Allocation BaseExplained & Defined

A cost can either be direct or indirect.

Direct costs are costs that you can directly relate to a product or activity.

For example, you can directly allocate the cost of direct materials depending on how many units of raw materials it requires for production.

The same goes with the cost of direct labor, which depends on how many labor hours a product requires for its completion.

On the other hand, indirect costs are costs that you cannot directly relate to one product or activity.

Instead, you can allocate them to the whole operations of the business.

We also refer to these costs as overhead costs.

But accounting requires that you allocate manufacturing overhead costs to products as they are also product costs.

Even if it isn’t for the sake of accounting, allocating costs is still a practice that businesses do.

It’s especially helpful for budgeting purposes.

For example the cost of support functions such as janitorial or IT services.

These are functions that don’t generate revenue, but the different departments of the business enjoy their benefits.

So it’s only fitting that the cost of these functions should be allocated to them.

But before you can start with the allocation of costs, you need something to base the allocation on.

That’s where the concept of allocation base comes in.

We will be learning about what the allocation base is in this article.

Can you apply it to your business?

If yes, how? Read on to find out.

What is an Allocation Base?

An allocation base is a type of measurement upon which a business bases its cost allocation.

It’s particularly useful for the allocation of overhead costs.

An allocation base can take many forms of quantity such as the number of labor hours worked, the number of machine hours used, power consumption, space occupied, the number of computers used, etc.  

Overhead costs are usually not directly attributable to a product or department.

For example, let’s say that two business functions, the sales, and administrative functions, occupy the same building.

How do we allocate the cost of renting the building? In financial accounting, it isn’t a huge deal as we only need the total cost of rent for the presentation of financial statements.

But for managerial accounting, it matters especially for budgeting.

We want to know the costs that each function or department incurs.

Now, to allocate the cost of rent, we need to determine the allocation base.

In this case, we can use the space occupied by each function as the allocation base.

Let’s say that the total cost of renting the building is $10,000.

The sales department occupies 70% of the space, while the administrative department occupies the remaining 30%.

With this information, we allocate $7,000 to the sales department and $3,000 to the administrative function.

For an allocation base to be effective, it should be a cause or driver of the cost that it corresponds to.

You can tell if an allocation base is appropriate when changes to it correspond to the changes in the cost that is being subjected to cost allocation.

For example, when the consumption of office supplies increases, the actual cost of office supplies also increases.

Businesses that employ activity-based costing (ABC) systems typically use a large number of allocation bases.

Examples of Allocation Bases

Here are some examples of allocation bases that are appropriate to the costs that they correspond to:

• The janitorial department allocates its costs based on the space occupied by each function or department; if we were to express it in units, it would be the square footage occupied by each function/department
• Likewise, we can set the space occupied by each function or department as the allocation base for the allocation of rent expenses
• The human resource department uses the number of employees working in each department as the allocation base for the allocation of its costs
• We can set the allocation base for the cost of quality inspection according to the number of conducted inspections
• The IT support department uses the number of services calls or the number of computes used by each function or department as the allocation base for the allocation of its costs
• The allocation base for the allocation of power and light costs can be based on the number of machine hours used
• You can also set the number of machine hours used as the allocation base for the cost of maintenance and repairs
• For the allocation of the cost of office supplies, we can set the consumption of each function or department as the allocation base; for example, it could be the amount of paper consumed, the number of pens used, etc.
• Likewise, for the allocation of the cost of factory supplies (e.g. oil, lubricants, etc.), we can set the consumption of each production run or process as the allocation base; this way, we can attribute such costs to specific products
• For the cost of training and development, we can set the number of employees that attend such training sessions as the allocation base; another appropriate allocation base is the number of training hours

How to Use Allocation Bases?

Cost allocation is a practice that most businesses follow.

But before a business can do cost allocation, it must first determine the allocation base.

The first step in using an allocation base is to determine which costs are subject to cost allocation.

This is usually an overhead cost such as maintenance and repair expenses, the cost of rent, office supplies expense, etc.

The next step is to identify the products, services, functions, or departments to which you’re going to allocate the costs to.

Usually, for overhead costs that behave as operating expenses, we allocate costs to functions or operating departments.

For manufacturing overhead costs, we usually allocate them to products.

After that, the next step is to set the allocation base for each cost that is subject to cost allocation.

Make sure that the allocation base is appropriate to the cost that it corresponds to.

Setting the number of machine hours used as the allocation base for the allocation of the cost of maintenance and repairs is an example of an appropriate allocation base.

Setting the number of employees as the allocation base for the allocation of the cost of rent is not.

The last step is to use the allocation base for the calculation of costs to be allocated to each product, service, function, or department.

To illustrate this whole process, let’s do a short exercise.

A short exercise

The Zero Company wants to allocate the cost of renting the building that it uses to house the sales, administrative, and collection departments.

Looking at the contract, the annual cost of renting the building amounts to $240,000.

The building has two floors, one of which is occupied by the administrative department, while the other is shared equally by the sales and collection departments.

Applying the steps we just learned, we first identify the cost that is subject to cost allocation.

In this case, it is the cost of rent which amounts to a total of $240,000.

Since the cost is an operating expense, the next step is to identify the functions/departments to which we’re going to allocate the costs.

In this example, we identify three functions/departments: sales, collection, and administrative.

Then we identify the allocation base.

For this type of cost, the appropriate allocation base would be the space occupied by each function or department.

The rented building has two floors. The administrative department occupies an entire floor, while the sales and collection departments equally share the other floor.

If we were to express it in percentage, the administrative department occupies 50% of the building, while the sales and collection departments occupy 25% each.

The final step is to allocate the cost. In this case, we will allocate the $240,000 cost of rent to the three departments based on the space that they occupy.

We allocate 50% of the cost to the administrative department, which amounts to $120,000.

For the sales and collection departments, we allocate $60,000 each.