What Are Cost Allocation Methods?
The cost allocation method is a process that facilitates identification and assignment of costs to products, departments, branches or programs based on certain criteria. When the allocation of costs is performed correctly, the business is able to account for its costs as well as trace them back to determine how they are making profits and losses.
Thus, it is a very useful technique that helps the business to distribute its expenses among various products, services, and cost centres. If the costs are accurately attributed, then it leads to better pricing strategy, production planning, resource allocation, cost control, and overall financial management, which leads to an increase in profitability.
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Cost Allocation Methods Explained
The term cost allocation methods refer to the different techniques that a company may use in order to allocate or distribute its costs across its operations, products or cost centres, which leads to efficient and smooth running of the business, through maximum cost control.
The cost allocation method starts with the identification of cost driversCost DriversA cost driver is a unit that derives the expenses and sets a basis on which a particular cost is to be allocated between the different departments and on the basis of that driver’s activity completed in that particular period the cost is allocated. These are the structural determinants of the activities on which cost is being incurred and determine the behavior of the costs on an activity.. The cost drivers tend to change the level of the cost incurred by the business for any aligned or identified activity. The cost drivers are generally composed of a number of machine-hours, the number of direct labour and the count of payment processed, the count of purchase ordersPurchase OrdersA Purchase Order (PO) serves as a legal document between buyer and seller, wherein, the buyer sends this contract that details the goods and services, date of delivery, payment terms as per the contract etc., and the count of invoices that are dispatched to the customers.
The establishment of comprehensive joint cost allocation methods helps in fast decision making for the management as they tend to get access to the important data of cost allocation and utilization on periodic fronts. It additionally keeps labour staff motivated as the business tends to recognize the department or product lineProduct LineProduct Line refers to the collection of related products that are marketed under a single brand, which may be the flagship brand for the concerned company. Typically, companies extend their product offerings by adding new variants to the existing products with the expectation that the existing consumers will buy products from the brands that they are already purchasing. that is the most profitable department. Since the data on cost allocationCost AllocationCost Allocation is the procedure of recognizing & assigning costs to different cost objects like a product, department, program, customer, etc., as per the cost driver serving as the base for this process. becomes accessible to the management, it helps the management evaluate the department and the associated staff.
It is to be noted that the selection of overhead cost allocation methods will depend on the type and nature of business, the size of operation, the kind of resource used and future planning. It is not necessary that the business will use only one method. It can use multiple and combination of techniques which will not only give a proper understanding of the costing situation but also guide the business regarding the next step.
Given below are some important and widely used types of such joint cost allocation methods that exist in the corporate world.
#1 – Identification Of Cost Object
This is the starting step in the identification of costs, wherein the business attempts to find and classify the cost objects. The cost objects are required as it helps the business to determine effective costs on segregated levels. Additionally, such identification is also regarded as critical as the business or organization cannot go ahead with the process of cost allocation if the cost objectsCost ObjectsA cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. are not known and defined.
The cost objects could be a project in the pipeline, product line, department, division, or entirely a new segregated brand. In parallel to this activity of determining the cost objects, the business identifies and determines the basis of the costsBasis Of The CostsCost basis is the valuation of assets at their original or at-cost price inclusive of incidental expenses determined after making relevant adjustments for dividends, stock splits and distribution of return on capital. It facilitates the taxation of assets.. The cost basis is basically the fundamental aspect basis allocation of costs that are performed on the cost objects.
#2 – Accumulation of Costs into the Cost Pool
- Once the cost objects are identified and established, the next step involves the addition or accumulation of the cost into a defined cost pool and allocate the cost objects. The cost accumulation could result in the creation of multiple categories wherein the costs aligned would be pooled and segregated basis the cost allocation method employed. This could result in several methods. The cost pools aligned with the basis could be composed of electricity usage, square footage, water usage, insurance, fuel consumption, motor vehicle insurance, and rent expenses.
- Basis the identified costs the business tends to finally establish some levels of cost objects. Such cost objects can be identified as direct costs. The direct costs help in segregating costs that have a direct impact on business profitabilityProfitabilityProfitability refers to a company's ability to generate revenue and maximize profit above its expenditure and operational costs. It is measured using specific ratios such as gross profit margin, EBITDA, and net profit margin. It aids investors in analyzing the company's performance. and can be attributed to the distinct product line or service line. They are not required to be aligned with the defined cost objects as the business knows the type of expenses that could be incurred in the production of specific services and products.
- There could be some costs that are not direct; rather, they indirectly impact the aligned cost function, product line, or department. Such costs are required for the facilitation of business operations and further be divided into fixed or variable costs. Such costs would, therefore, be identified and then simultaneously allocated to the identified cost objects within the business unit or the organization.
- The fixed costsFixed CostsFixed Cost refers to the cost or expense that is not affected by any decrease or increase in the number of units produced or sold over a short-term horizon. It is the type of cost which is not dependent on the business activity. are basically the cost that is business or department has to bear to sustain itself. The variable costs, on the other hand, are costs that the business may or may not bear and depends on the level of output. Such variable costs can increase or decrease in magnitude, and such costs are generally controllable by the business if identified with the correct cost objects.
