Pooling of Costs – Basic Understanding
Pooling of costs is an accounting trick used to facilitate better matching of costs against the respective revenue stream or predicted cost for the respective product or function. In layman’s terms, it means that costs are grouped together for one value and then divided by an objective (sometimes subjective) value to help management understand what it costs to get something done.
Pooling of costs is also known as aggregating costs. This aggregating concept is well-developed in cost accounting and used with manufacturing analysis. For example, many consumer products go through two basic steps, production and packaging. Pooling of costs is done with both steps. Labor is separated for the two steps and included in both aggregated groups. Other costs include materials, supplies, facility utilization, equipment usage and so forth. The goal is to understand how much it cost per unit in each step.
For small business, the pooling of costs is beneficial with understanding functional areas of operations. For example, some companies have many vehicles they use to service their clients/customers. Owners/Management want to know how much it costs to run the vehicles on a per mile basis. To successfully find out, any expense related to a vehicle is assigned to a particular ledger account and at the end of an accounting cycle (usually yearly) the total value is divided by the total number of miles driven on those vehicles and the result is cost per mile.
Common groupings or pooling of costs exist for:
- Labor Burden
- Administrative Functions (Human Resources, Accounting, Technology)
- Capitalization (Interest, Debt Burden, Reserves, Principal Payments)
There are many others, but in general the idea is to gather all the costs related to that respective function and then use the aggregated value as the numerator against some pertinent criterion. The following is an illustration:
Brown’s Pool and Spas is a small business company that retails pool and spa supplies as well as selling the actual spas. In addition, Brown’s installs pools and does backyard modifications. The owner wants to know what it costs in the form of marketing and advertising including the associated costs of discounts/coupons and other campaigns to generate a dollar of revenue. To do this, the accountant combines the following expenses and revenue adjustments into a single pool to obtain a single aggregated value for an entire year:
In the revenue adjustments section the accountant uses the following:
- Campaign Coupons
In a separate marketing account in the expenses section, the accountant accumulates costs such as:
- Website Costs
- Newspaper and Magazine Advertising
- Direct Mailers
- Door Hangers/Hand Delivered Fliers
- Display Booths/Trinkets
- Information packages
- Product Guides
- Printing and Design
- Business Cards
- Labor Time Assigned From Payroll
- Labor Burden Tied to Labor Time
All of the above costs are accumulated into one value. This value is the numerator and the denominator are total sales. The result is the cost of marketing/advertising per dollar of sales.
There are several drawbacks to the pooling of costs concept. The number one drawback is misapplication of the concept. I’ve seen this multiple times whereby management makes a decision to charge a customer based on a poor formula. In effect, the owner failed to include all the costs related to the particular item and thus used a lower value of cost to charge his customer. This ended up costing the company money.
A second drawback and the most common is its use with break-even analysis and the relation to the business financial profit. Here, the user creates the pool of costs and applies this value as either the cost of the product sold or as a sub-component of the item sold. Therefore the price to the buyer is based on this cost analysis. The fallacy is that the pricing model assumes all the products are sold. All pricing models need to take into consideration more than just the actual cost per unit sold. The final price should take into consideration other factors: 1) economy of scale, 2) unsold product, 3) waste, 4) overhead and 5) profit desired. The final formula is much more complicated than the simple cost of the product and some mark-up value.
In conclusion, pooling of costs is an excellent management tool to assist owners/managers in understanding functional or production costs against a known value. It is used with both financial and cost accounting. With proper application, it can be quite beneficial with understanding and improving the bottom line. ACT ON KNOWLEDGE.
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