Cost Allocation: Definition, and Example on How the Cost Allocation Works

To run a profitable business, you have to make sure that your prices are high enough to cover all your expenses and give you profits at the same time. Most business and company owners use cost allocation to allocate the costs of specific items.

That includes products, departments, materials, overhead costs, etc. Cost allocation is significant for businesses of any kind. However, it is mostly used by manufacturing businesses that carry a variety of costs. 

The cost allocation process becomes important when some costs can not be attributed to a particular cost object. These expenses are spent on different items in simple words, and then the sum is divided into multiple cost objects. These expenses are basically indirect costs. In this article, we are going to discuss cost allocation, its different aspects, and how does it actually work:

Definition of Cost Allocation:

Cost allocation is the process that plays a major role in identifying, assigning, and aggregating the expenses to cost objects. A cost object is anything that requires you to measure the costs separately. Here are some examples of cost objects: products, services, departments, activities, customers, etc. 

Cost Allocation is mostly used for reporting the financial details of a business or company. It helps to distribute the costs between departments and inventory items. Cost allocation can also be used for calculating the profits at a departmental or subsidiary level. And that can be used as a basis of bonuses or for the fundings for extra activities. 

Types of Costs:

Most running businesses carry a variety of costs while doing projects and deals. And the list of costs can be very long, from the material needed to make an item to the direct labor payroll cost for the employees who ran the machines and assembled the product. 

There are three main types of costs that a business or company must define before allocating the costs to their specified cost objects: 

1. Direct Costs:

Direct costs are anything that can be directly connected to cost objects. Tied to direct production, direct costs are the only expenses that do not require any allocation. Instead, they are used while calculating the costs of sold products and services.

Related article  What Does ‘Management by Exception’ Mean? How Does It Work?

Here are some of the most common direct costs of a business or company: Direct Labor, Direct Materials, and Production Supplies.

Direct Labor Costs: It includes the costs for employees who are responsible for manufacturing and assembling the product. Direct labor costs are basically payrolls.

Direct Materials Costs: It includes the costs of materials that were used for making the products, such as wood, cement, and bricks for construction companies. 

Production Supplies Costs: It includes any delivery cost. 

2. Indirect Costs:

Indirect costs are the expenses that are not directly related to cost objects such as production, department, activities, etc. These are the expenses that are necessary for running a healthy business or company.

Some of the common examples of indirect costs are security, electricity, administration, etc. Indirect costs should be identified first and then should be executed. And lastly, they should be allocated to other cost objects within the business. 

Indirect costs are divided into two parts: Fixed Costs and Variable Costs

Fixed Costs: Fixed costs are costs that are allocated to a specific product or department. An example would be a supervisor who is assigned to a specific department or project.

Variable Costs: The other category of indirect costs is variable costs. Common examples for variable costs would be goods sold, raw materials and inputs to production, packaging, wages, commissions, and certain utilities like electricity, gas, etc.

3. Overhead Costs: 

Overhead costs are the expenses that are used daily to run a business or company. Overhead costs are never directly or indirectly linked to production. But instead, these are the costs that a business carries, no matter if it is selling products or services or not.

Rent, insurance, office supplies, maintenance, etc., can be considered as overhead costs. These are some of the costs that a business or company carries regardless of its production quantity.

Overhead costs such as supplies can be variable. But on the other hand, costs such as insurance, payrolls, rents are some of the fixed costs that don’t change every month.

Similar to indirect costs, overhead costs must be allocated regularly to justify the production cost.

Importance of Cost Allocation:

Here are some of the benefits of Cost Allocation:

  • Cost allocation is important for financial reporting. It helps in assigning the cost of cost objects accurately
  • Cost allocation helps businesses and companies to calculate the real profitability of particular or different departments. This profitability report helps businesses to make decisions in favor of the development of the department
  • If the cost allocation is executed accurately, it will help the business to identify and understand the costs at each stage and their impact on the profit and loss. Similarly, if somehow the allocation is turned out to be incorrect, the business might make incorrect decisions regarding the allocation of the valuable resources among the various cost objects
  • It also works in favor of customers to get a better understanding of the product or service rates
  • It helps businesses and companies to make better decisions whether they should accept a new order or not
  • Cost allocation can also be used to increase the performance of your employees
  • It is also useful for finding the transfer price when there is a transaction between two or more subsidiaries
  • Cost allocation also helps businesses and companies to determine where their money is going and in what quantity. It helps businesses to use their resources responsibly. If the money is not distributed accurately, it can affect the business’s production as well as performance
Related article  What is the Ordering Cost? Definition, Formula, Example, and How Does It Work?

How does Cost Allocation work?

Now let’s see how does cost allocation actually work:

Identify the Costs:

As we discussed earlier, there are three types of cost: Direct Cost, Indirect Costs, and Overhead costs. Direct costs are directly related to the production process, such as labor costs, material costs, etc.

Indirect costs are the costs that are partially related to the production costs and are necessary to run a business. And lastly, overhead costs are the costs used regardless of the production of a business, such as rents, insurance, office supplies, etc. 

Identify the Cost Objects:

It is necessary to identify the cost objects before executing cost allocation. This is really important because we can not set a price for a product if we don’t have any information about it. Here are some examples of cost objects: products, services, departments, activities, customers, etc. 

Identify the Allocation Base:

Alongside the cost object, a company must identify a basis to allocate the costs. The basis could be the headcount, insurance, rent, number of hours, etc. 

Collect the Costs into a Cost Pool:

Once you have identified the costs, cost objects, and the allocation basis, not it’s time to categorize them into cost pools. This is the account head where the costs should be accumulated before being distributed to the cost objects. 

Example of Cost Allocation:

Here is an example of Cost Allocation:

Let’s assume A owns a manufacturing business and has an administrative office. The main office is 3,000 square feet, and the administrative office is 1,500 square feet.

The rent for the entire office is $10,000 each month. The rent must be allocated based on these two departments. 

Related article  Absorption Costing: Definition, Formula, Calculation, and Example

Let’s start the calculation:

The total area would be: 

3,000 square feet + 1,500 square feet = 4,500 square feet

So the rent per square feet would be around: 

$10,000 ÷ 4,500 = $2.2

Now we have to calculate the main office rent:

$2.2 x 3000 = $6,600

Now we have to calculate the administrative office rent:

$2.2 x 1,500 = $3,300

So now the total cost that should be allocated for the rental cost would be: 

$6,600 + $3,300 = $9,900

Why should you consider using Cost Allocation?

Cost allocation is important for businesses of any size. If you have zero ideas of how much it costs to produce a product or service, how will you set a price for your products or services?

A proper cost allocation is very important for accurate financial reporting. Most business owners depend on financial reports to make decisions. If the reports are incorrect, it might affect the business negatively. So proper cost allocation is very important to run a healthy business. 

So, in this article, we discussed cost allocation and how it actually works. Cost allocation is an important process that keeps businesses in profit by allocating the costs to cost objects.

It also helps businesses find profitable gaps and areas where businesses can make a significant profit. It also helps owners make good decisions regarding the costs.