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What is Cost Allocation? Definition & Process

Jul 16, 2020 Michael Whitmire

Working with the former accountants now working at FloQast, we decided to take a look at some of the pillars of the accounting professions.

The key to running a profitable enterprise of any kind is making sure that your prices are high enough to cover all your costs — and leave at least a bit for profit. For a really simple business — like the proverbial lemonade stand that almost every kid ran — that’s pretty simple. Your costs are what you (or your parents) paid for lemons and sugar. But what if it’s a more complex business? Then you might need to brush up on cost accounting, and learn about allocation accounting . Let’s walk through this using the hypothetical company, Lisa’s Luscious Lemonade. 

What is cost allocation ?

The cost allocation definition is best described as the process of assigning costs to the things that benefit from those costs or to cost centers . For Lisa’s Luscious Lemonade, a cost center can be as granular as each jug of lemonade that’s produced, or as broad as the manufacturing plant in Houston. 

Let’s assume that the owner, Lisa, needs to know the cost of a jug of lemonade. The total cost to create that jug of lemonade isn’t just the costs of the water, lemons, sugar and the jug itself, but also includes all the allocated costs to make it. 

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 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. 

What is the process?

The first step in any cost allocation system is to identify the cost objects to which costs need to be allocated. Here, our cost objec t is a jug of lemonade. For a more complex organization, the cost object could be a product line, a department, or a branch. 

Direct costs are the simplest to allocate. Last month, Lisa’s Luscious Lemonades produced 50,000 gallons of lemonade and had the following direct costs:

                                    Total costs     Cost per gallon Direct materials        $142,500               $2.85 Direct labor                   $37,500                   $.75

How are costs allocated?

Allocating overhead costs is a bit more complex. First, the overhead costs are split between manufacturing costs and non-manufacturing costs. Some of this is pretty straightforward: the factory floor supervisor’s salary is clearly a manufacturing cost, and the sales manager’s salary is a non-manufacturing cost. But what about the cost of human resources or other service departments that serve all parts of the organization? Or facilities costs, which might include the rent for the building, insurance, utilities, janitorial services, and general building maintenance?

Human resources and other services costs might be logically split based on the headcount of the manufacturing versus non-manufacturing parts of the business. Facilities costs might be split based on the square footage of the manufacturing space versus the administrative offices. Electricity usage might be allocated on the basis of square footage or machine hours , depending on the situation. 

Let’s say that for Lisa’s Luscious Lemonades, after we split the overhead between manufacturing and non-manufacturing costs, we have the following annual manufacturing overhead costs : 

Supervisor salary                                  $84,000 Indirect costs                                         $95,000 Facility costs                                           $150,000 Human resources                                  $54,000 Depreciation                                          $65,000 Electricity                                                $74,000 Total manufacturing overhead             $522,000

In a perfect world, it would be possible to keep an accurate running total of all overhead costs so that management would have detailed and accurate cost information. However, in practice, a predetermined overhead rate is used to allocate overhead using an allocation base . 

This overhead rate is determined by dividing the total estimated manufacturing overhead by the estimated total units in the allocation base . At the end of the year or quarter, the allocated costs are reconciled to actual costs. 

Ideally, the allocation base should be a cost driver that causes those overhead costs . For manufacturers, direct labor hours or machine-hours are commonly used. Since Lisa only makes one product — gallon jugs of lemonade — the simplest cost driver is the number of jugs produced in a year. 

If we estimate that 600,000 gallons of lemonade are produced in a year, then the overhead rate will be $522,000 / 600,000 = $.87 per gallon.

Our final cost to produce a gallon of Lisa’s Luscious Lemonade is as follows:

Direct materials                             $2.85 Direct labor                                     $0.75 Manufacturing overhead               $0.87 Total cost                                         $4.47

What is cost allocation used for?

Cost allocation is used for both external reporting and internally for decision making. Under generally accepted accounting principles (GAAP), the matching principle requires that expenses be reported in the financial statements in the same period that the related revenue is earned. 

This means that manufacturing overhead costs cannot be expensed in the period incurred, but must be allocated to inventory items, where those costs remain until the inventory is sold, when overhead is finally expensed as part of the cost of goods sold. For Lisa’s Luscious Lemonade, that means that every time a jug of lemonade is produced, another $4.47 goes into inventory. When a jug is sold, $4.47 goes to the cost of goods sold. 

However, for internal decision-making, the cost allocation systems used for GAAP financials aren’t always helpful. Cost accountants often use activity-based costing , or ABC, in parallel with the cost allocation system used for external financial reporting . 

In ABC, products are assigned all of the overhead costs that they can reasonably be assumed to have caused. This may include some — but not all — of the manufacturing overhead costs , as well as operating expenses that aren’t typically assigned to products under the costing systems used for GAAP. 

AutoRec to keep you sane

Whatever cost accounting method you use, it’s going to require spreadsheets that you have to reconcile to the GL. Combine that with the other reconciliations you have to do to close out the books, and like Lisa’s controller, you might be ready to jump into a vat of lemonade to drown your sorrows. 

