Cost allocation methods
/What is Cost Allocation?
Cost allocation is the process of assigning indirect or shared costs to different departments, products, services, or cost centers within an organization. Since some expenses—such as utilities, rent, or administrative salaries—benefit multiple areas of a business, cost allocation ensures these costs are fairly distributed based on a logical basis, such as usage, square footage, or labor hours. This helps in accurately measuring the true cost and profitability of each segment of the business, supporting better decision-making, budgeting, and performance evaluation. Proper cost allocation also ensures compliance with accounting standards and may be required for external reporting or cost reimbursement in regulated industries.
How to Allocate Costs
Various cost allocation methods are used to allocate factory overhead costs to units of production. Allocations are performed in order to create financial statements that are in compliance with the applicable accounting framework. The most common allocation methods are noted below, along with commentary about their advantages and disadvantages:
Allocate based on direct labor. Overhead is applied based on the amount of direct labor consumed by a unit of production. This is an easy calculation, for there is usually an industrial engineering standard already in place that documents the amount of direct labor associated with a product. However, the amount of direct labor consumed may be far smaller than the amount of factory overhead, which can result in large allocations based on small amounts of direct labor cost. This can cause large swings in cost allocations if direct labor totals change by only a small amount.
Allocate based on machine time used. Another favorite is cost allocations based on the amount of machine time used by a product. As was the case for direct labor, the reason for this popularity is that the standard amount of machine time used is already available in the form of industrial engineering documentation.
Allocate based on square footage. It may be useful to separate out those overhead costs related to inventory storage, and allocate these costs based on the number of square feet of storage space used by each product. While this is a more accurate way to associate certain overhead costs with products, it can be difficult to track, especially when inventory levels are constantly changing. Another concern is that square footage is only two dimensional. A more accurate approach would be to allocate costs based on cubic feet of storage space consumed.
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Allocation of Corporate Costs
It is possible that corporate headquarters costs are to be allocated to the subsidiaries of a multi-division company. If so, a number of possible allocation methods have been used, which may be based on sales, profits, or headcount. These allocation options are as follows:
Allocate based on sales. Costs are apportioned based on the net sales reported by each entity. Since high sales volume does not necessarily equate to high profits, this approach can result in a low-profit entity being burdened with a substantial corporate allocation.
Allocate based on profits. Costs are allocated based on the profits generated by each subsidiary. A problem is that high-profit entities will be charged with the bulk of all corporate expenses, so their inherent profitability will not be overly apparent when their results are viewed on a fully-burdened basis.
Allocate based on headcount. This is the most specious basis of allocation, for some entities can generate sales and profits with few staff, while others require massive numbers of employees. Also, a large number of low-paid employees might attract a large cost allocation, while another subsidiary with a much smaller number of higher-paid employees would attract a comparatively smaller charge.
When deciding upon which cost allocation method to use, keep in mind that none of these methods will achieve a close relationship between the allocated costs and the cost objects to which they have been applied. Consequently, it is best to use the simplest method available, and not worry about a high level of allocation precision.
Benefits of Cost Allocation
There are multiple benefits associated with cost allocations, which are noted below:
Improved cost visibility. Cost allocation provides a clearer understanding of where and how resources are being spent across departments, products, or projects. By assigning indirect costs to specific areas, organizations can see the true cost of operations. This visibility helps leaders make informed financial and strategic decisions.
Enhanced decision-making. With accurate cost data, managers can evaluate the profitability and efficiency of different business units. This enables them to allocate budgets more effectively and identify underperforming areas. As a result, organizations can make smarter, data-driven decisions to boost overall performance.
Fair budget distribution. Cost allocation ensures that shared resources and expenses are distributed fairly across departments based on usage or benefit received. This prevents one area from unfairly bearing more costs than it should. It also promotes accountability, as each department becomes responsible for its share of indirect expenses.
Performance measurement. By allocating costs accurately, organizations can better assess the financial performance of each unit or function. This makes it easier to track efficiency, identify cost overruns, and evaluate return on investment. Managers can then take corrective action where needed to improve operations.
Regulatory support. Many industries require transparent reporting of how costs are assigned, especially when dealing with government contracts or regulated pricing. Cost allocation supports compliance by providing clear documentation of expense distribution. This reduces the risk of regulatory issues or audit challenges.