Cost AllocationExplained, Advantages & Disadvantages, and Examples

Written By:
Lisa Borga

What is Cost Allocation?

Cost allocation refers to the act of identifying and then accumulating and distributing costs to several cost objects.

These cost objects could be products, departments, or programs.

Businesses need to identify their cost objects as well as the costs that are incurred by these cost objects and then distribute the costs among the cost objects by using certain established criteria.

Cost Allocation

If a business allocates cost correctly, it will be able to determine the cost objects that are causing the business to make a profit or loss.

Whereas should a business allocate their costs to the incorrect cost objects, the business could end up allocating resources to cost objects which will not produce the amount of profits the business expected.

Cost Categories

There are different kinds of costs a business needs to define in order to allocate costs to the different cost objects.

These are:

Direct Costs

Costs that can be associated with a certain service or product are direct costs, and it is not necessary to allocate these costs to a certain cost object.

This is due to the fact that the business already knows the expenses that are associated with any specific department.

An example of this would be the machine hours for a particular division.

The company would already be aware that these machine hours are associated with this division, so these costs would not need to be allocated to this division again.

Indirect Costs

Costs that cannot be directly associated with a certain cost object, such as a department or product, are indirect costs.

Indirect costs are necessary for a business’s health or operations.

Indirect costs are costs, such as office expenses, legal expenses, or insurance.

These costs need to be identified first, then pooled, and after this be allocated to a business’s specific cost objects.

Indirect costs are commonly split into variable or fixed costs.

Fixed costs are costs that do not change with the level of output or sales.

These costs remain the same in the short term.

One example of a fixed cost would be a production supervisor’s salary.

Indirect costs can also be variable costs.

These costs change with the level of sales or output.

Overhead Costs

Indirect costs that are not included in manufacturing costs are overhead costs.

Overhead costs are not associated with the material or labor costs that are necessary to produce or sell a service or good.

These costs get charged to a business expense account.

Additionally, they need to be paid on a regular basis whether or not the business sells any of its goods.

Typical examples of a business’s overhead costs are utilities, rent, supplies, and legal fees.

Cost Allocation Process

Next, the basic steps in the cost allocation process are described.

Identify the Cost Objects

If management wants to allocate costs, the first thing they need to do is to ascertain any cost objects that they will need to individually estimate any associated costs for.

Discerning distinct cost objects is essential due to the fact that they are what is driving the business.

Therefore, they need to be considered when making decisions.

Cost objects can vary considerably.

They can be things, such as product lines, departments, projects, brands, or even an entire branch of a company.

Businesses also need to determine a cost allocation base.

This would be the basis the business uses to allocate any of their costs to their cost objects.

Accumulate the Costs into Different Pools

Once management has discerned the cost objects, they should accumulate the costs into a cost pool before allocating these costs among any cost objects.

While you are accumulating these costs, you should make some categories, and this is where the costs will eventually be pooled using the cost allocation base.

There are many types of cost pools, such as purchasing, insurance, or supervising.

What is a Cost Driver?

A cost driver is what produces or causes the costs being allocated.

Examples of cost drivers are the number of miles traveled, number of machine-hours, number of customers, number of machine operators, or number of direct labor hours.

Advantages of Cost Allocation

Here are some reasons cost allocation is important for businesses.

Useful in Decision Making

Management can obtain useful information concerning cost utilization through cost allocation, which can then be used when making decisions.

Cost allocation will help management see which cost objects are contributing the most to costs.

It will also allow management to determine which products and departments are performing well enough to be worth the allocated costs.

Helps Analyze Specific Departments

Managers can use cost allocation to ascertain whether or not a department is profitable.

If the manager should find that the department is not profitable, the manager can consider whether the problem is due to the staff members.

In contrast, if the department is profitable, the staff could be rewarded, which would be an incentive for the staff to continue their good work.