Enter FloQast AutoRec. Rather than spend hours every month reconciling accounts, AutoRec leverages AI to match one-to-one, one-to-many, or many-to-many transactions in minutes. Simple set up means you can start using it in minutes because you don’t need to create or maintain rules. Try it out, and see how much time you can save this month. 

Ready to find out more about how FloQast can help you tame the beast of the close?

cost allocation in accounting

Michael Whitmire

As CEO and Co-Founder, Mike leads FloQast’s corporate vision, strategy and execution. Prior to founding FloQast, he managed the accounting team at Cornerstone OnDemand, a SaaS company in Los Angeles. He began his career at Ernst & Young in Los Angeles where he performed public company audits, opening balance sheet audits, cash to GAAP restatements, compilation reviews, international reporting, merger and acquisition audits and SOX compliance testing. He holds a Bachelor’s degree in Accounting from Syracuse University.

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What Is Cost Accounting?

Understanding cost accounting.

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Cost Accounting: Definition and Types With Examples

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cost allocation in accounting

Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by assessing the variable costs of each step of production as well as fixed costs, such as a lease expense.

Cost accounting is not GAAP-compliant , and can only be used for internal purposes.

Key Takeaways

  • Cost accounting is used internally by management in order to make fully informed business decisions.
  • Unlike financial accounting, which provides information to external financial statement users, cost accounting is not required to adhere to set standards and can be flexible to meet the particular needs of management.
  • As such, cost accounting cannot be used on official financial statements and is not GAAP-compliant.
  • Cost accounting considers all input costs associated with production, including both variable and fixed costs.
  • Types of cost accounting include standard costing, activity-based costing, lean accounting, and marginal costing.

Investopedia / Theresa Chiechi

Cost accounting is used by a company's internal management team to identify all variable and fixed costs associated with the production process. It will first measure and record these costs individually, then compare input costs to output results to aid in measuring financial performance and making future business decisions. There are many types of costs involved in cost accounting , each performing its own function for the accountant.

Types of Costs

  • Fixed costs are costs that don't vary depending on the level of production. These are usually things like the mortgage or lease payment on a building or a piece of equipment that is depreciated at a fixed monthly rate. An increase or decrease in production levels would cause no change in these costs.
  • Variable costs are costs tied to a company's level of production. For example, a floral shop ramping up its floral arrangement inventory for Valentine's Day will incur higher costs when it purchases an increased number of flowers from the local nursery or garden center.
  • Operating costs are costs associated with the day-to-day operations of a business. These costs can be either fixed or variable depending on the unique situation.
  • Direct costs are costs specifically related to producing a product. If a coffee roaster spends five hours roasting coffee, the direct costs of the finished product include the labor hours of the roaster and the cost of the coffee beans.
  • Indirect costs are costs that cannot be directly linked to a product. In the coffee roaster example, the energy cost to heat the roaster would be indirect because it is inexact and difficult to trace to individual products.

Cost Accounting vs. Financial Accounting

While cost accounting is often used by management within a company to aid in decision-making, financial accounting is what outside investors or creditors typically see. Financial accounting presents a company's financial position and performance to external sources through financial statements , which include information about its revenues , expenses , assets , and liabilities . Cost accounting can be most beneficial as a tool for management in budgeting and in setting up cost-control programs, which can improve net margins for the company in the future.

One key difference between cost accounting and financial accounting is that, while in financial accounting the cost is classified depending on the type of transaction, cost accounting classifies costs according to the information needs of the management. Cost accounting, because it is used as an internal tool by management, does not have to meet any specific standard such as  generally accepted accounting principles (GAAP) and, as a result, varies in use from company to company or department to department.

Cost-accounting methods are typically not useful for figuring out tax liabilities, which means that cost accounting cannot provide a complete analysis of a company's true costs. 

Types of Cost Accounting

Standard costing.

Standard costing assigns "standard" costs, rather than actual costs, to its cost of goods sold (COGS) and inventory. The standard costs are based on the efficient use of labor and materials to produce the good or service under standard operating conditions, and they are essentially the budgeted amount. Even though standard costs are assigned to the goods, the company still has to pay actual costs. Assessing the difference between the standard (efficient) cost and the actual cost incurred is called variance analysis.

If the variance analysis determines that actual costs are higher than expected, the variance is unfavorable. If it determines the actual costs are lower than expected, the variance is favorable. Two factors can contribute to a favorable or unfavorable variance. There is the cost of the input, such as the cost of labor and materials. This is considered to be a rate variance.

Additionally, there is the efficiency or quantity of the input used. This is considered to be a volume variance. If, for example, XYZ company expected to produce 400 widgets in a period but ended up producing 500 widgets, the cost of materials would be higher due to the total quantity produced.

Activity-Based Costing

Activity-based costing (ABC) identifies overhead costs from each department and assigns them to specific cost objects, such as goods or services. The ABC system of cost accounting is based on activities, which refer to any event, unit of work, or task with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. These activities are also considered to be cost drivers , and they are the measures used as the basis for allocating overhead costs .

Traditionally, overhead costs are assigned based on one generic measure, such as machine hours. Under ABC, an activity analysis is performed where appropriate measures are identified as the cost drivers. As a result, ABC tends to be much more accurate and helpful when it comes to managers reviewing the cost and profitability of their company's specific services or products.

