Activity-based costing allocates manufacturing costs based on production activities using cost pools for overhead, indirect materials, and indirect labor. Each item is necessary but cannot be traced to an individual product, so a cost pool and cost driver assign costs to all goods produced.
Activity-based costing is a cost accounting system that allocates manufacturing costs based on production activities. Cost pools represent the indirect costs of each activity that affect 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, item costs cannot be directly traced to an individual product. Therefore, a cost pool and a cost driver assign these costs to all goods and services produced in a given period of time.
Overhead cost pools include all costs that directly or indirectly affect the overall production process of a company. For example, depreciation of equipment or buildings, management salaries, property taxes, product or building safety payments, and similar costs are included in this group. Accountants must put these overhead costs into a single group and then apply them at the same time to all products produced. This is usually the most common cost pool in activity-based costing. The cost driver can be labor hours, machine hours, or another representative activity to apply overhead costs to products.
Indirect materials represent any item needed to make goods that does not directly trace back to a single item or batch of goods. For example, soldering is required to make connections on an electronic board. The manufacturing department may use soldering for multiple plates produced over a long period of time. Therefore, solder is an indirect material. Any material that has a similar use in the production process falls under the indirect material cost pools for further cost allocation in activity-based costing.
The final category for these cost pools is indirect labor. This category generally contains information related to hourly wages for all employees who do not have a direct impact on a company’s production process. Common examples here are equipment maintenance personnel or quality control inspectors. These people can have a slight impact on the production process, but again, it doesn’t go back to a single item or batch of products. The information for this cost group often coincides with a company’s internal production time period.
Once the cost pools are established, accountants must determine the cost driver that best allocates these costs to goods. Each activity can have its own cost driver, based on standard activity-based costing rules. Accountants often select the best allocating cost driver based on the specific activity. Only overhead, indirect materials, and indirect labor for each activity follow the corresponding cost driver.
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