Before we can discuss the differences between activity-based and volume-based costing systems, we should think of the following categories of product costing methods: cost accumulation, cost measurement, and factory overhead assignment methods.

Cost accumulation methods represent methods used to accrue costs. There are two types: job costing and process costing. These methods depend on the type of production.

• Job costing is a product costing system when costs are accumulated by specific job orders (e.g. Job Order XX2, Job Order 02357) and assigned to batches of products. In other words, manufacturing costs are assigned to specific jobs: specific customers, specific orders, specific projects, specific contracts, etc. Job costing is often used by small and medium-sized firms. Also, it is often used in the following industries: professional services (e.g. medical, legal), advertising agencies, construction, shipbuilding, custom equipment/furniture manufacturing, etc.

• Process costing is a product costing system when costs are accumulated by departments or processes (e.g. Printing Department, Assembling Department) and assigned to a large number of homogenous, identical products. In other words, manufacturing costs are assigned to each process in each manufacturing department: assembling costs (including direct materials, direct labor, and factory overhead) in the assembling department; cost of printing (direct labor, direct materials, and factory overhead) in the printing department, etc. Process costing is usually used by companies characterized by continuous mass production (i.e. firms that produce one or a few homogenous products). Process costing is often used in the following industries: textiles, food processing, automobile manufacturing, electronics, drugs, paper, paint, oil refining, chemicals, service companies offering homogenous services, etc.

Cost measurement methods represent methods used to measure and record the cost of direct materials, direct labor, and factory overhead. There are three methods: actual costing, normal costing, and standard costing.

• Actual costing is a product costing system when a company measures actual costs of direct materials, direct labor, and factory overhead. Actual costing system is rarely used because it does not provide accurate information on a timely basis: many costs can be measured only at the end of the production, and some actual costs fluctuate a lot leading to potential errors in price recording.
• Normal costing is a product costing system when a company measures the actual costs of direct materials and direct labor, but uses predetermined factory overhead rates to measure the factory overhead cost for a period. In other words, throughout the production time, the company measures and records the actual costs of direct materials and direct labor used, but it estimates a portion of factory overhead to be assigned to the product(s) (i.e. factory overhead applied). Normal costing system provides a timely cost estimate of a product or batch of products.
• Standard costing is a product costing system when a company measures all costs – direct materials, direct labor, and factory overhead – using standard quantities and costs. It is often used to measure performance, determine target costs, and improve production process.

Overhead assignment methods represent methods used to collect and allocate factory overhead costs. These methods depend on a type of cost drivers that a company uses to allocate factory overhead costs to products or batches of products.

• Volume-based costing, also called traditional costing, is a product costing system when a company allocates factory overhead costs to a single cost pool (e.g. factory overhead) and then uses volume-based cost drivers to allocate factory overhead costs to individual products or services. The company uses volume-based cost drivers that depend on number of units manufactured. Cost bases (or drivers) often used are: labor hours, machine hours, labor costs, etc.
• Activity-based costing (ABC) is a product costing system when a company allocates factory overhead costs to activity centers (e.g. machine set ups, running machines) and then uses activity cost drivers to allocate factory overhead costs to individual products or services.
• An activity cost driver is a quantity of activities needed to produce a product (e.g. ‘machine set ups’ activity center will have set-up hours as the activity cost driver).
• The activity cost driver rate is calculated by dividing activity expenses by the total quantity of the activity cost driver (e.g. machine set up expenses divided by total number of machine set up hours).

An easy way to remember the relationship between products, activity cost drivers, and resources, is to recall that products consume activities and activities consume resources.

Now, when we have covered the various costing methods used to collect, measure, and allocate manufacturing costs, we can discuss in greater detail the costing methods used to allocate factory overhead costs.