For example, cost accountants using ABC might pass out a survey to production-line employees who will then account for the amount of time they spend on different tasks. The costs of these specific activities are only assigned to the goods or services that used the activity. This gives management a better idea of where exactly the time and money are being spent.

To illustrate this, assume a company produces both trinkets and widgets. The trinkets are very labor-intensive and require quite a bit of hands-on effort from the production staff. The production of widgets is automated, and it mostly consists of putting the raw material in a machine and waiting many hours for the finished good. It would not make sense to use machine hours to allocate overhead to both items because the trinkets hardly used any machine hours. Under ABC, the trinkets are assigned more overhead related to labor and the widgets are assigned more overhead related to machine use.

Lean Accounting

The main goal of lean accounting is to improve financial management practices within an organization. Lean accounting is an extension of the philosophy of lean manufacturing and production, which has the stated intention of minimizing waste while optimizing productivity. For example, if an accounting department is able to cut down on wasted time, employees can focus that saved time more productively on value-added tasks.

When using lean accounting, traditional costing methods are replaced by value-based pricing  and lean-focused performance measurements. Financial decision-making is based on the impact on the company's total value stream profitability. Value streams are the profit centers of a company, which is any branch or division that directly adds to its bottom-line profitability.

Marginal Costing

Marginal costing (sometimes called cost-volume-profit analysis ) is the impact on the cost of a product by adding one additional unit into production. It is useful for short-term economic decisions. Marginal costing can help management identify the impact of varying levels of costs and volume on operating profit. This type of analysis can be used by management to gain insight into potentially profitable new products, sales prices to establish for existing products, and the impact of marketing campaigns.

The  break-even point —which is the production level where total revenue for a product equals total expense—is calculated as the total fixed costs of a company divided by its contribution margin. The contribution margin , calculated as the sales revenue minus variable costs, can also be calculated on a per-unit basis in order to determine the extent to which a specific product contributes to the overall profit of the company.

History of Cost Accounting

Scholars believe that cost accounting was first developed during the  industrial revolution  when the emerging economics of industrial supply and demand forced manufacturers to start tracking their fixed and variable expenses in order to optimize their production processes.

Cost accounting allowed railroad and steel companies to control costs and become more efficient. By the beginning of the 20th century, cost accounting had become a widely covered topic in the literature on business management.

How Does Cost Accounting Differ From Traditional Accounting Methods?

In contrast to general accounting or financial accounting, the cost-accounting method is an internally focused, firm-specific system used to implement  cost controls . Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Cost-accounting methods and techniques will vary from firm to firm and can become quite complex.

Why Is Cost Accounting Used?

Cost accounting is helpful because it can identify where a company is spending its money, how much it earns, and where money is being lost. Cost accounting aims to report, analyze, and lead to the improvement of internal cost controls and efficiency. Even though companies cannot use cost-accounting figures in their financial statements or for tax purposes, they are crucial for internal controls.

Which Types of Costs Go Into Cost Accounting?

These will vary from industry to industry and firm to firm, however certain cost categories will typically be included (some of which may overlap), such as direct costs, indirect costs, variable costs, fixed costs, and operating costs.

What Are Some Advantages of Cost Accounting?

Since cost-accounting methods are developed by and tailored to a specific firm, they are highly customizable and adaptable. Managers appreciate cost accounting because it can be adapted, tinkered with, and implemented according to the changing needs of the business. Unlike the  Financial Accounting Standards Board (FASB)-driven financial accounting, cost accounting need only concern itself with insider eyes and internal purposes. Management can analyze information based on criteria that it specifically values, which guides how prices are set, resources are distributed, capital is raised, and risks are assumed.

What Are Some Drawbacks of Cost Accounting?

Cost-accounting systems ,and the techniques that are used with them, can have a high start-up cost to develop and implement. Training accounting staff and managers on esoteric and often complex systems takes time and effort, and mistakes may be made early on. Higher-skilled  accountants  and  auditors  are likely to charge more for their services when evaluating a cost-accounting system than a standardized one like GAAP.

Cost accounting is an informal set of flexible tools that a company's managers can use to estimate how well the business is running. Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company's cost structure allows management to improve the way it runs its business and therefore improve the value of the firm. These are meant to be internal metrics and figures only. Since they are not GAAP-compliant, cost accounting cannot be used for a company's audited financial statements released to the public.

Fleischman, Richard K., and Thomas N. Tyson. "The Economic History Review: Cost Accounting During the Industrial Revolution: The Present State of Historical Knowledge." Economic History Review , vol. 46, no. 3, 1993, pp. 503-517.

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What Is Cost Allocation?

Cost Allocation Explained in Less Than 5 Minutes

cost allocation in accounting

Definition and Examples of Cost Allocation

How cost allocation works, types of cost allocation.

miodrag ignjatovic / Getty Images

Cost allocation is a method used to assign costs to cost objects for a specific department, project, program, or other area.

The methods for cost allocation involve simple calculations, which can be beneficial to small business owners who need accurate financial information to help them price their products or services and make overall decisions. Learning about these methods can help you get a handle on your expenses and positively affect your bottom line.

Cost allocation is a method used to assess the costs associated with cost objects in specific categories within a business. Cost objects might include a product or service you sell, a particular department within your company, or the costs of dealing with a supplier.

