What is Cost Allocation?
Cost allocation is the method of identifying as well as assigning the elements of cost to each cost object, such as a product or a department for which cost is to be allocated, based on an appropriate cost driver, which serves as a base for allocation of the elements of the cost.
Purpose
#1 – Decision Making
It helps the management to make informed decisions. It gives details as to which product or department is utilizing significant funds, and the same can be utilized to carry out profitability analysis.
#2 – Minimize Resource Wastage
It will provide results as to the costs that are incurred by each department. Thus, managers of such departments will keep a check on the costs incurred in their respective departments since they are to be held responsible for any unnecessary expenses incurred.
Process
- Identify the cost object for which the cost is to be allocated. It may include a product, department, project, customer, and so on.
- Establish the cost of pools. Cost pools are the elements of cost for which allocation is to be done based on cost drivers. It may include costs such as factory rent, electricity, fuel, labor cost, etc.
- Identify the cost driver, which means the appropriate base based on which cost can be reasonably allocated. For example, for allocating the factory rent to the products, the relevant cost driver can be the number of units produced.
Examples of Cost Allocation
This process can be understood by way of the following example. A company produces two products, namely “A” and “B” on the premises of the same factory.
- Factory Rent = $1,00,000
- Units Produced of “A” = 30,000
- Units Produced of “B” = 20,000
- Total no. of units produced = 50,000
Let us see how can the cost allocation of factory rent be done for the two products.
Here,
- Cost Object = Product “A” and “B”
- Cost Pool = Factory Rent
- Cost Driver = No. of Units Produced
- = $1,00,000 * 30,000/50,000
- = $ 60,000
- = $1,00,000 * 20,000/50,000
- = $40,000
This is done based on the cost driver, being number of units produced. Thus, the cost is allocated in the ratio of the number of units produced.
Methods of Cost Allocation
#1 – Direct Method
In the direct way of cost allocation, the allocation of the service departments is done to the production departments. This method does not take into effect the fact that a service department may be providing services to other service departments too. Cost is allocated only to the production or the operating departments.
#2 – Step-Down Method
In this method, the cost of service departments is allocated to operating departments as well as other service departments step-by-step. Firstly, the cost of that service department is allocated, which has incurred the maximum cost. After allocating the cost of such a department, the cost of the service department with the next highest cost is allocated. The process of cost allocation goes on until the cost of all service departments has been allocated. However, costs are not allocated back to a department, which has already allocated its entire cost.
#3 – Reciprocal Method
Under the reciprocal method, also cost of service departments is allocated to operating departments as well as other service departments. However, for this purpose, the relationship between each service department is identified. And the cost is allocated to each service department, unlike in the case of the step-down method.
Difference Between Cost Allocation & Cost Apportionment
- Cost allocation means the direct distribution of the cost heads to various departments based on a reasonable factor. It is a type of cost apportionment which allocates a cost to a cost object. The distribution is done to a department only when it is connected to a department.
- On the other hand, apportionment of cost means attribution of various cost heads to departments in proportion, based on a reasonable factor. Allocation is done in the ratio of benefits expected to be achieved from the cost heads. A cost is apportioned when it is not directly related to a particular department but instead is connected to various departments.
Advantages
- When a company follows cost allocation for its various departments, each department tries to maintain efficiency in their operations and keep the cost under control.
- It helps in determining the actual cost of a product produced or a service rendered.
- It enables a company to fix accountability on the various departments regarding the cost that is incurred by them.
- It is helpful in decision making as it can provide information as to what is the actual cost, which can be compared with the revenues and suggest if any changes are required in pricing.
Disadvantages
- This process is based on cost drivers. If cost drivers are not chosen wisely, it may give misleading results.
- It is a very complex process and may require extra time and effort.
Conclusion
It becomes necessary, especially for large organizations, because of the existence of various departments. It becomes vital to keep track of the cost incurred in each department to fix accountability and maintain control over costs.
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