Definition: Cost allocation is the process of finding cost of different cost objects such as a project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.
Allocation implies that the assigning of the cost is somewhat arbitrary. Some people describe the allocation as the spreading of cost, because of the arbitrary nature of the allocation. Efforts have been made over the years to improve the bases for allocation. In manufacturing, the overhead allocations have moved from plant-wide rates to departmental rates, from direct labor hours to machine hours to activity-based costing. The goal is to allocate or assign the costs based on the root causes of the common costs instead of merely spreading the costs.
Cost objects are those items that people want to track the costs of individually. These might be external or internal. External costs would be a company’s products, services, sales teams, or activities. These are things that are outside of what goes on within the company. An internal cost could be something assigned to a unit, department, franchise, or assembly line. A cost allocation is a good tool to use on an annual basis to track changes in costs.
Cost pool is the account head in which costs are accumulated for further assignment to cost objects.
Cost driver is any variable that ‘drives’ some cost. If an increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost.
An effective cost allocation methodology enables an organization to identify what services are being provided and what they cost, to allocate costs to business units, and to manage cost recovery.
- Typical cost allocation mechanism involves:
- Identifying the object to which the costs have to be assigned,
- Accumulating the costs in different pools,
- Identifying the most appropriate basis/method for allocating the cost
An Allocation Plan: Allocation plans allow accountants to standardize techniques that define activities and expenses. When implementing the allocation plan, special attention is paid to personnel costs because these account for over half of all expenses. By understanding the functional duties of employees, management is able to better control costs.
Cost Allocation for Decision Making: One of the main purposes for allocating costs is to provide information for decision making. Knowing what department or product is taking a greater proportion of funds is important for weighing alternatives in both the short and long run. Cost allocation is an important planning tool for reducing costs and increasing profits. It can also be a cost motivator, giving managers incentives for making sure that costs are not accumulated carelessly. Managers will be more likely to operate their departments with greater efficiency.
Types of Costs: Every organization must define their costs, like how funding runs through the organization, who touches it, what they do and how they do it serves as a foundation for this understanding. According to the Office of Management and Budget’s (OMB) Uniform Guidance, there are only three types of costs – Indirect, Indirect-Admin (Overhead) and Direct. By correctly defining and allocating costs, the true cost of service can be fully captured.
Cost allocation base: Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool.