A wide variety of factors can cause overhead to increase. To gain a better understanding of these factors, managerial accountants use activity-based costing. The assumption that the more direct labor your employees work, the more overhead your company incurs made sense in the days before automation, but today completely automated factories operate with little or no direct labor.

Activity-based costing gets around the problem of automated factories that use very little direct labor. It also provides you with valuable insights into how costs behave and can help you reduce the costs and get the manufacturing process to flow more smoothly. Here are the steps of activity-based costing:


Add up total overhead.

Total overhead includes indirect materials, indirect labor, and other manufacturing costs. Add up indirect materials, indirect labor, and all other product costs not included in direct materials and direct labor.


Identify one or more cost drivers.

Scrutinize the nature of your overhead to identify different pools of overhead costs and specific measures that affect them. For example, one overhead pool may be storage costs. This pool would be affected by the number of square feet assigned to each department. Ideally, try to identify a single measure that actually causes each overhead pool to increase.

Research the nature of your overhead to try to find measurable factors that affect overhead costs. Ideally, try to find a measure that actually causes the total overhead pool to increase.

Activity-based costing doesn’t prohibit using direct labor hours to allocate overhead. If managers decide direct labor hours are a cost driver, that measure can function as part of the activity-based costing system.

This process eventually results in breaking total overhead down into several different cost pools and identifying a single cost driver for each.


Compute the overhead allocation rate.

Divide total overhead in each cost pool by its cost driver.


Apply overhead.

Multiply the overhead allocation rate for each cost pool by the individual product’s cost driver activity level.