Examples Of Activity Cost Pools And Cost Drivers
What is an 'Activity Cost Driver' An activity cost driver is a factor that influences or contributes to the expense of certain business operations. In activity-based costing (ABC), an activity cost driver drives the, maintenance or other variable expenses. Cost drivers are essential in, a branch of managerial accounting that allows managers to determine the costs to perform an activity at various activity levels.
BREAKING DOWN 'Activity Cost Driver' A cost driver is an activity that is the root cause of why a cost occurs. It must be applicable and relevant to the event that is incurring a cost. There may be multiple cost drivers responsible for the occurrence of a single expense. A cost driver assists with allocation expenses in a systematic manner that theoretically results in more accurate calculations of the true costs of a producing specific products. Examples of Cost Drivers The most common cost driver has historically been direct labor hours. Expenses incurred relating to the layout or structure of a building or warehouse may utilize a cost driver of square footage to allocate expenses.
More technical cost drivers include machine hours, the number of change orders, the number of customer contacts, the number of product returns, the machine setups required for production or the number of inspections. Example of Cost Allocation A factory has a machine that requires periodic maintenance. This maintenance incurs costs to be allocated to the products produced by the machinery. Therefore, the cost driver is identified and used as a base to distribute the costs. In this example, the cost driver selected is machinery hours. It is determined that after every 1,000 machine hours, maintenance costing $500 is performed. Therefore, every machine hour results in an eventual 50 cents in maintenance costs that can be allocated to the product being manufactured based on the cost driver of machine hours.
Distribution of Overhead Costs A cost driver exists to allocate manufacturing overhead. The correct allocation of manufacturing overhead is important for determining the true cost of a product.
Internal management utilizes the cost of a product in the determination of the product's price. For this reason, the selection of accurate cost drivers has a direct impact on the profitability and operations of an entity. Subjectivity of Cost Drivers Management selects cost drivers as the allocation base for distributing manufacturing overhead. There are no industry standards or regulations stipulating mandating cost driver selection. A cost driver is selected at management's discretion based on the associated variables relating to the expense being incurred.
Activity-based costing is a system that allocates manufacturing costs based on production activities. Cost pools represent the from each activity that affects the activity-based costing process.
Three different types of cost pools are most common in this system:,. 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 and 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, 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.
Example Of Cost Pools
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 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 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.
What Is A Cost Pool
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.