Cost pools and drivers are important
tools in the operation of the Activity-Based Costing (ABC) method. They help to
disseminate indirect costs into the specific activities in the production
process. The breakdown helps to create a clear discernment of the cost of each
activity. Depending on the total number of production activities and the cost
of each, a company can estimate its profit. This paper will analyze the
importance of cost pools and drivers and their applicability in the ABC method.
It will delve into the advantages of using the ABC accounting method and
illustrate this using a fictitious company.
Discussion
Cost pools and drivers are essential
to the ABC accounting method (Bilant, 2017). Cost pools are comprised of
activities that are pulled together to one group based on a similarity of their
individual cost drivers. Cost drivers are the activities that influence the
function ability of a business exercise. They are essential in determining what
activities can be pulled together into one cost pool as an organization does
its financial planning.
Cost pools and drivers are important
in determining the exact cost that goes into every activity. It helps a company
to be more exact in its expenses data. This is useful in financial planning and
management (Bilant, 2017). A company is able to identify which costs are
unnecessary and may be eliminated. It also makes it easier to deduce the
activities that are more sensitive to the production process and need more
funding. Cost pools help a firm to make its output method more efficient by
bringing out the activities in the production chain that may be relied on to
decrease the manufacturing and processing costs.
ABC method determines the costs of
each production activity by using cost pools and drivers to evaluate how many
and cost of resources that go into each manufacturing or process step (Schmidt,
2017). The aim is to find an accurate data on the cost of each production
activity and use it to manage the production process. The ABC method is
different from the traditional accounting method. It is more detailed and the
analysis is more precise and clear, especially on the factors that influence
the eventual cost of a product. The ABC method is mostly different in the
analysis of the indirect cost in the production chain. Indirect costs comprise
the expenses of all the activities that are overhead in the manufacturing
process and cannot be directly pinned on a specific activity. For example,
machine purchase, repair, and maintenance, packaging, and rent. By pooling
these activities together as per their cost drivers, the ABC method is able to
create a clearer data of the expense of each activity (Schmidt, 2017). It does
not change the accounting framework of a corporation. The balance sheet and
other financial statement remain basically the same but more detailed. The
essence of deviating from the traditional accounting method and venturing into
the ABC method is to make the production process more efficient (Schmidt,
2017). It helps in determining which products create less profit, which
activities may be eliminated from the processing chain and where the company
needs to concentrate its production resources.
As earlier stated, the efficiency of
the ABC method relies on cost pools and drivers. Cost drivers determine the
force behind the functioning of a production activity, for example in a company
that deals in the production of pens the processing of ink rely on the use of
machines which in turn depend on electricity. The cost driver is therefore
electricity. Cost pools group together the activities that rely on the same
cost drivers, for example, processing of ink and filling the ink into pens will
require machines and use of electricity. These two may be placed in the same
pool and their costs used to determine the specific cost of production of each
item. The costs of the individual activities of every pool help to establish
the exact cost of production of each item. This method is more efficient in
discovering the cost of each activity as compared to the traditional method
where each production activity is considered without necessarily pooling the
activities together.
Ark Pen Company
Ark Pen Company deals in the
production of blue and black pens. The company produces a total of 5000 blue
pens and 3000 black pens. The production activities of each product include
processing of ink, filling of ink into pens and packaging as illustrated by
Table 1 (blue pens) and Table 2 (black pens) below:
|
Activity
pool (Blue pens)
|
Cost
Driver Activity Units
|
Cost
Driver Unit Cost
|
Total
Activity blue pens
|
Total
Indirect Cost blue pens
|
|
1. Processing
ink
|
No. of liters
|
$ 30
|
5
|
150
|
|
2. Filling
in ink
|
No. of pens filled in
|
$ 25
|
960
|
24,000
|
|
3. packaging
|
No. of packages
|
$ 45
|
80
|
3,600
|
|
TOTAL
|
$27,750
|
|||
Table 1 blue pens
|
Activity
pool (black pens)
|
Cost
Driver Activity Units
|
Cost
Driver Unit Cost
|
Total
Activity black pens
|
Total
Indirect Cost black pens
|
|
1. Processing
ink
|
No. of liters
|
$ 40
|
3
|
120
|
|
2. Filling
in ink
|
No. of pens filled in
|
$ 25
|
960
|
24,000
|
|
3. packaging
|
No. of packages
|
$ 45
|
80
|
3,600
|
|
TOTAL
|
$27,720
|
|||
Table 2 black pens
Table 1 shows that the production
cost of blue pens is $27,750 divided by the total number of pens (5,000) each
blue pen costs $5.55 in production. On the other hand, Table 2 shows that the
total production cost of black pens is $27,720, divided by the total number of
pens (3,000) each black pen costs $9.24 to produce which is much higher than
that of blue pens. An analysis of the production activity costs of Ark Pen
Company using the ABC method shows that blue pens are more profitable than
black pens.
Advantages of the
ABC Method
The increased use of the ABC method
over the traditional accounting method can be accounted to its immense
advantages. Through the ABC a firm is able to ascertain the profit margin of
individual products. In an organization that produces several products, it may
be challenging to tell the exact production cost of each individual product on
the face of it. ABC makes this possible by analyzing the production activities
of each product. A firm is then able to tell the real value of each profit.
This helps in better pricing of each product. With clear knowledge of the exact
cost of production, it is easier to place an appropriate price on a product
depending on the exact targeted profit. The ABC method makes it effortless to
verify unnecessary costs. Reducing the cost of production requires exacting the
essential costs and getting rid of the non-essential costs. The ABC method
improves production management by establishing and eliminating unnecessary
costs (Schmidt, 2017). On the flip side, it helps to establish and improve the
necessary costs and thus make the processing process more efficient. In the
same limp, it makes it unchallenging to deduce value-add costs and concentrate
more resources on them.
Conclusion
In conclusion, cost pools group together production activities that rely
on similar cost drivers. In the ABC accounting method, it is essential to
create cost pools in order to determine the exact cost of each production
activity. This helps to discern the necessary activities, which should be
accorded more resources and which should be eliminated. It also helps to
determine which product is more profitable and which value-add costs contribute
to the efficient production of a product. This helps in determining the
performance of each product, human resource, and financial management.
References
Bilant
S. (2017). Activity Cost Pools:
Definitions and Examples. Retrieved from https://study.com/academy/lesson/activity-cost-pools-definition-examples.html
Schmidt
M. (2017). Activity Based Costing and ABC
Management. Retrieved from https://www.business-case-analysis.com/activity-based-costing.html
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