Activity Cost Pool

What Is an Activity Cost Pool?

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 includes both fixed and variable costs and is a temporary account, used only to get an idea of how much a certain activity costs a business.

Understanding an Activity Cost Pool

Activity cost pools are used in activity-based costing (ABC), a common method for determining production costs. This method assigns fixed and variable costs, or overhead and indirect costs, to related products and services, allowing a company to realize the true cost of a product, service, or task.

One example of the use of activity costs is in manufacturing. A manager may be asked to evaluate the production costs of each product produced by a factory. 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 producing a particular product, and the set-up cost would be one cost included in an activity cost pool. Purchasing materials might be another cost assigned to the pool. Those two costs and any others would comprise the activity cost pool.

Assigning costs accurately is important to determine the profitability of products and subsequently to make rational production decisions, particularly to improve efficiency and profit margins.

Activity-Based Costing vs. Traditional Costing

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. According to some managers, allocating these costs to the production of products can produce distorted estimates, especially if a factory produces many different products. However, for a company with a single product, 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. The comparison between traditional costing methods and ABC provides an opportunity for insights related to areas of waste, underutilized capacity, and any other cost that does not directly support productivity — and making decisions about these insights.

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.

Example of an Activity Cost Pool

Cobbler and Sons manufacture high-quality leather shoes. It is a family business of a few employees that creates handmade shoes. The main divisions of the company include the research and development of the shoes, the production of the shoes' components, and the assembly of the shoes.

The costs of making the shoes include the rent for the factory, the cost of the raw materials, the cost of machines, and the cost of labor. The total costs for the month are $35,000.

The total cost can then be allocated to the different divisions as activity cost pools based on what makes sense. For example, the rent for the factory wouldn't be included in the research and development cost pool as research and development would not be using factory space. The activity cost pool allows Cobbler and Sons to better understand where its costs come from, which in turn allows it to better manage its costs.