What Is Activity-Based Costing (ABC)? A Small Business Guide

Activity-based costing (ABC) is a way to assign overhead, the indirect costs you can't trace straight to one product or client, according to the activities that cause those costs. You group overhead into pools by activity, such as project management or client meetings, and pick a measure for each, such as hours or number of meetings. You then charge each product or client for what it uses. The alternative spreads all overhead with one rate, such as per labor hour.

The definition

OpenStax's Principles of Accounting, Volume 2: Managerial Accounting (section 6.3, opened October 29, 2026) defines it:

"Activity-based costing (ABC) is the process that assigns overhead to products based on the various activities that drive overhead costs."

It isn't only for factories. OpenStax adds: "Activity-based costing is not restricted to manufacturing. Service industries also have cost drivers and can benefit from analyzing what drives their costs."

Key terms

• Overhead: indirect costs, such as rent, software, management time and admin, that support the work but aren't traced to a single job.
• Activity: something the business does that uses resources, such as managing projects, holding client meetings or processing orders.
• Activity cost pool: the overhead grouped under one activity.
• Cost driver: the measure of how much of an activity something uses, such as hours of project management or number of meetings.
• Activity rate: a pool's cost divided by its total driver quantity, such as $90 per hour.

The five steps

OpenStax lists the stages of the ABC process:

1. "Identify the activities performed in the organization"
2. "Determine activity cost pools"
3. "Calculate activity rates for each cost pool"
4. "Allocate activity rates to products (or services)"
5. "Calculate unit product costs"

For a service business, the last step can be the cost of serving each client or project, rather than a unit cost.

Worked example: two clients, two methods

The figures here are a sample. A design studio has $60,000 of overhead for the quarter and two clients.

Client facts for the quarter:

• Client A: revenue $70,000; 800 billable hours at a direct labor cost of $30 an hour ($24,000); 300 hours of project management; 30 client meetings.
• Client B: revenue $35,000; 400 billable hours at $30 an hour ($12,000); 100 hours of project management; 90 client meetings.

Method 1: one blanket rate (traditional). The studio spreads overhead by billable hours.

• Rate: $60,000 ÷ (800 + 400) hours = $60,000 ÷ 1,200 = $50 per billable hour.
• Client A overhead: 800 × $50 = $40,000. Client B: 400 × $50 = $20,000. Total $60,000.
• Client A profit: $70,000 − $24,000 − $40,000 = $6,000.
• Client B profit: $35,000 − $12,000 − $20,000 = $3,000.

Method 2: activity-based costing.

1. Activities and pools: project management $36,000; client meetings and admin $24,000. Together that's $60,000.
2. Drivers: project management hours (300 + 100 = 400) and meetings (30 + 90 = 120).
3. Activity rates:
   • project management: $36,000 ÷ 400 = $90 per hour;
   • meetings: $24,000 ÷ 120 = $200 per meeting.
4. Allocate:
   • Client A: (300 × $90) + (30 × $200) = $27,000 + $6,000 = $33,000;
   • Client B: (100 × $90) + (90 × $200) = $9,000 + $18,000 = $27,000;
   • total $60,000.
5. Cost and profit per client:
   • Client A: $70,000 − $24,000 − $33,000 = $13,000;
   • Client B: $35,000 − $12,000 − $27,000 = −$4,000.

What changed: total profit is $9,000 under both methods ($6,000 + $3,000 = $13,000 − $4,000). But ABC shows that Client B's 90 meetings use far more overhead than its billable hours suggest, so the client loses money at its current price. The blanket rate hid that. The studio might raise B's fee, limit meetings in the scope, or change how it serves B.

When ABC helps and when it doesn't

It tends to help when:

• overhead is a large share of your costs;
• clients or products use support very differently: meetings, revisions, setups, orders;
• you suspect some work is underpriced, but a blanket rate shows it as profitable.

It's more effort than it's worth when:

• overhead is small compared with direct costs;
• your products or clients use support in similar ways;
• you can't collect the driver data reliably.

OpenStax (section 6.4) names the main drawbacks: ABC "is more expensive, as there is a cost to collect and analyze cost driver information as well as to allocate overhead on the basis of multiple cost drivers". In addition, "Some manufacturing costs may be excluded from product costs" because they don't fit an activity pool.

Keeping it simple

1. List your largest overhead costs for a period, such as a quarter.
2. Group them into two to four activities that explain them.
3. Pick a driver for each that you can count from records you already keep, such as hours logged or meetings in your calendar.
4. Work out the rates and allocate them to your clients or products, as in the example.
5. Use the results for pricing and scoping decisions, and ask your accountant before changing how costs appear in your financial statements.

Where Billed fits

Billed's time tracking page describes how you can "Log time for each task as you work, and see how much time goes into each project." Hours logged per project like this can supply one cost driver, such as project management hours. That page doesn't describe overhead allocation or activity-based costing, so you'd do the calculation yourself or with your accountant.

Related Articles

• What Is Cost Accounting?
• What Is Overhead Cost?
• How to Calculate Manufacturing Overhead Costs
• What Is Contribution Margin?
• How to Price Your Services
• Cost per unit calculator

Frequently Asked Questions

What is activity-based costing in simple terms?

It's a way to assign overhead according to the activities that cause it. You group overhead by activity, measure how much of each activity a product or client uses, and charge each one for what it uses, instead of spreading all overhead with one rate.

What is the difference between activity-based costing and traditional costing?

Traditional costing assigns overhead with one predetermined rate, such as per direct labor hour or machine hour. Activity-based costing uses several pools, each with its own cost driver and rate, so products or clients that use more of an activity carry more of its cost.

What are examples of cost drivers?

Hours of project management, number of client meetings, number of orders processed, number of machine setups and number of invoices issued. A good driver is a count that rises when the activity's cost rises.

Can a service business use activity-based costing?

Yes. OpenStax notes that activity-based costing "is not restricted to manufacturing" and that service industries "also have cost drivers". In a service business, the result is the cost of serving each client or project.

What are the disadvantages of activity-based costing?

It takes more time and money to set up and run, because you have to collect and analyze driver data for several activities. Some costs may not fit any activity pool and are left out of the product or client cost.