Cost Allocation

Article byNiti Gupta
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Cost Allocation Definition

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.

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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.

Cost Allocation Explained

Cost allocation refers to the process in which a company is able to distribute or assign the cost among its different departments, products or projects. Every company, producing any type of goods or services incur large amount of cost during various stages of production. It is important to allocate them to the proper stage, part or type of products, processes or even departments so that the management can identify the total cost incurred for each good.

This concept contributes to calculation of production cost, gross and net profits and ultimately the financial position of the business after dealing with such products, services or business operations. If cost is high, then very often the management has to take decision regarding modification, alteration or termination of those procedures or make changes in factors like marketing expense, labor cost, type of raw material used, etc.

Thus, a proper cost distribution and cost allocation techniques will reflect the impact and usage level of products or performance of departments. Such costs can be direct ones, which are related to production like raw material, direct labor, or indirect ones like rent, utilities or administrative expenses. The allocation is done using different methods like machine hours, or as a proportion of total cost, or activity-based costing method.

Companies require actual and authentic data regarding cost in order to take important financial decisions regarding investment or raising capital for funding operations. So a comprehensive overview of the same will help them to make such informed decisions, design strategies, and allocate resources where they are actually necessary and productive.

Purpose

Let us identify the main purpose of the concept of cost allocation techniques and why it is so important for businesses to concentrate on it so much.

Purpose of Cost Allocation

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#1- Decision Making

It helps the management to make informed decisions. It details which product or department is utilizing significant funds, and the same can be utilized to carry out 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.read more analysis.

#2 – Minimize Resource Wastage

It will provide results as to the costs that each department incurs. Thus, managers of such departments will check on the costs incurred in their respective departments since they are to be held responsible for any unnecessary expenses incurred.

#3 – Evaluation

It is a process that facilitates the evaluation of performance of different departments and operations taking place inside the company. When costs are allocated to various processes, the management can very well identify which are the areas involving more cost are which are the ones that have a controlled cost levels. Accordingly modification and adjustment should be made so that the factor does not affect the profitability.

#4 – Budgeting

Budget is the financial provisions made to meet foreseen and unforeseen expenses of the business. Such budgets are necessary so that there is no sudden cash outflow which was not pre-planned, because this leads to financial constraint and limits operations flexibility. Allocation of cost plays a huge role in budgeting because if cost for a particular process is more, higher budget has to be allocated for that function.

However, it should be noted that this basis of cost allocation should be done in a planned and methodical manner and not in an arbitrary way, so that there is transparency and accuracy in the process of decision making.

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Methods

Here, we identify the different methods or the basis of cost allocation as per the company operations.

Cost Allocation

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Examples

Let us understand the concept of cost allocation plan with the help of a suitable example as given below.

This process can be understood by way of the following example. A company produces two products, “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
Example 1
  • = $1,00,000 * 30,000/50,000
  • = $ 60,000
Example 1-1
  • = $1,00,000 * 20,000/50,000
  • = $40,000

This is done based on the cost driver, being the number of units produced. Thus, the cost is allocated in the ratio of the number of units produced.

Advantages

Some advantages of the concept of cost allocation plan are detailed below.

Disadvantages

Some disadvantages of the concept as follows:

  • 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.
  • It may also sometimes require special skills an expertise or any particular type of software which many be complex and costly.
  • There may be arbitrariness in the entire process because especially in case of indirect cost it is difficult to perfectly allocate them which may not reflect the actual usage.
  • Cost allocation directly or indirectly affects the salaries and compensation levels of employees. This may create dissatisfaction and lower the productivity, straining relationships and creating resentment.
  • From the above point cost allocation in accounting can be derived that there may be fall in motivation among employees.
  • If the methods adopted for the same does not suit the business properly, them there may be adverse effects, resulting in lack of flexibility and wastage of resources, adding to the cost of the company.

Thus, it is necessary to clearly understand the positive and negative sides of this concept so that it they can be allocated with transparency and fairness.

Cost Allocation Vs Cost Apportionment

Both the above terms are every closely related to each other but there are some differences between them, which are as follows:

  1. 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 objectA Cost ObjectA cost object is a method that measures product, segment, and customer cost separately to determine the exact cost and selling price. read more. The distribution is done to a department only when it is connected to a department.
  2. A cost is apportioned when it is not directly related to a particular department but is connected to various department
  3.  On the other hand, apportionment of cost means attributing various cost heads to departments based on a reasonable factor. Allocation is done in the ratio of benefits expected from the cost heads.

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