Chapter Four

Cost Pools, Capacity, and

Activity-Based Costing

Prepared by:
Joshua R. Zender, PH.D., CPA

Copyright © 2017 by Institute of Management Accountants, Inc. All Rights Reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or
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by any means – electronic, mechanical, photocopying, recording or otherwise – without prior written permission from the publisher, except for the inclusion of brief quotations in a review.
 4 Cost Pools, Capacity, and
Activity-Based Costing
Learning Objectives
Define the key characteristics of a cost pool, and combine direct and indirect resources into cost pools
1 using resource drivers.

Explain capacity and calculate: 1) managed and committed capacity costs using the avoidability criterion
2 and 2) productive, nonproductive, and idle capacity costs for a machine-paced cost pool.

Define and know how to use activity drivers and identify key differences between machine- and people-
3 paced cost pools.

Characterize a cost object and assign costs to individual units of output.

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 Define the key characteristics of a cost pool, and
Learning
Objective 1 combine direct and indirect resources into cost pools
using resource drivers.

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 LO 1
Traditional Costing System

Under a traditional costing system, a single cost driver is typically used to

allocate costs to products.

Overhead Costs

One-Stage
Activity Driver
(Direct Labor,
Machine
Hours, etc.)
Products
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 LO 1
Activity-Based Costing System

Overhead Costs
Cost
Machining
Pools Assembly Shipping Purchasing

# of
Activity Machine Direct Square
Purchase
Cycle Labor Footage
Drivers Orders

Products
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Understanding Costs Pools
Cost pool: a combination of
resources that support a
common goal.
LO 1
Easy Air: Cost Pools
• A lot of money spent on indirect
costs.
• When capacity is not used
productively, Easy Air loses
money.
• Activity-based costing is
considered one solution to better
understanding costs.
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 LO 1

Tables & Figures

Six core
features of
creating an
accurate
cost pool

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 LO 1
Costs that Get Allocated

Overhead: the sum of indirect

product costs that are not
assigned to a specific capacity-
or activity-based cost pool.
Examples:
 Lubricants
 Machine maintenance
 Factory cleaning activities

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 LO 1
Basis Used to Allocate Costs

Process: a linked sequence of activities that

transforms some forms of input into outputs.

Resource Driver: a measure used to assign

a resource to a cost pool.

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 Tables & Figures
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LO 1
 LO 1
Hierarchy of Activity Levels

Four Levels Types of Activities Examples of Cost Drivers

Unit-level Fastening, assembling, painting, Direct labor
polishing, clear coating. Machine cycle time

Batch-level Calibrating equipment, conducting Set-up time

safety inspections. Number of inspections

Product-level Engineering plans and designs. Number of new product plans

Number of alterations

Factory-level Taxes, depreciation, utilities, Square footage

plant maintenance Number of factory employees

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 LO 1
Common Types of Activity Measures

Transaction
Driver

Duration
Driver

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 LO 1
Order-to-Payment Process

The primary process, or linked set

of activities, that begins with the
receipt of a customer’s order and
ends with the customer’s payment
for the goods or services received.

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 LO 1

Tables & Figures

Resources

Drivers 14
 Tables & Figures
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LO 1
 LO 1
Homogenous vs. Heterogeneous Cost Pools

Grouping resources around a common purpose vs.

mixing costs that do not support the same type of work.

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 LO 1
Heterogeneous Cost Pool

A cost pool that contains a mix of resources

that are the result of many different causes.

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 Tables & Figures
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LO 1
 LO 1
Causality

The reason for a specific outcome or activity; the thing that drives
the cost.

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 LO 1
Check Your Progress

What is a cost pool?

Give one example.

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 Explain capacity and calculate: 1) managed and
Learning
Objective 2 committed capacity costs and 2) productive,
nonproductive, and idle capacity costs

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 LO 2
Capacity and Cost Pools

Scientific Management:
 “One Best Way”
 Taylor: father of the stopwatch
“The Principles of Scientific Management” published in 1910.

Capacity refers to the value-creating ability of an organization and its

resources.

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 LO 2
Managed and Committed Costs

Avoidability Criterion: a Capacity Costs

measure of cost in
relation to work;
specifically concerned
with whether costs go Managed
away when no work is Committed
being done.

Idle Machine? Costs Avoidable Costs Unavoidable

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Managed LO 2

Tables & Figures

Committed

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 LO 2

Tables & Figures

Idle capacity: A period during
which a company plans to not
use a machine, which is
unstaffed; therefore, only
committed capacity costs are
wasted.

Productive capacity: the

amount of a cost pool’s time—
the actual use of a cost pool
—that results in the
completed product for the
customer..

Nonproductive capacity: time

wasted when a machine is
fully manned but no output is
generated.

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 Tables & Figures
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LO 2
 LO 2
Nonproductive Activities

Adds cost to, or increases the time spent on, a product/service without
increasing its perceived value, such as:

Manufacturing Sector Service Sector

• Storage of inventory • Taking appointments
• Moving of inventory • Reception
• Inspections • Bookkeeping and billing
• Fixing defective goods • Traveling
• Set up machines • Ordering supplies
• Advertising
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 LO 2
Cycle Time

The amount of time that elapses

between units coming off of the
end of a production line or
process.

