Cost Allocation Methods

Article byRishab Nigam
Edited byPallabi Banerjee
Reviewed byDheeraj Vaidya, CFA, FRM

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.

Cost Allocation Methods

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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.

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.read more. 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.read more, 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.read more 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. read more 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.

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Types

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. read more 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.read more. 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

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. read more 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.

Examples

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.

Advantages

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.

Disadvantages

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.

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