What is an Activity Cost Pool?
Definition: An activity cost pool is a temporary account that is used to total the costs incurred for a specific group of activities. In other words, it’s a way to record the cumulative costs of a group of similar activities. Even though the cost pool account is similar to the factory overhead account it actually contains both fixed and variable costs. The fixed coststypically include equipment purchases; whereas, the variable costs include material and supply purchases.
An activity cost pool is an aggregate of all the costs associated with performing a particular business task, such as making a particular product. By pooling all costs incurred in a particular task, it is simpler to get an accurate estimate of the cost of that task.
An activity cost pool is an account in which is aggregated a number of costs that are related to a certain type of activity. The grand total of these costs is then allocated to products and other cost objects in order to gain a better understanding of the total costs incurred by a product or cost object. A number of different cost pools may be used in order to more distinctly identify the costs of different activities, but doing so also requires more accounting effort. Consequently, most organizations organize their costs into only a small number of activity cost pools. The cost pool concept is most heavily used in an activity-based costing system.
What Does Activity Cost Pool Mean?
Activity cost pools are used in the managerial accounting method of activity-based costing to assigned costs to products based on their activities and production processes.
During the activity based costing process, cost accountants use activity cost pools to accumulate and total all of the costs for a specific activity. Once all of the costs have been sorted and totaled in pools, an overhead rate can be computed for the activities and eventually assigned to the products or objects based on their activity cost drivers.
One example of the use of activity costs is in manufacturing. A manager may be asked to evaluate production costs of each product produced by a factory. Activity-based costing (ABC) is a common method for determining those production costs. ABC defines production as consisting of a variety of activities, and it assigns costs to those activities. For example, machine set-up might be one activity associated with the production of a particular product. The cost of set-up would be one cost included in an activity cost pool. Purchasing materials might be another cost assigned to the pool. Assigning costs accurately is important to determine the profitability of products and subsequently to make rational production decisions.
Manufacturing companies use product costing techniques to determine how much it costs to manufacture each product it produces. One such technique is activity-based costing. Activity-based costing systems allocate manufacturing overhead by assigning indirect costs to activity cost pools, then dividing each cost pool by a cost driver to obtain the rates used for allocation. Manufacturing overhead costs are the expenses incurred in the manufacture of a product that cannot be directly allocated to that product. These costs are also known as indirect costs. Activity cost pools are groups of individual costs influenced by the same cost drivers , which are activities that control the amount of costs incurred.
Activity-based costing allows for more accurate product costing than other types of costing method because it requires the calculation of multiple rates to allocate manufacturing overhead to products. Activity cost pools are an important part of activity-based costing as they enable companies to group similar overhead costs together and divide by a common cost driver. This enables the companies to have multiple criteria for allocating overhead instead of just one like in traditional costing systems. For example, instead of allocating overhead based on machine hours alone, the use of activity cost pools would allow a company to allocate overhead based on machine hours, direct labor hours, number of inspections, and other criteria as their specific processes required.
Now let’s look at an example.
Lynn’s manufacturing plant has several different departments that make vary different products. One department manufactures sunglasses and uses activity based costing to help allocate the overhead. The sunglasses department’s operations can be divided up into three main pools: design, molding, and assembly. The total costs for the department are $50,000.
Using the activity cost pools, Lynn comes up with the following cost drivers: factory square footage used, maintenance hours, machine hours, labor hours, and number of units produced. Lynn can analyze these three different pools in relation to the cost drivers and allocate the $50,000 total costs appropriately between the three pools.
As you can see, this method of assigning costs is far more accurate and helpful than estimating expenses or splitting the total costs equally amongst all three pools. Some drivers, like machine hours, don’t apply to all the pools.
Activity-Based Costing vs. Traditional Methods
ABC differs from traditional costing methods. Traditional costing is product-based and period-based. Product-based costs include materials, labor, and overhead while period-based costs include sales, general costs, and administration (SG&A). These are charged against revenue for each accounting period. Allocating these costs to the production of products can produce distorted estimates, according to some managers, especially if a factory produces many different products. For a company with a single product, however, traditional costing and ABC would produce similar product cost estimates.
The advantage of ABC is that it ties activity costs more directly to production. It achieves this by removing the distinction between product and period-based costs. In addition, under ABC, products are not allocated costs of unused capacity. Under traditional costing methods, some portion of purchasing costs might be assigned to a product regardless of how much actual purchasing activity was required. ABC would seek to assess actual purchasing activity associated with a particular product. In addition, unused capacity might also be assigned to a product, potentially distorting its cost.
ABC is not used only in manufacturing businesses. It may also be applied to service businesses.
Considering all possible costs that would result from a business activity or investment helps a manager make a more informed decision. An activity pool is a more detailed cost breakdown than what is typically recorded in financial accounting. Comparing potential revenue to activity costs helps you avoid unprofitable moves. Cost pools also are useful in comparing two options.