Cost allocation is not just for large corporations looking to reduce expenses. Small business owners can greatly benefit from cost allocation; you get a more detailed look into the actual costs associated with your business, which allows you to assess prices better and increase your profitability.

For example, you might want to determine the costs of dealing with one of your suppliers, so you’d add up all of the associated costs. These costs can include everything from the phone calls you make to the time spent dealing with issues caused by them. Additionally, you could count how much you pay for the supplies you get from them.

Cost allocation essentially works by assigning costs to smaller areas within the overall business so that you can view profits or losses at a more granular level. When you use cost allocation, you might discover that your true production cost per unit is higher than expected.

It’s important to remember that cost objects will vary depending on your business and industry.

That means you might consider increasing prices to maintain a specific profit margin . On the opposite end of the spectrum, you may decide to scrap a product that turned out to be a money pit.

To accurately calculate cost allocation, you must first identify the cost object, then begin to assess the actual cost.

Determining Costs

Spreading costs is not an exact science when it comes to cost objects. Some ways to allocate costs are based on units manufactured, square footage, number of hours, headcount, or usage.

Let’s say you have a building with a photography studio on the first floor and a salon on the second floor; you’ll use square footage as your cost object. The salon is 2,000 square feet, and the studio is 1,000 square feet. The total rent for the building is $6,000 per month. To allocate rent between the two spaces, you would first divide the total rent by the total square footage of the building:

$6,000 (overall rent) ÷ 3,000 sq. ft. (total space) = $2 per sq. ft.

Second, you’ll want to calculate the rent for the photography studio:

$2 (price per sq. ft.) x 1,000 (studio sq. ft.) = $2,000

Third, you can calculate the rent for the salon:

$2 (price per sq. ft.) x 2,000 (salon sq. ft.) = $4,000

Your rent per space should be $2,000 for the overhead expense of the studio and $4,000 for the overhead expense of the salon.

Other scenarios might include payroll cost allocation based on employee cost centers, or payment processing cost allocation based on transactions per location or franchise.

Cost objects can be just about anything you assign a cost to. Some examples of cost objects are jobs, payroll, departments, projects, financial systems, IT, and programs.

Cost allocation is based on different types of costs that fall into one of three categories, generally speaking.

Direct Costs

Direct costs are the easiest to assign to an identified cost object, because they are directly related. For example, a direct cost could be the labor required to produce a product or the materials used.

Indirect Costs

When you have an indirect cost, it is not attached to a specific cost object but still is necessary for the business to function. For example, common indirect costs could be security costs or administrative costs not related to a specific department.

Overhead Costs

Overhead costs—also called operating costs—are those costs associated with the day-to-day operations of your business. These accrue regardless of actual production, but still support productivity. Operating costs might include insurance, rent, and legal fees.

Costs can be fixed or variable depending on the type. A fixed cost is constant, while a variable cost can fluctuate depending on other factors.

The cost type factors into how you allocate the cost later. For example, if you were cost allocating rent, it would be allocated to overhead expenses. You would likely use the square-footage method to allocate the cost.

When allocating costs directly related to a product, you might use the units-produced allocation method to factor in overhead costs with the direct costs to create the product. This will allow you to determine better the price you should be asking.

Key Takeaways

  • Cost allocation helps business owners identify areas of opportunity with their products or services.
  • Cost objects can include anything you want to measure and assign a cost to, such as products, programs, projects, or even a customer.
  • Ways to allocate costs include square footage, units produced, usage, and headcount.

Warren Averett. " Types of Cost Allocation Methods for Government Contractors ."

Municipal Research and Services Center of Washington. " Cost Allocation ."

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Cost Allocation

The process of identifying a company’s costs and assigning those costs to cost objects

Christopher Haynes

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds  asset management  firm with $20 billion under management, and as an investment banking analyst in  SunTrust Robinson Humphrey 's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Sid Arora

Currently an investment analyst focused on the  TMT  sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a  BS  from The Tepper School of Business at Carnegie Mellon.

  • What Is Cost Allocation?
  • Types Of Costs
  • How To Allocate Costs
  • Why Do We Need To Allocate Costs?
  • Examples Of Cost Allocation & Calculations

What is Cost Allocation?

Cost allocation is the process of identifying a company’s costs and assigning those costs to cost objects. Cost objects are the products, services, and activities of different departments of a company. 

This process of allocating costs helps a business determine which parts of the company are responsible for what costs. 

Sometimes it is difficult to draw the connection between allocated costs and their cost objects. When this happens, companies can use spreading costs. 

Spreading costs occur when businesses spread the responsibility for production expenses across various areas. 

When businesses can accurately allocate their costs, they are able to easily assess what particular cost objects are creating profits and losses for the company. On the other hand, if businesses are unable to allocate their costs correctly, their profit and loss calculations will be off. 

Also, businesses must charge a price for their goods and services that covers their expenses and allows them to make a profit.  

Intuitively, one can recognize the importance of cost allocation for the optimal performance of a company. Incorrect cost allocation calculations are extremely detrimental to any business and disrupt the ability to operate properly.

Cost allocation is necessary for any business, but as companies get larger and more complex, it becomes even more important to allocate costs accurately. 

