What are the advantages and challenges of using departments as cost pools?

Using departments as cost pools and sometimes as proxies for cost objects

During cost accumulation, accountants give transactions codes telling the period in which they were incurred and indicating both their nature (origin, where resources come from, or type of contractual arrangement) and their purpose (destination, where resources go). When the purpose of the cost is a well-identified cost object, the cost is direct; when the purpose of the cost is not unambiguously one well-identified cost object, the cost is indirect.

Indirect costs are not traced to cost objects, but they usually are assigned to the departments initiating the transaction or consuming the resource. Which department consumed the resource is a strong indication about the purpose of the resource consumption. Organizations typically have two types of departments: operating (or production) departments, which directly produce or distribute the firm’s products or services and support (or service) departments, whose main output is to provide services to other departments.

Operating (or production) departments are departments adding a value observable by a customer to a product or service.

Support (or service) departments are departments that provide internal services that maintain other internal departments (Both operating and support departments).

When an operating department is dedicated to the production of one specific cost object, its costs can be considered direct and thus they are traced. However, the costs of support departments are always indirect and must be allocated. When departments are the main basis for cost classification, each support department serves as a cost pool for its own costs.

Solution. Costs incurred for each operating department are direct manufacturing costs of either bread or pastries. However, resources used by either HR or maintenance are indirect. With the information provided, we can accumulate costs by filling in the first part of the assignment table:

Assignment HR Maintenance Bread Pastries
Materials 1000 20000 15000
Labor 15000 10000 1000 9000
Rent 5000 7000
Depreciation 5000 1000 8000 1000
Total before allocation 25000 19000 29000 25000
Allocation HR
Allocation maintenance
Total after allocation

For HR costs, the measure of activity which is the most likely cost driver is the number of employees. As for maintenance costs, machine hour could work but we have a record of maintenance time which is likely to be a better allocation base because it has a more direct causal relationship with maintenance costs (if we had the data, we would have to check correlations though). This leads to the following allocation rates:

Cost Amount Quantity Rate Base
HR 25000 10 2500.00 euros per employee
Maintenance 19000 150 126.67 euros per maintenance hour

Using the consumption of each allocation base (employees and maintenance time) by each cost object and the corresponding allocation rates, we can now allocate indirect manufacturing costs by filling in the first part of the assignment table:

Assignment HR Maintenance Bread Pastries
Materials 1000 20000 15000
Labor 15000 10000 1000 9000
Rent 5000 7000
Depreciation 5000 1000 8000 1000
Total before allocation 25000 19000 29000 25000
Allocation HR -25000 2500 22500
Allocation maintenance -19000 15200 3800
Total after allocation 0 0 46700 51300

Issues related to using departments as cost pools

Departments are convenient cost pools because it is easy for accountants to identify which department consumed which resource since companies are usually organized by department. However, departments often suffer from a fatal flaw from a costing perspective: they typically perform several activities having different cost drivers. Therefore, departments are rarely homogeneous cost pools and using them as such introduces more or less distortions in costing.

For instance, HR typically conduct many different and, more importantly, uncorrelated activities. They contribute to hiring personnel, administer wages, and address legal consequences of employee termination. Each one of these activities is triggered by a different event: hiring costs increase with the number of vacancies, wage administration costs increase with the number of employees, and termination costs increase with the number of terminations.

Moreover, these three cost drivers are not necessarily correlated with each other: a growing company will start with many vacancies, few employees and few terminations. Then the number of vacancies will progressively diminish as positions are filled in and the number of employees will increase. Finally, terminations may lead to more vacancies or just less personnel. Add the impact in voluntary turnover1 and the three measures of HR activity become completely uncorrelated with, and thus cannot serve as proxies for, each other.

HR activities (hiring, administering and terminating) have thus different cost drivers which are independent from each other. Therefore, HR departments, and most other departments for the same reason, cannot be considered as homogeneous cost pools, unless one their activities clearly dominates the others (in which case they would be mostly, but not perfectly, homogeneous). This reasoning suggests however that activities might serve as homogeneous cost pools and led to the development of Activity-Based Costing (Kaplan & Johnson, 1987).

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Kaplan, R. S., & Johnson, H. T. (1987). Relevance Lost: The Rise and Fall of Management Accounting. Boston: Harvard Business School Press.

  1. Voluntary turnover refers to employees leaving the firm on their own accord, in contrast with involuntary turnover which refers to an employee’s contract being terminated by the employer.↩︎