Activity based costing (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 low volume product will be assigned few overhead dollars. However, this product 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 allocating overhead will result in this product being assigned too little cost for all of the work it is causing.

On the other hand, another product that runs day and night with few setups and not much special handling will be assigned an enormous amount of overhead due to the high number of machine hours. As a result, 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. In a competitive environment a company might lose a customer if it raises its price based on faulty cost allocations.

Activity based costing seeks to find the real cause of the overhead and to assign the appropriate overhead to the products and customers that are causing or driving those overhead costs.

A common activity (out of the many activities involved in manufacturing a product) is setting up a machine for a production run. The setup activity is likely to be the same whether the production run or batch 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 end up with lots of low volume production runs and few high volume 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.