Key Takeaways

Cost allocation is fundamental and necessary for any business, big or small. 

It helps with assessing profits and losses and the management of staffing. 

Cost allocation allows companies to explain the pricing of their goods and services to customers. 

Allocating costs is necessary for companies to maintain efficiency and financial accountability. 

Types of Costs

Companies have various types of costs, and it is important to be able to distinguish between the different types when allocating them. 

We can break them down into a few different categories.

  • Direct costs:  direct costs are those that can be traced to a certain product or service offered by a company. Included in direct costs are materials and labor that go into the production of a good. 
  • Indirect costs :  these expenses are those that go into the production of a good but do not have a connection to a specific cost object. Examples of indirect costs include rent, utilities, and office supplies.
  • Fixed costs : these costs remain constant, regardless of a company’s production volume. (e.g., rent)
  • Variable costs : these costs increase or decrease as a company’s volume of production changes (e.g., supplies). 
  • A few examples of fixed overhead costs include rent, insurance, and workers’ salaries. Variable overhead costs include supplies and energy expenses, which both change as the  volume of production  increases or decreases. 

How to Allocate Costs

Now that we understand the different types of costs, we can better understand the processes involved in cost allocation. Regardless of what good or service a company produces, the process remains consistent across industries. 

  • Identify  Cost Objects : anything within a business that creates an expense is considered a cost object. The first step for allocating costs is to note all the cost objects of your company. 

Electricity usage

Water usage

Fuel consumption

  • Fixed cost allocation:  this method assigns particular direct costs with cost objects. Drawing direct connections between costs and cost objects makes this method one of the most simple.
  • Proportional allocation:  proportional allocation deals with the distribution of indirect costs across associated cost objects. Sometimes proportional allocation divides costs equally across cost objects, while other times, it considers other factors (i.e., size) and divides costs accordingly. 
  • Activity-based allocation:  this method is commonly considered the more accurate method of allocating costs. Activity-based allocation utilizes precise documentation to determine costs within departments and allocates the costs appropriately. 

Why Do We Need to Allocate Costs?

A company must allocate its costs in order to optimize its business activities.

Recognizing Profits And Losses

Understanding the distribution of expenses helps companies analyze which areas of their business may be profitable or which areas may be causing a loss. This allows companies to determine whether or not certain expenses can be justified or not. 

Companies do not know how much to charge the customer’s goods and services without cost allocation. Once non-profitable cost objects are identified, companies can cut expenses in those departments and focus their efforts on profitable cost objects. 

Management Decisions

Cost allocation is also important for a company to manage its staff. In areas where the company is not profitable, it can evaluate the staff performance of that department. Often, the losses incurred by part of a company are due to the underperformance of employees. 

Similarly, companies can analyze the allocation of their costs to determine where they are profitable and award the employees of that department. 

Using cost allocation to motivate employees offers the administration of a company an objective, quantitative justification for their management decisions. 

Transfer Pricing

Transfer pricing is the practice of charging for goods and services at an arm's length. The practice is used by departments the organization to charge for the goods and services exchanged within the same firm.

Cost allocation is vital for deriving transfer pricing, the exchange price of goods or services between two companies. 

Examples of Cost Allocation & Calculations

Now we understand cost allocation, the different types, and why we need it. Here are several examples of different ways a company might allocate its costs. 

Example 1: Square Footage

Christina’s business has an office and a manufacturing space. The square footage of the office is 1,000 square feet, and the manufacturing space is 1,500 square feet. The rent for the two spaces is $10,000 per month. The company will allocate the rent expense between the two spaces. 

$10,000 (rent) / 2,500 square feet = $4 per square foot

  • Calculate the rental cost for the office

$4 x 1,000 = $4,000

This means that Christina will allocate $4,000 of the rent to the office.

  • Calculate the rental cost for the manufacturing space

$4 x 1,500 = $6,000

This means that Christina will allocate $6,000 of the rent to the manufacturing space.

Example 2: Units Produced

Alex’s manufacturing company makes water bottles. In January, Alex produced 5,000 water bottles with direct material costs of $2.50 per water bottle and $3.00 in direct labor costs per water bottle. 

Alex also had $6,500 in overhead costs in January. Using the number of units produced as his allocation method, Alex can calculate his overhead costs using the overhead cost formula. 

  • Calculate the overhead costs: 

$6,500 / 5,000 = $1.30 per water bottle

  • Add the overhead costs to the direct costs to find the total costs:

$1.30 + $2.50 + $3.00 = $6.80 per backpack

So, Alex’s total costs in January were $6.80 per backpack. If Alex had not allocated the overhead costs, he would have most likely underpriced the backpacks, which would have resulted in a loss of income. 

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What Is Cost Allocation?

Table of contents.

cost allocation in accounting

For your business to make money, you must charge prices that not only cover your expenses, but also provide a profit. Cost allocation is the process of identifying and assigning costs to the cost objects in your business, such as products, a project, or even an entire department or individual company branch.

While a detailed cost allocation report may not be vital for extremely small businesses, such as a teen’s lawn service, more complex businesses require the process of cost allocation to ensure profitability and productivity.

In short, if you can assign a cost to any part of your business, it’s considered a cost object.