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 LO 2

Tables & Figures

Idle

Value-add
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 Tables & Figures
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LO 2
 Tables & Figures
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LO 2
 LO 2
Direct Costs and Overhead at Easy Air

We’re onto something here!! Easy Air: Direct Costs

• Can’t charge every cost to a
plane- need to refine industry
definition of capacity
• Need to determine capacity by
seat minutes – which seats are
producing revenue?
• Need to generate a new form of
capacity measurement

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 LO 3
Check Your Progress

The period of time in

which a machine is a) Idle time
fully manned, but no b) Nonproductive capacity
output is created is c) Productive capacity
called:
d) Activity driver

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 Define and know how to use activity drivers and identify
Learning
Objective 3 key differences between machine- and people-paced cost
pools.

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 LO 3
Activity-Based Costing

Activity driver: the event that

causes us to use the cost
pool’s resources, as well as
the total estimated amount of
work the pool’s capacity can
support.

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 LO 3
ABC Costing Key Terms

Budget: Cost Tracing:

the financial plan for one or
several years; used to establish
capacity- and activity-cost
estimates.
attaching a cost to the specific
activity, product, or service that
uses it.

ABC
Cost Assignment:
use of estimates to attach costs
to specific activities that directly
benefit from their consumption.
Cost Allocation:
the arbitrary assignment of costs
to an activity, product, customer,
or unit of output.

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 LO 3
ABC Steps

1. Trace
2. Identify
Trace and/or
assign 3. Estimate
Identify the
resources. activity 4. Divide
Estimate the
driver for quantity of Divide the 5. Attach
each pool. work. costs in cost Attach these
pool. activity costs
to output
using cost
drivers.

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 LO 3
Treatment of Direct Costs under ABC

Direct
Direct Direct
Direct Overhead
Overhead Costs
Materials Labor

Traced
Traced Traced
Traced

Cost
Cost Object:
Object:
Products,
Products, Invoices,
Invoices, Payments,
Payments, etc.
etc. 38
 LO 3
First Stage ABC Allocations

Direct
Direct Direct
Direct Overhead
Overhead Costs
Materials Labor

First Stage

Schedule Set Up Customer Move

Take
Take Orders
Orders
Orders Machines
Machines Relations
Relations Materials

Cost
Cost Object:
Object:
Products,
Products, Invoices,
Invoices, Payments,
Payments, etc.
etc. 39
 LO 3
Second Stage ABC Allocations

Direct Direct
Direct Overhead
Overhead Costs
Costs
Materials Labor

First Stage

Schedule Set Up Customer Move

Take
Take Orders
Orders
Orders Machines
Machines Relations
Relations Materials

Second Stage

$/Order $/Run $/MH $/Customer $/Shipment

$/Shipment

Cost Object:
Products,
Products, Invoices,
Invoices, Payments,
Payments, etc.
etc. 40
 LO 3

Tables & Figures

Cost Pools

Cost
Assignment

Activity Driver

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 In the News

Issue: U.S. healthcare costs increasing, now exceeding

more than $10,000 per person.

Solution: ABC used at Pittsburgh Medical Center to control

costs accompanied by structural change and shift in
management philosophy.

Outcome:
Cost reduction opportunities identified
Supply savings
Contribution margins calculated by procedure
Faster processing times
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 LO 3
Cost Pools

People vs. Machine

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 LO 3

Tables & Figures

• Drivers are
quantifiable
measures
• Average cost
estimates
• ABC pools
consist of
traced and
assigned costs
• Significant
differences
between
people vs.
machine cost
pools

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ABC Strengths and Limitations
Strengths
 More cost pools; therefore,
more accurate product costing.
 Enhanced control over
overhead costs.
 Better management decisions.
LO 3
Limitations
 Costly to set up
 Does not conform to U.S. GAAP.
 If activity driver estimates are
inaccurate, can adversely impact
the true product costs.
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 LO 4
Elements of Strong ABC Implementations

Key Features

• Top management support

• Cross-functional
involvement
• Data-driven
• Link evaluations to rewards

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 LO 3
Check Your Progress

What is a distinctive
feature of labor cost a) Must be estimated
pools? b) Activity driver usually time-based
c) Entails the assignment of costs
d) Estimates must be prepared for the
quantity of work.

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 Characterize a cost object and assign costs to individual
Learning
Objective 4 units of output.

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 LO 4
From Cost Pools to Cost Objects

Cost driver: a measure used to

attach a cost to its final use
(activity drivers can often serve
this purpose).
Cost object: the activity or
outcome that is the focus of the
costing effort, the company’s work
product

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 LO 4

Tables & Figures

Total costs
=
Materials (Table 4.2)
+
Soap Press (Table 4.5)
+
Other Activities (Table 4.7)

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 LO 4
Job-Order Costing (JOC)

Job: a discrete custom order from

a specific customer.

Job-Order Costing: traces actual

materials, labor, and activity costs
to a specific order.

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 LO 4
Pricing the Order

Cost-Plus Pricing Example:

Market
Cost-Plus
Rates
Cost of order $944.30
Plus: 25% profit $236.07
Sales Price $1,180.37
Profit-
Customer-
Maximizin
Based
g

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 LO 4
Cost Objects

Basic Rule
Unless a specific cost object is defined, the costing activity has little or
no value. “Different costs for different purposes”

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 LO 4
In Context

Assigning People Costs Easy Air: Assigning People Costs

• Pulled data from multiple databases.

• Quick survey to get more precise
activity-based cost estimates.
• Activity-based management effectively
leverages resources.
• Goal is to focus staff time on
productive work.

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 LO 4
Check Your Progress

Which costing
approach traces a) Activity-based costing
materials, labor, and b) Target costing
overhead to a specific c) Process costing
order?
d) Job-order costing

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Learning
Objective End of Chapter

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