Chivaka & Cairney, 2007) points out that in order to have a more accurate picture of the costs of products and services, it is required that you understand and identify the activities that the products and services require. Once activities required by the product and service have been identified, the costs incurred (resources consumed) in the performance of those activities can then be established.

It is important to acknowledge the fact that, for most products and services, the assumption made by the traditional costing methods that only one cost driver explains why overhead costs are increasing in the cost structure is not valid. ABC is superior to the traditional costing methods because it captures every form of diversity that causes overhead costs in products and services.

In order to support strategic cost management effectively, companies should allocate overhead costs correctly by identifying the relevant activities associated with the different products and services. Using activity-based costing ABC, the costs associated with the unit-level, batch-level, and service-sustaining activities can be identified and assigned as such. This process allows company management to understand fully what is driving costs in the different products and services it provides.

How might a company incorrectly allocate overhead costs?