Cost pools are used in cost accounting to separate costs into groups. The pools are then used to allocate costs to a cost object. Again, the cost object is the reason you’re incurring costs. A cost object can be a unit of product, a batch, or a department of your company. Notice how similar the terms cost pool, cost hierarchy, and cost allocation base are.
Consider cost pools and your corporate costs. Your goal is to create cost pools that have the same cause and effect on the cost object. The same activities should cause your costs to increase or decrease. In other words, the cost behavior is similar for all costs in the cost pool.
For example, combining vehicle repair, vehicle maintenance, and vehicle insurance into one cost pool makes sense. If you increase vehicle use (cause), you increase these costs (effect). So put them in the same cost pool. Then consider where in the cost hierarchy the cost pool belongs — unit, batch, division, facility, and so forth.
You decide that all head-office costs should be allocated to the divisions, because you determine that the corporate costs are incurred primarily to support each division’s business activity.
Assume your firm took out a loan to finance machines. The cost pool is the interest cost on the loan. You decide to allocate the interest cost to each division, based on the percentage of the total loan proceeds each division received. Your logic is that if the residential refrigerator division got 60 percent of the loan proceeds spent on machines, it should incur 60 percent of the interest cost.
Machine costs can also be allocated to each unit produced. So you can relate the interest cost of the machines purchased to individual units.
You decide to allocate the interest cost using machine hours (activity). What you end up with is each product receiving an indirect cost allocation for interest.
Say $50,000 of your $5,000,000 corporate costs is for interest. That could be a 5 percent annual interest cost on a $1,000,000 loan. The residential division used 60 percent of the loan proceeds for machines, so it gets 60 percent of the interest cost:
Residential division interest cost allocation = company interest cost x 60 percent of loan proceeds used for machines Residential division interest cost allocation = $50,000 x 0.60 Residential division interest cost allocation = $30,000
Now you need to allocate the $30,000 interest cost allocated to each unit of product. You do that using machine hours. Assume 2,000 machine hours for the year:
Residential division interest cost per machine hour = interest cost ÷ machine hours Residential division interest cost per machine hour = $30,000 ÷ 2,000 Residential division interest cost per machine hour = $15
If a unit of product requires less than 1 machine hour (say, 20 minutes of time — 1/3 of an hour), the interest cost for that product would be $15 ÷ 3, or $5 of interest cost. And there you are! Each unit of product has $5 more attached to the product cost due to the interest paid on the machines.
Because interest cost took a lot of effort, it’s a relief to look at simpler items. Say you make a judgment that $2,000,000 in salary and other costs for corporate legal and accounting staff is a facility-sustaining cost, needed to support the business company-wide. That means that the cost should be allocated on a broad basis, not by unit or by batch. Consider the divisions.
You decide to allocate the legal and accounting costs based on percentage of total profit. The residential division generated $10,000,000 of $17,000,000 in profit (before allocating corporate costs). It turns out to be 59 percent (rounded). Here’s the cost allocation to the residential division:
Residential division legal and accounting cost allocation = $2,000,000 x 0.59 Residential division legal and accounting cost allocation = $1,180,000
Interest costs and the legal and accounting costs were allocated. Each used a different level in the cost hierarchy. Some of the $5,000,000 in corporate cost still needs to be allocated, but you get the idea of how to allocate the costs.
Again, your goal is to allocate all costs down to a unit of product. If you can’t do that, any costs not allocated to a unit should still be posted to your profit and loss statement.