What Is Cost Allocation?
Cost allocation is a process in which businesses and individuals identify the costs incurred by activity and distribute them to appropriate accounts.
This allows for better decision-making when determining how much should be spent on different business areas.
Types of Costs
There are types of costs to consider during the process of cost allocation. They include:
1. Fixed costs. These are expenses that remain the same no matter how many units of production have been made or sold.
For example, a business spends $100,000 on rent every month. Even if the company can only produce and sell 50 units of a product in one month (when they normally make and sell 100), this cost remains at $100,000 for that given time period.
2. Variable costs. These expenses depend on the amount of production or sales made within a given period, such as raw materials used for making products.
For example, it costs a furniture shop $50 to make a chair—$20 for raw materials such as wood, cane, metal, leather, and fabrics, and $30 for the direct labor involved in making one chair.
Below shows how the variable costs change as the number of chairs made vary.
As the production output of chairs increases, the bakery’s variable costs also increase. When the furniture shop does not make any chair, its variable costs drop to zero.
4. Direct Costs. These are costs that can be directly linked to the making or selling of goods or services.
For example, if a company pays for equipment rental to produce their product, this cost is considered direct because it links back to how many units have been produced.
Why Is Cost Allocation Important?
Cost allocation is an important part of any business. The following points reflect why you should always be sure to allocate all your expenses:
- It helps in accurate decision-making. When costs are known, it is easier to determine which strategies will most benefit the business or individual.
- Allocating cost enables comparison between different products and services.
For example, comparing the cost of producing one product versus another can help decide which should be produced more often based on its profitability compared with other goods or services offered by a company.
- It helps in understanding which departments are more profitable than others. Identifying the cost of different areas of business allows for better decision-making at the departmental level, and overall.
- It can help identify problem areas within a company to allow for improvements or changes that might be beneficial for future production or sales.
Taking these factors into account when allocating cost allows businesses and individuals to understand better how much money they need coming in (revenue) compared with how much they must spend (costs).
This makes setting prices easier since there is an understanding of what each unit sold brings in revenue-wise.
Common Mistakes People Make When Allocating Costs
- Not accounting for overhead. Overhead is a general term that refers to indirect expenses, which are not directly attributed to the cost of goods sold (COGS) or fixed costs.
- Not taking into account which projects are currently generating revenue and which ones aren’t.
- Not allocating indirect expenses equally among departments and projects within a company.
- Not considering how fluctuating revenue affects indirect expenses. If you’re seeing a lot of variability in revenue over time, you need to account for that when allocating costs.
- Using the incorrect allocation method. There are many different methods for allocating costs and using more than one can help you get a better idea of where your business is spending its money.
Process of Cost Allocation
The following is an overview of how to allocate costs and some tips on what you should take into consideration when doing so.
Step One: Identify Your Costs
The first step is to identify all of your costs.
This includes both direct and indirect expenses, as well as fixed or variable costs.
Step Two: Allocate Indirect Costs Between Departments or Products
Indirect costs should be allocated between departments, projects, and products based on a fair allocation plan that reflects their use in those areas.
For example, suppose your company produces two products, products A and B. In that case, you will need to construct a cost-allocation plan that reflects the allocation of overhead expenses between these areas.
Step Three: Allocate Fixed Costs Among Departments or Projects
Fixed costs are allocated among departments or projects based on how they benefit each area.
For example, if Product A produces a specific product that is used for Product B, it would be appropriate to allocate the fixed costs associated with producing Product A between these two products.
Step Four: Allocate Variable Costs Among Departments or Projects
Variable costs are allocated among departments or projects based on how much of each cost driver they use.
For example, if your company produces two products, A and B (and each product has its own direct labor cost), you would first need to determine how many units of Product A are produced for every unit of Product B sold.
You can then use this information to allocate the variable costs associated with producing each product based on their respective rates.
Step Five: Use Cost-Volume-Profit Analysis to Determine the Best Allocation Method
If your company uses multiple products, services, or departments that incur indirect costs, cost allocation is important in determining which method will work best for reporting profits accurately.
For example, suppose you’re using a full absorption costing (FAC) system and another department within your company is using a direct labor cost system. In that case, you may need to use more than one allocation method.
Step Six: Use Cost Allocation for Decision Making & Reporting
Cost allocation is important for both decision-making and reporting purposes.
Using cost allocation, you can determine which areas of your company are over or under-spending and how changes to specific processes will affect the overall profitability of a product or department.
Common Cost Allocation Methods
- Step-up/down method. This is a simple way to allocate indirect expenses, but it can result in higher costs for products and departments that use a large number of resources.
- High/low method. This is appropriate if you have multiple cost drivers and each one has different fixed or variable rates associated with them. It’s also helpful if your company uses more than one allocation base.
- Direct materials cost method. This is useful when the allocation base and variable rate are the same for all products.
- Direct labor cost method. This can be used if your company produces only one product or has multiple indirect expenses that vary with direct labor costs. However, this approach may result in some inaccuracies since it’s difficult to determine which areas of production each labor cost is associated with.
- Full Absorption Costing (FAC). This approach uses the actual costs of indirect expenses, as well as a predetermined FAC rate that can be calculated based on your company’s historical data and industry standards for determining this type of expense. It also includes direct material and direct labor in its calculation, so you’ll have more accurate reporting of costs.
- Variable costing. This approach is appropriate when you have many variable cost allocations and your company uses a high amount of direct labor in production. Still, it may result in inaccurate financial reports since fixed expenses aren’t allocated to products or departments based on their use.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.