Overhead costs are analyzed and grouped based on similar activity bases. A cost driver, such as inspections, machine setups, or order taking, is selected for each cost grouping.
Analysis of cost drivers allows for better selection of true overhead cost drivers and more appropriate allocation of overhead.
Traditional allocation assigns overhead based on a single overhead rate, while ABC assigns overhead based on several cost pools and the activities that drive costs.
Traditional allocation is optimal when the manufacturing process is labor driven and overhead increases based on traditional activity bases, such as direct labor hours, direct labor dollars, or machine hours.
ABC costing is optimal when the manufacturing process is technology driven and overhead increases based on various activities that differ for each product.
Absorption costing assigns all manufacturing costs to products, whereas variable costing only assigns variable costs to the products.
Income statements from both methods can be reconciled by starting with the net income or loss using variable costing and adding the amount of fixed costs included in ending inventory and subtracting the fixed costs included in beginning inventory.
Variable costing is not considered GAAP compliant but lends itself to cost-volume-profit analysis.