Cost Allocation

16/10/2022 0 By indiafreenotes

Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs. Examples of cost objects are a product, a research project, a customer, a sales region, and a department.

Cost allocation is used for financial reporting purposes, to spread costs among departments or inventory items. Cost allocation is also used in the calculation of profitability at the department or subsidiary level, which in turn may be used as the basis for bonuses or the funding of additional activities. Cost allocations can also be used in the derivation of transfer prices between subsidiaries.

Example of Cost Allocation

The African Bongo Corporation (ABC) runs its own electrical power station in the hinterlands of South Africa, and allocates the cost of the power station to its six operating departments based on their electricity usage levels.

Types of allocated costs

When allocating costs, it’s important to know the types of costs your organization associates with the selected cost objects. Here are some of the most common types of costs you may use in your cost accounting processes:

Fixed costs

Fixed costs are the expenses that remain consistent when other factors change. For example, the cost of rent or loan payments are fixed costs because they don’t usually change from month to month. Fixed costs are usually relatively easy to connect with specific cost objects, and they can be direct or indirect.

Variable costs

Variable costs change based on factors such as market conditions and production. For example, think of a toy company that produces a toy car featuring plastic pieces. If there’s a shortage of plastic material for a short period, the production costs for the toy may increase. In addition to production costs, other variable costs may include packaging supplies and delivery costs. Variable costs are often direct costs but can be indirect as well. For example, the cost of a utility bill may fluctuate depending on the weather.

Operating costs

Operating costs, which some people also refer to as overhead costs, can be either fixed or variable. They relate to a company’s daily functions. For example, operating costs can include sales, marketing and travel costs.

Direct costs

A business professional can connect a direct cost with an identifiable cost object. For example, you may consider the materials and labor that are necessary for a product’s production. These are direct costs because they result in a tangible cost object.

Indirect costs

Indirect costs are expenses that contribute to production without a direct connection to any particular cost object. For example, you can consider rent, utilities and office supplies. These costs are necessary for production, but a company doesn’t usually associate them with a specific cost object.

Cost Allocation Methods

The very term “allocation” implies that there is no overly precise method available for charging a cost to a cost object, so the allocating entity is using an approximate method for doing so. Thus, you may continue to refine the basis upon which you allocate costs, using such allocation bases as square footage, headcount, cost of assets employed, or (as in the example) electricity usage. The goal of whichever cost allocation method you use is to either spread the cost in the fairest way possible, or to do so in a way that impacts the behavior patterns of the cost objects. Thus, an allocation method based on headcount might drive department managers to reduce their headcount or to outsource functions to third parties.

Cost Allocation and Taxes

A company may allocate costs to its various divisions with the intent of charging extra expenses to those divisions located in high-tax areas, which minimizes the amount of reportable taxable income for those divisions. In such cases, an entity usually employs expert legal counsel to ensure that it is complying with local government regulations for cost allocation.

Reasons Not to Allocate Costs

An entirely justifiable reason for not allocating costs is that no cost should be charged that the recipient has no control over. Thus, in the African Bongo Corporation example above, the company could forbear from allocating the cost of its power station, on the grounds that none of the six operating departments have any control over the power station. In such a situation, the entity simply includes the unallocated cost in the company’s entire cost of doing business. Any profit generated by the departments contributes toward paying for the unallocated cost.

Cost Allocation Mechanism

Identify cost objects

The first step when allocating costs is to identify the cost objects for which the organization needs to separately estimate the associated cost. Identifying specific cost objects is important because they are the drivers of the business, and decisions are made with them in mind.

The cost object can be a brand, project, product line, division/department, or a branch of the company. The company should also determine the cost allocation base, which is the basis that it uses to allocate the costs to cost objects.

Accumulate costs into a cost pool

After identifying the cost objects, the next step is to accumulate the costs into a cost pool, pending allocation to the cost objects. When accumulating costs, you can create several categories where the costs will be pooled based on the cost allocation base used. Some examples of cost pools include electricity usage, water usage, square footage, insurance, rent expenses, fuel consumption, and motor vehicle maintenance.

Benefits of Cost Allocation

Helps evaluate and motivate staff

Cost allocation helps determine if specific departments are profitable or not. If the cost object is not profitable, the company can evaluate the performance of the staff members to determine if a decline in productivity is the cause of the non-profitability of the cost objects.

On the other hand, if the company recognizes and rewards a specific department for achieving the highest profitability in the company, the employees assigned to that department will be motivated to work hard and continue with their good performance.

Assists in the decision-making process

Cost allocation provides the management with important data about cost utilization that they can use in making decisions. It shows the cost objects that take up most of the costs and helps determine if the departments or products are profitable enough to justify the costs allocated. For unprofitable cost objects, the company’s management can cut the costs allocated and divert the money to other more profitable cost objects.