What it means
Overhead cannot be traced to products directly, so it must be allocated, and allocation requires a base: something measurable about each product that stands in for the overhead it caused. But overhead is not one thing.
The costs of running machines are caused by machine hours; the costs of setting them up by the number of set-ups; the costs of buying materials by the number of orders; the costs of the building by the space used. Allocating all of them by one base (labour hours, say) assumes they are all caused by labour hours, which they are not.
Cost pools solve the problem by grouping costs that are caused by the same thing and giving each group its own base. A traditional system has one or a few pools: a plant-wide pool allocated by direct labour hours, or a pool per production department allocated by that department's labour or machine hours.
The approach suited factories where overhead was small relative to labour and roughly proportional to it. As overhead has grown and labour shrunk, the approach has produced distortions: products with high labour content absorb overhead they did not cause, and products that consume set-ups, engineering, inspection and handling without much labour escape the costs they did cause.
Activity-based systems have more pools, each corresponding to an activity with an identifiable driver: a machining pool (energy, depreciation, maintenance) by machine hours; a set-up pool (set-up labour, tooling) by number or hours of set-ups; a purchasing pool by purchase orders; a receiving pool by deliveries; a quality pool by inspections; an engineering pool by engineering change orders or hours; a customer service pool by service calls; an occupancy pool by floor space. Each product or customer is charged for the driver units it consumes from each pool, and the resulting cost reflects the mix of activities it caused.
The design questions are: how many pools (enough to capture the significant, differently driven costs; few enough to maintain); what goes in each (costs that respond to the same driver; a pool mixing machine depreciation with purchasing salaries has no sensible driver); what driver for each (causal, measurable, available); and how to treat costs with no product driver (facility-level costs such as the plant manager and the building, which are either allocated arbitrarily or, better, left unallocated and treated as period costs). Pools are also organised hierarchically: unit-level, batch-level, product-level and facility-level, so that decisions at each level are informed by the costs that respond to them.
Cost pools also serve service departments. The costs of maintenance, IT, HR and finance are pooled and allocated to the departments that use them, by service hours, tickets, headcount or transactions, before those departments' costs are allocated onward to products.
The sequencing (direct, step-down or reciprocal methods) affects the result when service departments serve each other. The test of a pool is homogeneity.
If the costs in a pool are driven by different things, the allocation will be wrong for every product that consumes those things in different proportions. Analysts test pools by asking whether a change in the driver would change all the costs in the pool proportionately; if not, the pool should be split.
In practice
Real-world examples.
Example
A hospital pools theatre costs (staff, equipment, consumables) and allocates by theatre minutes, pooling ward costs separately and allocating by bed-days.
Example
A logistics company pools vehicle costs by vehicle type and allocates by kilometres, and pools depot costs and allocates by pallets handled.
Example
A software company pools cloud infrastructure by service and allocates to products by compute and storage consumed, pooling customer support and allocating by tickets.
Think of it
“A cost pool collects similar costs together before spreading them out-grouping related expenses.
Formula
Calculation
Pool Rate = Total cost in the pool / Total driver units for the pool
Cost allocated to a cost object from a pool = Pool rate x Driver units consumed by the object
Total overhead allocated to an object = Sum over pools of (Pool rate x Driver units)
Homogeneity test: within a pool, Cost / Driver units should be stable across the range of activity and across the objects served
Worked example. A precision components manufacturer has overhead of $3,600,000 a year, previously allocated as a single pool by direct labour hours (60,000 hours: $60 per hour). It redesigns its costing into five pools.
Pool 1, machine operations: energy $320,000, machine depreciation $680,000, machine maintenance $400,000, tooling consumables $200,000: total $1,600,000. Driver: machine hours, 40,000: rate $40 per machine hour.
Pool 2, set-ups: set-up technicians $360,000, set-up tooling and fixtures $120,000: total $480,000. Driver: set-up hours, 4,000: rate $120 per set-up hour.
Pool 3, materials management: purchasing staff $240,000, receiving and stores $200,000, inventory systems $80,000: total $520,000. Driver: purchase orders plus receipts, 13,000 transactions: rate $40 per transaction.
Pool 4, quality: inspection staff $300,000, test equipment $100,000, calibration $40,000: total $440,000. Driver: inspection hours, 5,500: rate $80 per inspection hour.