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.

Regardless of your business size, you’ll want to review and choose the best accounting software to help this process run as smoothly as possible.

Types of costs

In the boutique example above, the process of cost allocation is pretty simple. For larger businesses, however, many more costs are involved. These costs break down into seven categories.

  • Direct costs: These expenses are directly related to a product or service. In your business’s financial statements, these costs can be linked to items sold. For a small clothing store, this might include the cost of inventory.
  • Direct labor: This cost category includes expenses directly related to the employee production of items or services your business sells. Direct labor costs include payroll for employees involved in making the items your business sells.
  • Direct materials: As the name suggests, this category includes costs related to the resources used to manufacture a finished product. Direct materials include fabric to make clothing, or the glass used in building tables.
  • Indirect costs: These expenses are not directly related to a product or service, but necessary to create the product or service. Indirect costs include payroll for those who work in operations. It also lists costs for materials you use in such small quantities that their costs are easy to overlook.
  • Manufacturing overhead: This category includes warehouse costs, and any other expenses directly related to manufacturing the products sold. Manufacturing overhead costs include payroll for warehouse managers, as well as warehouse expenses such as rent and utilities.
  • Overhead costs: These include expenses that support the company as a whole but are not directly related to production. Some examples of overhead costs are marketing, operations and utilities for a storefront.
  • Product costs: Also called “manufacturing costs” or “total costs,” this category includes expenses for making or acquiring the product you sell. All manufacturing overhead costs are also listed in this category.

Example of cost allocation

To better explain the process of cost allocation and why it’s necessary for businesses, let’s look at an example.

Dave owns a business that manufactures eyeglasses. In January, Dave’s overhead costs totaled $5,000. In the same month, he produced 3,000 eyeglasses with $2 in direct labor per product. Direct materials for each pair of eyeglasses totaled $5.

Here’s what cost allocation would look like for Dave:

Overhead: $5,000 ÷ $3,000 = $1.66 per pair

Direct costs:

  • Direct materials: $5 per pair
  • Direct labor: $2 per pair
  • Overhead: $1.66 per pair
  • Total cost: $8.66 per pair

As you can see, without cost allocation, Dave would not have made a profit from his sales. Larger companies would apply this same process to each department and product to ensure sufficient sales goals. [Read related article: How to Set Achievable Business Goals ]

How to allocate costs

Cost objects vary by business type. The cost allocation process, however, consists of the same steps regardless of what your company produces.

1. Identify cost objects.

To begin allocating costs, you’ll need to list the cost objects of your business. Remember that anything within your business that generates an expense is a cost object. Review each product line, project and department to ensure you’ve gathered all cost objects.

2. Create a cost pool.

Next, gather a detailed list of all business costs. It’s a good idea to categorize the costs based on the reason for each amount. Categories should cover utilities, insurance , square footage and any other expenses your business incurs.

3. Allocate costs.

Now that you’ve listed cost objects and created a cost pool, you’re ready to allocate costs. As demonstrated in the example above, add up the costs of each cost object. At a glance, your report should justify all expenses related to your business. If costs don’t add up correctly, use the list to determine where you can make adjustments to get back on track.

What is cost allocation used for?

Cost allocation is used for many reasons, both externally and internally. Reports created by this process are great resources for making business decisions , monitoring productivity and justifying expenses.

External reports are usually calculated based on generally accepted accounting principles (GAAP) . Under GAAP, expenses can only be reported in financial statements during the time period the associated revenue is earned. For this reason, overhead costs are divided and allocated to individual inventory items. When the inventory is sold, the overhead is expensed as a portion of the cost of goods sold (COGS) .

Internal financial data, on the other hand, is usually reported using activity-based costing (ABC). This method assigns all products to the overhead expenses they caused. This process may not include all overhead costs related to operations and manufacturing.

Cost allocation reports show which cost objects incur the most expenses for your business and which products or departments are most profitable. These findings can be a great resource to pair with employee monitoring software when evaluating productivity. If you determine that a cost object is not as profitable as it should be, you should do further evaluations on productivity. If another cost object is found to exceed expectations, you can use the report to find staff members who deserve recognition for their contributions to the company.

Recognition is one of the best ways to keep employees motivated .

What is a cost driver?

A cost driver is a variable that can change the costs related to a business activity. The number of invoices issued, the number of employee hours worked, and the total of purchase orders are all examples of cost drivers in cost accounting .

While cost objects are related to the specific process or product incurring the costs, a cost driver sheds light on the reason for the incurred cost amounts. These items can take different forms – including fixed costs, such as the initial fees during the startup phase . Cost drivers give a bird’s-eye view of the entire company and how each department operates.

It’s common for only one cost driver to be used with very small businesses , since they are focused on using minimal reporting to estimate overhead costs.

Benefits of cost allocation

  • It simplifies decision-making. Cost allocation gives you a detailed overview of how your business expenses are used. From this perspective, you can determine which products and services are profitable, and which departments are most productive.
  • It assists in staff evaluation. You can also use cost allocation to assess the performance of different departments. If a department is not profitable, the staff productivity may need improvement. Cost allocation can also be an indicator of departments that exceed expectations and deserve recognition. Awards and recognition are a great way to motivate staff and, in turn, increase productivity. [Read related article: Best Business Productivity Apps ]

Even if you operate a very small business, it’s a great idea to learn the process of cost allocation, especially if you anticipate expansion in the future. Since the method can be complex, it’s ideal to use accounting software as an aid. Whether you choose to start allocating costs on your own with software or hire a professional accountant , it’s a process no business owner can afford to overlook.

