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A traditional costing system allocates overhead to products on the basis of predetermined plantwide or departmentwide rates such as direct labor or machine hours. An ABC system allocates overhead to identified activity cost pools and then assigns costs to products using related cost drivers that measure the activities (resources) consumed.
The development of an activity-based costing system involves the following four steps. (1) Identify and classify the major activities involved in the manufacture of specific products and assign overhead to cost pools. (2) Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool. (3) Compute the activity-based overhead rate for each cost pool. (4) Allocate overhead costs to products using the overhead rates determined for each cost pool.