What is cost allocation? Explained with example

Cost allocation is a key factor in any business’s profitability. Business owners can use cost allocation findings to evaluate staff performance. The process of cost allocation involves calculating both direct and indirect expenses, such as factory labor and small quantities of materials.

What is cost allocation?

Cost allocation is the method business owners use to calculate profitability for the purpose of financial reporting. To ensure the business’s finances are on track, costs are separated, or allocated, into different categories based on the area of the business they impact. 

For instance, cost allocation for a small clothing boutique would include the costs of materials, shipping, and marketing. Calculating these costs consistently would help the store owner ensure that profits from sales are higher than the costs of owning and running the store. If not, the owner could easily pinpoint where to raise prices or cut expenses. 

For a larger company, this process would be applied to each department or individual location. Many companies use cost allocation to determine which areas receive bonuses annually. 

What is cost allocation?

Basic Steps of Cost Allocation

The key to successful cost allocation is to establish an allocation system that is fair, equitable, and supported by current data. In particular, a cost allocation system should:

  • Identify shared facilities or support services
  • Identify the costs to be allocated
  • Determine the allocation factors/methodology to distribute the costs equitably
  • Allocate the costs
  • Update and monitor the data and methodology to ensure the allocation remains fair and equitable over time

Types of Costs

Let’s start by defining some terms…

  • Direct costs are costs that can be traced directly to the product or service itself. For manufacturers, these consist of direct materials and direct labor. They appear in the financial statements as part of the cost of goods sold.
  • Direct materials are those that become an integral part of the finished product. This will be the costs of the water, sugar, lemons, the plastic jug, and the label. 
  • Direct labor includes the labor costs that can be easily traced to the production of those finished products. Direct labor for that jug will be the payroll for the workers on the production line. 
  • Indirect costs are the costs that can’t be easily traced to a product or service but are clearly required for making whatever an enterprise sells. This includes materials that are used in such insignificant quantities that it’s not worth tracing them to finished products, and labor for employees who work in the factory, but not on the production line. 
  • Overhead costs encompass all the costs that support the enterprise that can’t be directly linked to making the items that are sold. This includes indirect costs, as well as selling, marketing, administration, and facility costs. 
  • Manufacturing overhead includes the overhead costs that are directly related to making the products for sale. This includes the electricity, rent, and utilities for the factory and the salaries of supervisors on the factory floor. 
  • Product costs are all the costs in making or acquiring the product for sale. These are also known as manufacturing costs or total costs. This includes direct labor, direct materials, and allocated manufacturing overhead. 
The Benefits of Dividing Costs Logically

The Benefits of Dividing Costs Logically

Cost allocation seems like a simple process of linking a cost to its source, but what happens when you have thousands of devices, assets, and services, tangible and virtual? It quickly becomes a ponderous process. Organizations have thousands of employees and various assets and services that are used by individual employees, departments,s or even whole business units.

For example, there are individually-ended services such as mobile numbers and internet lines, used by individual employees, but on the other hand services such as VoIP, servers and circuits serve many resources at a time.

The cost associated with employees need to be allocated individually, the cost of resources used by a group of individuals in a department should be allocated to the department and, finally,  the costs associated with services used by all employees of a particular site need to be allocated to a business unit. This is why cost allocation matters.

Allocation Best Practices

  • Document the allocation methodology. Documentation should explain how the allocation methodology is reasonably related to the costs being allocated. Document how measures such as headcount, square footage, or hours are directly related to the benefit received. Documentation should be retained along with the purchase receipt and made available for review.
  • The allocation methodology must be used consistently in like circumstances.
  • Routinely review the methodology to ensure it continues to represent a reasonable basis for distributing costs. The methodology should be updated if it is determined that it no longer represents a reasonable distribution of costs.
  • Review estimated allocations on a routine basis. If a cost has been allocated based on an estimate, that cost can be reallocated – if needed – using a cost transfer. Ensure that reallocations are completed promptly so that accurate costs are recorded on the appropriate funding source within 90 days, per GIM 15, of the original expense posting date.

Examples

Here are a few examples to help you better understand how cost allocation is implemented in financial reporting:

Units produced cost allocation

Polly’s business designs and manufactures stationary and paper products. In November, Polly produced 5,000 notebooks with direct material costs of $3 per notebook and direct labor costs of $2 per notebook.

Polly also had $4,000 in overhead costs for the month of November. Using the number of units produced as the allocation method, we can calculate overhead costs using the formula:

$4,000 / 5,000 = $0.80 per notebook

When added to Polly’s direct costs, the cost to produce each notebook is $5.80, calculated as follows:

Direct materials: $3 per notebook
Direct labor: $2 per notebook
Overhead: $0.80 per notebook
Total cost: $5.80 per notebook

Square footage cost allocation

Polly’s business has a small shared office for its four employees, plus a manufacturing space to create the paper goods. The square footage of the manufacturing space is 1,500 square feet, and the office space is 1,000 square feet. Rent for both spaces is $7,000 per month. To allocate rent between the two departments, start by dividing the total rent by total square footage.

$7,000 (rent) / $2,500 square feet = $2.80 per square foot

Calculate the rental cost for the manufacturing space:

$2.80 x 1,500 = $4,200

Polly can allocate $4,200 to overhead expenses for the manufacturing space.

Then, calculate the rental cost for the office space:

$2.80 x 1,000 = $2,800

Polly can allocate the balance of the rent, $2,800, to the office space.

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