- There could be overhead cost allocation methods as well, which are indirect and are not identified with the process of production or manufacturing. Such costs are not related to the material costs and labour costs that the business has to incur in the generation of services and finished goodsFinished GoodsFinished goods inventory refers to the final products acquired from the manufacturing process or through merchandise. It is the end product of the company, which is ready to be sold in the market. . However, overhead costs if identified correctly with the cost poolsCost PoolsA cost pool is a strategy to identify the company's individual departments or service sector costs incurred. It determines the total expenses incurred in manufacturing goods and allocates them to different departments or service sectors based on valid identifiers known as cost drivers., help the business in terms of selling the finished goods or services, and it helps in the production process.
- The overhead costsOverhead CostsOverhead cost are those cost that is not related directly on the production activity and are therefore considered as indirect costs that have to be paid even if there is no production. Examples include rent payable, utilities payable, insurance payable, salaries payable to office staff, office supplies, etc. are levied on the expense account, and they should be comprehensively compensated irrespective of the fact whether the business is making sales on the services or finished products. Such costs are aligned with the administrative expensesAdministrative ExpensesAdministrative expenses are indirect costs incurred by a business that are not directly related to the manufacturing, production, or sale of goods or services provided, but are necessary for the smooth functioning of business operations, such as information technology, finance & accounts. as well as such expenses can be aligned to the legal expenses.
The cost allocation methods basically focus in terms of accumulation of costs followed by the establishment of cost drivers and cost pools to establish cost objects further and then aligned such costs to the cost objects. Cost allocationCost AllocationCost Allocation is the procedure of recognizing & assigning costs to different cost objects like a product, department, program, customer, etc., as per the cost driver serving as the base for this process. is basically a critical task for the business as it helps the business in determining the effective profit and loss for themselves, and this attribute further helps the management to establish effective decision-making policy.
Let us assume a company ABC Ltd, which is looking into its cost allocation and analysing areas that need better control and strategy. It produces two kinds of products, A and B. Total quantity produced for A is around 20000 and B is produced by 50000 units. It management has calculated that the total cost of production comes to $150000. After identification it is seen that these include the cost or resource employment, usage of utility, purchase of various machinery, upgradation of software, procurement of raw materials, etc.
Now they need to allocate it among both products, then we can say that for products A and B, the total cost would be as follows:
Total cost = $150000, Total production = 70000 units
Therefore for A = (150000/70000)* 20000 = $42,857
For B = (150000/70000)* 50000 = $107,143
Thus, the above is a very simple calculation of allocation. However, the components may change and calculation may be more complex, depending the type of product, the various cost breakups and the operational process.
The various methods explained above help in distributing the costs across the operations so that it enables the business to fairly align it across various outputs. But corporate cost allocation methods come with their own advantages and disadvantages. Let us look at the advantages first.
- Cost control – It is important for the business to have a proper control over its cost so that proper planning and revenue maximization can lead to profitability. The management of the business should take special care to select the correct common cost allocation methods of cost allocation so that the cost can be reduced.
- Decision making – A business needs proper decision making at every step. Correct strategy and planning are the key to success of operation. Cost control is the best way to cost management and revenue optimization. The methods help in not only doing so but also identify areas that need proper understanding and control so that wastage of resource is reduced.
- Fairness – A proper cost allocation leads to distribution of resources as per the usage and contribution of each resource.
- Reporting – This is the most important part, where financial details is reported in the statements that are widely viewed, used and analysed by investors, shareholders, and the management. Proper allocation of cost through corporate cost allocation methods reveals a clear and positive picture about the business, which not only make the company appear financially stable but also increase faith of stakeholders.
Here are some disadvantages of the common cost allocation methods.
- Subjective– The entire process is very subjective in the sense that the methods are selected based on past experiences and historical results. This may lead to disagreements or misallocation and disputes.
- Complex process – There are multiple types of cost allocation methods, which are difficult to select, based on company operations and strategies. Moreover, even after selecting a method, using it is not very easy because it involves a number of assumptions, calculations, and analysis.
- Assumptions – It is quite obvious that there are a number of assumptions that are used in the process which may not be very realistic or related to actual usage of resource contribution.
- Inaccuracy – Due to complexity and assumptions used the ultimate result may not always be accurate. There may be deviations from expectation which may later lead to cost increase and requirement of new strategy to conduct the business.
- Cost involved – Any new method implementation requires some amount of cost. This is extra cost that the company has to bear and above all the management may not be sure of its positive result. Therefore, the skill and expertise employed for achievement of the objective involves cost.
Thus, the above are some important advantages and disadvantages that should be kept in mind while selecting and implementing the different cost allocation methods.
This has been a guide to What are Cost Allocation Methods & its Definition. Here we discuss the two broad cost allocation methods, i.e. explain them in detail. You can learn more about from the following articles –