Activity-based costing is a cost accounting system that allocates manufacturing costs based on production activities. Cost pools represent the indirect costs from each activity that affects the activity-based costing process. Three different types of cost pools are most common in this system: overhead, indirect materials, and indirect labor. While each item is necessary to produce goods or services, the costs for the items are not directly traceable to an individual product. Hence, a cost pool and cost driver allocate these costs to all goods and services produced in a given time period.
Overhead cost pools include all costs that affect a company’s overall production process in a direct or indirect manner. For example, equipment or building depreciation, management salaries, property taxes, security payments for products or buildings, and similar costs all fall under this group. Accountants must place these overhead costs into a single pool and then apply them at one time to all produced products. This is typically the most common cost pool in activity-based costing. The cost driver may be labor hours, machine hours, or some other representative activity for applying overhead costs to products.
Indirect materials represent any items needed to manufacture goods that are not directly traced to a single item or batch of goods. For example, solder is necessary to make connections on an electronics board. The manufacturing department may use the solder for multiple boards produced over a lengthy time period. Therefore, the solder is an indirect material. Any material that has a similar use in the production process falls under indirect materials cost pools for later cost allocation in activity-based costing.
The final category for these cost pools is indirect labor. This category typically holds information relating to hourly wages for all employees that do not have a direct impact on a company’s production process. Common examples here are equipment maintenance staff or quality control inspectors. These individuals may have a slight impact on the production process, but again, it is not traced to a single item or batch of goods. The information for this cost pool often matches a given production time period internal to the company.
Once the cost pools are set, accountants must determine the cost driver that best allocates these costs to goods. Each activity can have its own cost driver, per standard activity-based costing rules. Accountants often select the cost driver that best allocates based on the specific activity. Only the overhead, indirect materials, and indirect labor for each activity follow the corresponding cost driver.