Pool 5, facility: plant management $260,000, building occupancy $220,000, insurance and other $80,000: total $560,000. No product driver; allocated by machine hours as the least bad option ($14 per machine hour), with the allocation shown separately so that decisions can exclude it.
Two products compared. Product X: a high-volume bracket, 20,000 units a year, 1.0 direct labour hour per 100 units (200 hours), 0.05 machine hours per unit (1,000 hours), 8 set-ups a year of 2 hours (16 set-up hours), 40 purchasing transactions, 20 inspection hours. Product Y: a low-volume precision housing, 500 units a year, 2.0 labour hours per unit (1,000 hours), 0.8 machine hours per unit (400 hours), 25 set-ups of 4 hours (100 set-up hours), 60 transactions, 150 inspection hours.
Single pool by labour hours: X gets 200 x $60 = $12,000 ($0.60 per unit); Y gets 1,000 x $60 = $60,000 ($120 per unit).
Five pools:
- X: machine 1,000 x $40 = $40,000; set-ups 16 x $120 = $1,920; materials 40 x $40 = $1,600; quality 20 x $80 = $1,600; facility 1,000 x $14 = $14,000. Total $59,120; $2.96 per unit (or $2.26 excluding facility).
- Y: machine 400 x $40 = $16,000; set-ups 100 x $120 = $12,000; materials 60 x $40 = $2,400; quality 150 x $80 = $12,000; facility 400 x $14 = $5,600. Total $48,000; $96.00 per unit (or $84.80 excluding facility).
The single-pool system undercosted X by a factor of five (it uses machines heavily but little labour) and overcosted Y by 25% (its labour hours attracted overhead it did not cause). With direct material and labour of $4.00 and $0.25 for X and $60 and $50 for Y, full costs move from $4.85 to $7.21 for X and from $230 to $206 for Y. The company had been pricing X below its cost and losing the volume business it thought was its most profitable, while overpricing Y.
Homogeneity check on pool 1: machine depreciation is fixed and energy is variable with machine hours; in a year of low volume the pool rate rises (fixed depreciation over fewer hours), which is the normal capacity issue rather than a homogeneity failure, and the company sets the rate on normal machine hours (42,000) with the under-absorbed balance expensed. Pool 3's transactions are found to vary in cost: purchase orders for new suppliers cost three times routine reorders; the company splits the pool if the difference matters to product decisions (it does for Y, whose components come from specialist suppliers).Case study
Seen in the real world.
A packaging company had allocated all overhead through a single pool by machine hours for twenty years. Its product range had diversified from standard cartons to short-run printed packaging with frequent changeovers, specialist inks and customer-specific tooling. The single pool charged both types the same overhead per machine hour, and the short-run products, which used few machine hours per order, appeared highly profitable while the standard cartons appeared marginal.
Sales pursued short runs. Overhead grew as set-up, prepress, purchasing and quality staff were added to handle the complexity, and the machine-hour rate rose, making the standard cartons look worse still. A new controller built six pools with drivers (machine hours, set-up hours, prepress jobs, purchase orders, inspections, floor space) and found that short-run products absorbed 65% of overhead while producing 30% of revenue; their true margin was negative on half the orders.
The company repriced short runs by 35% to 70%, lost a third of them, invested in faster changeovers for the rest, and rediscovered that standard cartons were its most profitable business. Overhead fell 12% as the complexity it had been carrying went away. The controller's note observed that the single pool had been accurate for the factory the company used to be.
Watch out
Common mistakes.
- A single plant-wide pool in an operation where overhead is driven by several different things, which undercosts complex low-volume products and overcosts simple high-volume ones.
- Pooling costs with different drivers together because they sit in the same department, which produces a pool with no meaningful base.
- Allocating facility-level costs with no product driver as if they had one, and then making product decisions on the result.
Questions
People also ask.
How many cost pools should a business have?
Enough to separate the significant overheads that are driven by different things, typically five to fifteen for a manufacturing plant. Beyond that, maintenance cost usually exceeds the gain in accuracy.
What is the difference between a cost pool and a cost centre?
A cost centre is an organisational unit responsible for costs. A cost pool is a grouping of costs for allocation, which may cut across cost centres (set-up costs from several departments in one pool) or subdivide one (a department's costs split into machine and set-up pools).
What should be done with costs that have no product driver?
Ideally, leave them unallocated and treat them as period costs for decision purposes, while allocating them for inventory valuation if the standards require. If allocated, show the allocation separately so decisions can exclude it.
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