Activity based costing or ABC arose from the shortcomings of assigning an ever increasing amount of manufacturing overhead to products on the basis of one variable, such as direct labor hours or machine hours.

When manufacturing overhead costs are allocated, spread, or assigned to products on the basis of the production equipment's machine hours, a product run in small batches will be assigned few overhead dollars. However, this small batch might actually use a significant amount of setup time, movement of materials, and require other attention. Using only the machine hours as the means of allocation will mean this product will be assigned too little cost for all of the work it is causing.

Another product might run day and night with few setups and not much special handling. This product will be assigned an enormous amount of overhead based on the number of machine hours. This product will be assigned far more overhead costs than it is causing.

When companies manufacture diverse products and have diverse demands from its customers, the allocation of manufacturing overhead on one base, such as machine hours, will lead to cost distortions.

Activity based costing seeks to find the real cause of the overhead and to assign the overhead to the products and customers that are causing or driving the overhead costs. Rather than using the traditional allocation based on machine hours, managers are first determining the true cost of the activities being demanded for each product. With global competition, a company might lose a customer if it raises its price based on faulty cost allocations.

A common activity is setting up a machine for a production run. The setup activity is likely to be the same whether the production run will be 100 units or 10,000 units. If the setup activity costs $200, then $200 should be assigned to each batch or production run. If you don't recognize the setup activity and simply allocate the cost on the basis of machine hours, you might attract lots of small production runs and lose a lot of long production runs. That could lead to financial disaster.

Striving to learn about activities and their costs has led to what is referred to as activity based management.