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The Comprehensive Guide to Cost Allocation in Accounting

Accounting is a fascinating field, and cost allocation is one of the most important concepts in accounting. Whether you’re an accounting student or an accountant just starting out, it’s important to understand how to allocate costs.

In this comprehensive guide, we’ll cover everything from what it means to its pros and cons. 

How Can Costs Be Allocated Among Departments or Product Lines When There Is No Clear Source?

Allocation is distributing costs among different departments or product lines in an organization. Trying to accurately estimate the cost of producing a good or rendering a service is a common challenge for many businesses.

This is especially true when there is no apparent source of the costs, as it requires the use of various techniques and methods to distribute the expenses fairly and reasonably.

What Is the Concept of Allocation?

Allocation (also known as “cost allocation”) is a process used to distribute the costs of a shared resource or expense among different departments, product lines, or activities within an organization.

This process is necessary to accurately determine the cost of producing a product, providing a service, or running a business. Allocation allows firms to identify the expenses incurred by each department or product line and helps make informed decisions about allocating resources.

The allocation concept has existed for centuries and is a fundamental part of modern accounting and financial management. The cost allocation process involves assigning costs to specific departments or product lines based on objective criteria, such as resource use or the benefit received from the expense.

The objective criteria used in the allocation process may vary depending on the type of business, but the goal is always to distribute the costs fairly and reasonably.

One of the main challenges of allocation is that many expenses cannot be traced directly to a specific department or product line. For example, the cost of electricity used to run a manufacturing plant cannot be directly traced to one particular product line.

In such cases, the cost of electricity must be allocated to different departments or product lines based on objective criteria, such as the number of hours each department uses the electricity or the production output of each product line.

There are different methods of allocation, each with its strengths and weaknesses. Some of the most common ways include direct allocation, step-down allocation, sequential allocation, and activity-based allocation. Each mode uses a different approach to allocating costs, but the goal is always to ensure that the costs are distributed fairly and reasonably.

What Doesn’t the Term Allocation Mean?

The term allocation” is commonly used in various contexts, such as finance, economics, project management, and resource management. However, it’s essential to understand that allocation ” doesn’t mean “equal distribution” or “uniform distribution” of resources.

Allocation refers to assigning a portion of resources, such as time, money, or labor, to specific tasks or activities. The goal of allocation is to optimize the use of resources to achieve the desired outcomes.

One of the most common misunderstandings about allocation is that it means dividing resources equally among tasks or activities. However, this is only sometimes the case. Resources are often not distributed evenly because different tasks or activities have different requirements and priorities.

For example, in project management, some jobs may require more time, money, or labor than others. In such cases, the project manager must allocate more resources to these critical tasks to ensure the project’s success.

Another misunderstanding about allocation is that it means distributing resources inflexibly and rigidly. Allocation is a flexible process that can be adjusted based on priorities or changes in resource availability. For example, in a business setting, the budget allocation may change based on market conditions or changes in customer demand. In these situations, the business must be able to reallocate its resources to respond to these changes.

The allocation also doesn’t mean that the resources are assigned once and never adjusted. Allocation is an ongoing process requiring constant monitoring and adjustments to ensure that resources are used optimally.

For example, in finance, the allocation of investments must be reviewed regularly to ensure that the portfolio is aligned with the investor’s goals and objectives.

Another misconception about allocation is that it only applies to tangible resources, such as money or equipment. However, allocation also applies to intangible resources like time and labor. These intangible resources are often more critical and limited than tangible ones. For example, allocating time is crucial in project management to ensure that projects are completed on time and within budget.

As you can see, allocation is a complex and flexible process that requires careful consideration of multiple factors, such as resource availability, priorities, and goals. It’s essential to understand that allocation doesn’t mean equal distribution or limited distribution of resources.

Instead, it’s a dynamic process that requires ongoing monitoring and adjustments to ensure the optimal use of resources. By avoiding common misconceptions about allocation, individuals and organizations can more effectively allocate their resources and achieve their desired outcomes.

Where the Term Allocation Originated From?

The word “allocation” comes from the Latin word “allocare.” The word allocation ” refers to setting aside or assigning a particular portion, amount, or portion of something for a specific purpose or recipient.

The allocation comes from the Latin prefix ad- (meaning “to”) and the noun loci (meaning “place”). The combination of these two words implies the idea of assigning a place, or portion of something, for a specific purpose.

In finance and economics, “allocation” refers to distributing resources, such as money, to different projects or initiatives based on their perceived importance and likelihood of success.

The allocation concept is ancient and can be traced back to the earliest civilizations, where resources were allocated based on the community’s needs. In early societies, central planning or direct control by the ruling class were common methods of allocation.

However, with the advent of market-based economies, the allocation has become more decentralized and is now primarily done through the market mechanism of supply and demand.

