What Is a Cost Pool?

A cost pool is an accounting method for grouping individual indirect costs. Once collected, these costs are then assigned to different parts of a business, such as specific products, services, or departments. This technique is used in manufacturing but is applicable to any business wanting a more precise understanding of its expenses.

Consider a shared utility bill for a building with multiple tenants. The total electricity cost is the cost pool. This total is then divided based on a logical factor, like each tenant’s square footage, to determine individual bills. This principle applies within a business to distribute shared operational costs.

Identifying and Grouping Costs

The first step is to distinguish between direct and indirect costs. Direct costs are expenses that can be traced specifically to a single product or service, such as the cost of wood to make a chair. These expenses are not included in a cost pool.

Indirect costs, often called overhead, are the focus of this method. These are expenses necessary for operations but do not tie to a single, specific product. Examples include factory rent, the electricity bill for a production facility, salaries for administrative staff, and the depreciation of manufacturing equipment.

An effective cost pool groups similar costs driven by the same underlying activity, creating what is known as a “homogeneous” cost pool. For instance, a company might create a “Building Occupancy” cost pool that includes expenses like factory rent, property insurance, and utilities, as all of these costs are incurred by using the physical space.

Another example is a “Machine Maintenance” cost pool, which could group the salaries of maintenance staff, the cost of spare parts, and machinery lubricants. All these expenses are driven by the operation of machines. This allows the business to assign maintenance costs more accurately to the products that require more machine time.

Selecting an Allocation Base

After costs have been grouped, the next step is to choose a method for distributing them using an allocation base, which is a measure of activity that drives the costs within the pool. An effective allocation base has a direct cause-and-effect relationship with the indirect costs, meaning the activity measure should rise and fall in proportion to the costs in the pool.

For example, if a cost pool contains all the expenses related to running machinery, then machine hours would be a suitable allocation base. Products that require more time on the machines will be assigned a larger share of the machinery-related costs.

Different cost pools within the same company will require different allocation bases. For a cost pool related to facility expenses like rent and insurance, square footage is a common allocation base. For a pool that groups labor-related indirect costs, like the salaries of production supervisors, direct labor hours would be a logical allocation base.

The choice of allocation base impacts the perceived cost of products. An inappropriate base can distort these figures and lead to poor business decisions. For instance, allocating machine maintenance costs based on direct labor hours would be inaccurate if some products are handmade while others are machine-intensive, as the handmade products would be unfairly burdened with machine costs they did not incur.

The Allocation Process

The allocation process systematically assigns a portion of the total pooled costs to individual products or departments. It begins by summing all the individual indirect costs that have been grouped into the cost pool for a specific period, such as a month or quarter.

Next, the total amount of the chosen allocation base for the same period is calculated. For example, if the allocation base is machine hours, the company would total all machine hours used across the entire production facility during that period.

With these two totals, a predetermined overhead rate is calculated. The formula is the total cost in the pool divided by the total units of the allocation base. For instance, if a facility-related cost pool totals $50,000 and the total factory space is 5,000 square feet, the overhead rate would be $10 per square foot ($50,000 / 5,000 sq. ft.).

Finally, this rate is used to apply the overhead cost to a specific product, service, or department. The calculated rate is multiplied by the number of allocation base units consumed by that specific item. In the facility example, a product line that occupies 800 square feet of the factory would be allocated $8,000 of the facility costs ($10 per sq. ft. x 800 sq. ft.).