Allocation definition
/What is an Allocation in Accounting?
An allocation is the process of shifting overhead costs to cost objects, using a rational basis of allotment. Allocations are most commonly used to assign costs to produced goods, which then appear in the financial statements of a business in either the cost of goods sold or the inventory asset. If financial statements are not to be distributed outside of an entity, then there is less need to use allocations.
Advantages of Allocations
There are several advantages associated with the use of allocations in accounting, which are as follows:
Complies with standards. A proper allocation methodology brings a business into compliance with the applicable accounting framework. By doing so, the firm’s financial statements can now be audited, and the external auditor can give them a favorable opinion. This opinion is needed when an organization needs audited financial statements to obtain funding from investors.
Better cost information. If allocations are based on an activity-based costing system, the assigned costs can give management a better view of where overhead costs are being incurred within the organization, and may show how to alter activity levels in order to reduce overhead.
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Disadvantages of Allocations
If used improperly, cost allocations can cause incorrect management decisions. For example, assigning overhead costs to a product can make it appear to have an excessively low profit, which could lead to a decision to terminate a product that is still generating a reasonable contribution margin. Another concern is that the basis of an allocation can change, resulting in a change in the amount of the allocation. For example, when $5 of overhead is allocated based on an hour of machine time, and then the machine time is changed to two hours, then the allocated overhead doubles to $10. These changes in applied overhead can lead to incorrect management decisions.