Cost Allocation

The process of identifying a company's costs and assigning those costs to cost objects

Cost allocation is the process of identifying a company's costs and assigning those costs to cost objects. Cost objects are the products, services, and activities of different departments of a company. 

This process of allocating costs helps a business determine which parts of the company are responsible for what costs. 

Sometimes it is difficult to draw the connection between allocated costs and their cost objects. When this happens, companies can use spreading costs. 

Spreading costs occur when businesses spread the responsibility for production expenses across various areas. 

When businesses can accurately allocate their costs, they are able to easily assess what particular cost objects are creating profits and losses for the company. On the other hand, if businesses are unable to allocate their costs correctly, their profit and loss calculations will be off. 

Also, businesses must charge a price for their goods and services that covers their expenses and allows them to make a profit.  

Intuitively, one can recognize the importance of cost allocation for the optimal performance of a company. Incorrect cost allocation calculations are extremely detrimental to any business and disrupt the ability to operate properly.

Cost allocation is necessary for any business, but as companies get larger and more complex, it becomes even more important to allocate costs accurately. 

Types of Cost 

Companies have various types of costs, and it is important to be able to distinguish between the different types when allocating them. 

We can break them down into a few different categories.

1. Direct costs: direct costs are those that can be traced to a certain product or service offered by a company. Included in direct costs are materials and labor that go into the production of a good. 

2. Indirect costs: these expenses are those that go into the production of a good but do not have a connection to a specific cost object. Examples of indirect costs include rent, utilities, and office supplies.

3. Fixed costs: these costs remain constant, regardless of a company's production volume. (e.g., rent)

4. Variable costs: these costs increase or decrease as a company's volume of production changes (e.g., supplies). 

5. Overhead costs: overhead costs reflect a company's everyday expenses of doing business. A company incurs overhead costs even when they are not producing goods or services. These costs are also known as operating costs and can be fixed or variable. 

A few examples of fixed overhead costs include rent, insurance, and workers' salaries. Variable overhead costs include supplies and energy expenses, which both change as the volume of production increases or decreases. 

How to Allocate Costs 

Now that we understand the different types of costs, we can better understand the processes involved in cost allocation. Regardless of what good or service a company produces, the process remains consistent across industries. 

1. Identify cost objects: anything within a business that creates an expense is considered a cost object. The first step for allocating costs is to note all the cost objects of your company. 

2. Pool associated costs together: after you have gathered all of your business costs, you need to pool the costs according to what cost object they are associated with. This process creates cost pools, which generally group costs based on purpose. 

Some examples of costs pools:

  • Electricity usage

  • Water usage

  • Insurance

  • Fuel consumption

3. Select a method to allocate your costs: now that you have identified your cost objects and established cost pools, you must choose how you will allocate your costs. Companies choose different methods depending on several factors like staffing and documentation capabilities. 

Here are a few of the most common methods for allocating costs:

  • Fixed cost allocation: this method assigns particular direct costs with cost objects. Drawing direct connections between costs and cost objects makes this method one of the most simple.

  • Proportional allocation: proportional allocation deals with the distribution of indirect costs across associated cost objects. Sometimes proportional allocation divides costs equally across cost objects, while other times, it considers other factors (i.e., size) and divides costs accordingly. 

  • Activity-based allocation: this method is commonly considered the more accurate method of allocating costs. Activity-based allocation utilizes precise documentation to determine costs within departments and allocates the costs appropriately. 

Why Do We Need to Allocate Costs?

A company must allocate its costs in order to optimize its business activities.

  • Recognizing profits and losses: 

  • Understanding the distribution of expenses helps companies analyze which areas of their business may be profitable or which areas may be causing a loss. This allows companies to determine whether or not certain expenses can be justified or not. 

  • Companies do not know how much to charge the customer's goods and services without cost allocation. Once non-profitable cost objects are identified, companies can cut expenses in those departments and focus their efforts on profitable cost objects. 

  • Management decisions:

  • Cost allocation is also important for a company to manage its staff. In areas where the company is not profitable, it can evaluate the staff performance of that department. Often, the losses incurred by part of a company are due to the underperformance of employees. 

  • Similarly, companies can analyze the allocation of their costs to determine where they are profitable and award the employees of that department. 

  • Using cost allocation to motivate employees offers the administration of a company an objective, quantitative justification of their management decisions. 

  • Transfer pricing:

  • Also, cost allocation is vital for deriving transfer pricing, the exchange price of goods or services between two companies. 

Examples of Cost Allocation & Calculations

Now we understand cost allocation, the different types, and why we need it. Here are several examples of different ways a company might allocate its costs. 

Example 1: Square Footage

Christina's business has an office and a manufacturing space. The square footage of the office is 1,000 square feet, and the manufacturing space is 1,500 square feet. The rent for the two spaces is $10,000 per month. The company will allocate the rent expense between the two spaces. 

                                 $10,000 (rent) / 2,500 square feet = $4 per square foot

  • Calculate the rental cost for the office:

    • $4 x 1,000 = $4,000

    • This means that Christina will allocate $4,000 of the rent to the office.

  • Calculate the rental cost for the manufacturing space:

    • $4 x 1,500 = $6,000

    • This means that Christina will allocate $6,000 of the rent to the manufacturing space.

Example 2: Units Produced

  • Alex's manufacturing company makes water bottles. In January, Alex produced 5,000 water bottles with direct material costs of $2.50 per water bottle and $3.00 in direct labor costs per water bottle. 

Water Bottle

Alex also had $6,500 in overhead costs in January. Using the number of units produced as his allocation method, Alex can calculate his overhead costs using the overhead cost formula. 

  • Calculate the overhead costs: 

$6,500 / 5,000 = $1.30 per water bottle

  • Add the overhead costs to the direct costs to find total costs:

$1.30 + $2.50 + $3.00 = $6.80 per backpack

So, Alex's total costs in January were $6.80 per backpack. If Alex had not allocated the overhead costs, he would have most likely underpriced the backpacks, which would have resulted in a loss of income. 

Key Takeaways: Importance of Cost Allocation

Key Takeaways

  • Cost allocation is fundamental and necessary for any business, big or small. 

  • It helps with assessing profits and losses and the management of staffing. 

  • Cost allocation allows companies to explain the pricing of their goods and services to customers. 

  • Allocating costs is necessary for companies to maintain efficiency and financial accountability. 

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Researched and authored by Rachel KimLinkedIn

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