Activity-based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity-based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.
Activity-based costing recognizes that special engineering, special testing, machine setups, and others are activities that cause costs—they cause the company to consume resources. Under ABC, the company will calculate the cost of the resources used in each of these activities.