By using only machine hours to allocate the manufacturing overhead to products, it is implying that the machine hours are the underlying cause of the factory overhead. Traditionally, that may have been reasonable or at least sufficient for the company's external financial statements. However, in recent decades the manufacturing overhead has been driven or caused by many other factors. For example, some customers are likely to demand additional manufacturing operations for their diverse products. Other customers simply want great quantities of uniform products.
If a manufacturer wants to know the true cost to produce specific products for specific customers, the traditional method of cost accounting is inadequate. Activity based costing (ABC) was developed to overcome the shortcomings of the traditional method. Instead of just one cost driver such as machine hours, ABC will use many cost drivers to allocate a manufacturer's indirect costs. A few of the cost drivers that would be used under ABC include the number of machine setups, the pounds of material purchased or used, the number of engineering change orders, the number of machine hours, and so on.
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