Traditional overhead absorption spreads all overheads using a single rate — usually machine hours or labour hours. This works fine when all products use resources in roughly the same way. But in a modern factory making both a simple bolt and a complex circuit board, lumping all overheads together and dividing by hours gives you a completely wrong cost. That's the problem Activity Based Costing (ABC) solves.
ABC's big idea is simple: products don't consume costs — activities do, and products consume activities. A complex product triggers more purchase orders, more quality inspections, more setups. ABC traces costs to the activities that actually cause them, then traces those activity costs to products. You first identify Cost Pools (a bucket of costs for each activity — e.g., Machine Setup Cost Pool) and then identify the Cost Driver for each pool (the thing that drives that cost — e.g., number of setups). Dividing the pool by the driver gives you the Cost Driver Rate. Multiply that rate by how many times a product triggers that activity, and you have the product's fair share of overhead.
The four steps every student must memorise: (1) Identify activities (machine setup, procurement, quality control, dispatch). (2) Assign overheads to cost pools — group costs by activity. (3) Determine the cost driver for each pool and calculate the driver rate = Pool Cost ÷ Total Driver Units. (4) Absorb costs into products using each product's driver consumption. ABC is especially powerful when a firm has high overhead costs, diverse product mix, and varying complexity across products. The ICAI exam frequently tests a full ABC computation as a 10–12 mark question, or compares ABC cost per unit versus traditional absorption cost.