according to its actual consumption. According to ABC if a product is not consuming any activity then, product will not absorb any overhead on that activity, on the other hand if product consumes high activity, then that product will absorb high portion of overhead of activity. A numerical Example is as follows: 

There are two methods to allocate overhead to the product line.

First method is traditional costing method in which first we first calculated the total selling general and admin expenses as percentage of variable cost. This comes out be 30.1%. Selling admin and general expense allocated to each product line is 30.1% of their variable cost. After allocating fixed cost to product line we can analyze that. Book”s product line has generated highest profit of $ 264115 whereas Café’s product line has generated loss of $6723.

Second method to allocate fixed overhead is Activity based costing. In activity based costing first cost drivers associated with various department are identified. Like purchasing department has number of purchase orders as cost driver and so on.  Then total cost is divided by number of cost divers used for example total purchasing cost is divided by number of purchase orders released in order to calculate cost per unit of cost driver.  In third step cost per unit of cost driver is multiplied with number of cost drivers used by particular product line to allocate the fixed overhead to a product line. 

We can observe that net profit generated by books is still highest $ 546851 and Cafe has generated a loss of $ 296135. Costs allocated by ABC costing are:

We can observe that there is significant difference between both cost allocation systems, this is because traditional costing allocates fixed overhead on the basis of variable cost here as activity based costing does it on the basis of units of cost drivers consumed.