What is the Cost Allocation? (Definition, Example, and How the Cost Allocation Works)

Cost allocation

Cost allocation is the process that includes identification, aggregation, and assigning all of the costs incurred during the period to the specific object. The cost object can be anything for which the business wants to know the cost incurred. It may be some project, product, activity, department, region, location, or any other object.

The business needs to allocate the cost to different cost objects to measure and analyze the cost. An appropriate allocation of the cost to the cost objects enables a business to identify if a particular cost object (product/project) is making losses or profits for the company. Let’s discuss different types of costs from perspective to allocation.

Direct cost allocation

Direct cost can be allocated to the specific cost object under consideration. It does not need to be allocated as the entire cost is related to the same cost object.

For instance, the wages paid to direct workers on the plant producing product-A can be entirely allocated to product-A. Hence, there is no need to allocate the cost.

The concept of allocation arises when the cost objects share cost drivers. In other words, the cost same cost is shared by different cost objects.

Indirect cost

Indirect cost is incurred to facilitate production but can not be traced directly with the cost object.

Consider a machine that is used for manufacturing multiple products, this machine requires periodic repairs, maintenance, cleaning, and other related expenses.

It is clear that the machine is used for manufacturing different products. Hence, the cost is allocated among different products by identifying the number of units produced for each product.

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Overheads

Overheads are the supportive cost for production. These costs can not be directly allocated to the units manufactured.

For instance, the canteen department of the company serves employees of different departments like sales, production, accounting, and operations.

The cost of the canteen department needs to be allocated to these departments as the company’s canteen does not earn revenue as it’s just a cost center.

So, the cost of the canteen department can be allocated based on the number of employees in each of the departments.

Steps of cost allocation

Following are the steps of cost allocation for the cost object. The complexity of the allocation process increases with an increase in the cost drivers and basis of allocation.

1- Cost identification

Cost identification is the process of identifying all the costs associated with the cost driver. It’s a manual exercise requiring managers to observe the manufacturing process closely. So, all the costs associated with the cost object can be identified.

2- Identify the basis of allocation

An appropriate allocation basis helps allocate the overheads between different cost objects fairly. For instance, machine overhead costs can be allocated based on machine hours.

Similarly, the overhead cost for production in a labor-intensive environment can be allocated based on the number of hours.

3- Cost allocation

This is the stage of allocating the identified cost based on the identified allocation base. If the portion of allocation is higher for a specific cost object, the amount of the cost allocated will be higher and vice versa.

Examples of cost allocation

  1. The periodic depreciation expense of the production facility is allocated to the different products produced in the period under consideration.
  2. The cost of electricity is allocated among different departments of the company. The allocation basis may be square fit occupancy of the departments or some other appropriate basis depending on the usage of the electricity.
  3. The salary of the CFO can be allocated among different functions/departments of the business.
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Advantages

1- Transparency

The basic purpose of cost allocation is to bring transparency between different cost objects of the company. It helps to understand which cost object consumes more benefit brought by the cost driver and allocates the cost.

Hence, allocating the cost based on usage brings transparency. This helps to improve overall reporting as well.

2- Decision making

The cost allocation helps to identify the total cost of the cost object like department, project, product, etc. It helps to identify which cost object consumes more proportion of the funds.

Hence, knowing what product or department is taking a greater proportion of funds is important for weighing alternatives and making a decision on which cost object should be given priority.

Although, related revenue brought by the cost object needs to be considered before making any final decision for the extension/closure of the cost object.

3- Waste Reduction

The cost allocation enables us to identify the potential wastage of organizational resources. For instance, if the allocated cost of the stationary is higher for the accounting department than other departments, the business needs to analyze If the accounting department is using stationary for business purposes or if there is any wastage.

4- Enhanced reporting

The allocation process helps to get the valuation for the different finished goods items and work in the process.

These items are reported in the financial statement. Hence, managers might not be able to report valuation for the inventory without using cost allocation.

Limitations

Process complications

The process of cost allocation can be difficult in the real world. There may be a gretar number of cost drivers and cost pools that need to be allocated.

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Further, the allocation process requires the selection of the basis for allocation. This can be really complex and judgmental.

Traditional vs. ABC system of cost allocation

The main difference between ABC costing and the traditional system of allocation is the basis for the allocation.

ABC allocation system considers the different bases of allocation for the different cost drivers. On the contrary, the traditional system of allocation uses a single basis which may not be accurate.

ABC system is considered to be more fair and transparent considering the fair bases for the allocation of the cost.

On the contrary, the traditional cost allocation system is considered to be an arbitrated method of cost allocation.