Definition of Activity Cost Pool
An activity cost pool is defined as the aggregate amount of all the costs that are associated with performing a given business task. This might be a full-fledged business operation, or simply manufacturing of a certain product.
The main concept behind pooling all the costs together is to get a closer estimate of the associated cost of the business task itself. In this regard, it is further simple to get an accurate estimate of the given cost of the task itself.
In this regard, the activity cost pool includes both, fixed cost, as well as variable costs. It is a temporary account, which is created simply for the purpose of gauging how much a particular activity costs in a business.
Therefore, it can be described as a strategy that is adopted by the given departments of the business activity. It plays a very important role in allocating it towards different departments or service sectors, for any reasonable identifier known as a reasonable identification, or cost drivers.
Activity Cost Pools are used in Activity Based Costing. This is a costing mechanism, which can help accountants to create efficient and effective pricing policies.
What is Activity Based Costing?
Activity Based Costing can be defined as a costing method, which assigns overhead costs, as well as indirect costs to related products and services.
This particular accounting method recognizes the relationship between costs, as well as overheads incurred, and the manufactured products. This accounting method involves figuring out relationships between costs, overhead activities, as well as manufactured products.
The main rationale behind activity-based costing is to ensure that there is traceability pertaining to costs associated with indirect costs, so that product costs can accurately be calculated. Hence, the ABC system mainly relies on activities, which are considered to be true for any event, unit of work, or a given task with a specific goal.
An activity is considered to be a cost driver, which incurs a cost, as a result of operations and functions within the company. Similarly, a cost-driver rate is also incurred, that includes cost pool, divided by cost driver. This is used to calculate the amount of overhead, as well as indirect costs related to a particular activity.
Therefore, ABC is used as a costing mechanism that helps companies to get a better idea regarding their costing, so that they are able to decide on their pricing strategy accordingly.
Explanation and Analysis of Activity Cost Pool
As mentioned earlier, it can be seen that activity cost pool is defined as the total costs that are incurred in execution of a certain business task.
In this regard, it is also important to consider the fact that within the temporary account, an activity cost pool is created in order to include the fixed costs, and the variable costs associated with a specific task.
Activity Cost Pools are mostly used in activity-based costing, which is an accounting method used in production, as well as manufacturing. The main rationale behind using an activity cost pool is to help assign costs.
This it is important in determining the existing profitability of the products, as well as making production decisions that are likely to increase efficiency, and subsequently profit margins of the company.
The methodology involved behind Activity Cost Pools is to determine the exact production costs that are incurred in manufacturing a certain product.
This requires assigning fixed and variable costs, as well as direct and indirect costs to the related products and services. This acts as a great aid in helping companies realize the actual costs incurred in producing a certain product.
Given the fact that it helps in traceability of a certain product, it is widely used in the manufacturing, and the production industry.
This can, in return help companies to make decisions regarding pricing, and cost control of certain elements. This helps in accurately determining the profitability of the products, subsequently helping the company to make better informed decisions.
How to create Activity Cost Pools?
Creating Activity Cost Pools comprises of three major steps. These steps are as follows:
- Identification of the amount of overheads in the business.
- Identifying activities that are related to the amount of overhead.
- Grouping the said activities into respective pools.
- Identifying and calculating ways to measure cost pools.
These steps are not stringent, but they allow accountants to get a better understanding regarding the overall overhead cost outlay, as well as how they can subsequently be distributed across different activities in order to make the costing process more precise.
The main aim of creation of activity cost pools is to accurately proportion the overhead costs in areas that incur a higher volume of activity, as compared to other cost drivers in the organization.
Example of Activity Cost Pool’s Application
The application of activity cost pool is explained in the following examples:
Joota Co. is a company that specializes in producing shoes for men. They are a mid-sized company, and therefore, have under 50 employees. Research and Development, and Raw Material procurement are defined as the main cost centers of the company. Additionally, there is rent incurred, as well as labor cost that needs to be taken in the cost centers.
The total cost that is incurred in the manufacturing process is used by the organization to understand different activity cost pools and subsequent allocation.
For example, rent for the factory premises is not supposed to be included for in the research and development activity cost pool. Therefore, by creating a segregated activity cost pool, Joota Co. can understand their costing better, in terms of which particular activity is incurring a higher costing as compared to other metrics.
Chris Inc. has a manufacturing facility, where they produce a number of different consumer products, like utensils, and other electric kitchen equipment.
For the utensils department, the operations can be divided into three main areas: design, manufacturing, and packaging. The total cost incurred in the utensils side of the business amounts to $45,000.
Using the concept of activity cost pools, the accountant at Chris Inc. identified cost drivers including factory square footage, maintenance hours, labor hours and the total output produced. These three different cost pools are finalized, and the cost incurred is then appropriately dividend amongst other present alternates.
Using activity cost pools, the segregation of costs is relatively easier, primarily because of the fact that it helps allocating costs to pools where they actually belong. For example, machine hours might not necessarily apply to the design component within the costing.
Benefits of Activity Cost Pools
Creation of activity cost pools is important because of a number of reasons. The advantages of using activity cost pools are as follows:
- Firstly, using activity cost pools, overheads can be properly assembled, in order to properly allocate the stated overhead costs.
- It helps in creating new bases, using which overhead costs are allocated based on the actual activities that are carried out. The allocation using cost pools is based on the overall activity carried out, as compared to other metrics including machine hours, or direct labor hours.
- Using activity cost pools, accountants can alter the existing nature of several different indirect costs. Therefore, costs that were previously categorized as indirect costs, become traceable on certain grounds and activities. Therefore, the impact of traceability on specific products play an important role in pricing the products.