In modern economies, allocation is crucial in ensuring that resources are used efficiently and effectively. For example, in capital allocation, investors allocate their funds to different projects and businesses based on the perceived potential return on investment. This helps direct investment toward the most promising and profitable opportunities, thereby increasing the economy’s overall efficiency.

Similarly, prices play a crucial role in allocating goods and services in directing resources to where they are most needed. In a market economy, the interaction of supply and demand determines prices. When demand for a particular good or service is high, the price will increase, directing more resources toward its production. On the other hand, when demand is low, the price will decrease, reducing the allocation of resources to its production.

Government policies and regulations can also have an impact on allocation in addition to the market mechanism. For example, the government may allocate resources to specific sectors through funding or subsidies, such as education or healthcare.

Similarly, government regulations and taxes can also impact the allocation of resources by affecting the incentives for businesses and individuals to allocate their resources in a particular way.

How Allocation Relates to Accounting?

In accounting, allocation determines the cost of producing a product or providing a service. This information is then used to create accurate financial statements and make informed decisions about allocating resources in the future.

For example, a company may allocate resources to a new product line based on the expected revenue it will generate or distribute costs to specific departments based on their usage of resources.

The allocation also plays a crucial role in cost accounting . Cost accounting involves analyzing the cost of production, including direct and indirect costs, and using this information to make decisions about pricing and resource allocation.

By accurately allocating costs, a company can determine the actual cost of production and make informed decisions about pricing , production volume, and resource allocation.

In addition, allocation is used to allocate the costs of long-term assets, such as property, plant, and equipment. This is done through the process of depreciation, which is a systematic allocation of the cost of an asset over its useful life. Depreciation is used to determine the value of an investment for financial reporting purposes and the amount of tax that a company must pay.

Finally, allocation is also used in the budgeting process. In budgeting, an organization allocates resources to various departments and activities based on their priorities and goals. By accurately allocating resources, a company can ensure that it has enough resources to meet its goals and objectives while staying within its budget.

3 Examples of Allocation Being Used in Accounting Practice

Example #1 of allocation being used in accounting practice.

Allocating the Cost of Goods Sold In accounting, “cost of goods sold” (COGS) refers to the direct costs associated with producing a product or providing a service. These costs include the raw materials, labor, and overhead expenses incurred to produce the goods. COGS is crucial in determining a company’s gross profit because it represents the cost of producing and selling a product.

One example of allocation in accounting practice is when a company allocates the cost of goods sold to each product. This is done to understand the cost of producing each product and identify the most profitable products. 

The allocation process involves dividing the total COGS by the number of units sold to arrive at an average cost per unit. This average cost per unit is then applied to each unit of product sold to determine the COGS for that specific product.

This allocation process is vital because it allows the company to accurately determine the cost of producing each product. This information is then used to make informed business decisions such as pricing strategies, production decisions, and cost control measures. 

For example, suppose a company realizes that the cost of producing one product is much higher than the cost of producing another. In that case, it may choose to discontinue the higher-cost product or find ways to reduce the cost of production.

Example #2 of Allocation Being Used in Accounting Practice

One example of allocation in accounting practice is allocating indirect costs to different departments or products within a company. Indirect costs, such as rent, utilities, and office supplies, cannot be directly traced to a specific product or department. These costs must be allocated among different departments or products to calculate the cost of each accurately.

For example, consider a manufacturing company with three departments: production, research and development, and administration. The company has a total indirect cost of $100,000 for the year, which includes rent, utilities, and office supplies.

The company might determine the proportion of space each department uses to allocate these costs. If production uses 40% of the total space, R&D uses 30%, and administration uses 30%, the company would allocate 40% of the indirect costs to production, 30% to R&D, and 30% to administration.

Next, the company might allocate indirect costs based on the number of employees in each department. If production has 20 employees, R&D has 15, and administration has 10, the company would allocate indirect costs based on the ratio of employees in each department.

In this example, production would receive 40% of the indirect costs, R&D would receive 30%, and administration would receive 30%.

Finally, the company might allocate indirect costs based on the number of products produced in each department. If production produces 1000 products, R&D produces 500, and administration produces none, the company would allocate indirect costs based on the ratio of products produced in each department.

In this example, production would receive 67% of the indirect costs, R&D would receive 25%, and administration would receive 8%.

Example #3 of Allocation Being Used in Accounting Practice

Suppose a manufacturing company produces two products: Product A and Product B. To determine the cost of each product, the company must allocate the factory overhead costs, including utilities, rent, maintenance, and supplies, among other expenses. The overhead costs must be assigned to each product based on the proportion of total machine hours used to produce each product.

For example, if the company uses 60% of the total machine hours to produce Product A and 40% to produce Product B, then 60% of the factory overhead costs would be allocated to Product A and 40% to Product B. The company would then use the allocated overhead costs and the direct costs of material and labor to calculate the total cost of each product.

The allocation of overhead costs to each product is critical for the company to accurately determine the cost of goods sold and price its products competitively. The company can use an allocation method to ensure a fair and accurate picture of the costs of producing each product.

How to Do Cost Allocation in Simple Steps?

Cost allocation can be complex, but it doesn’t have to be. Here are five simple steps for cost allocation:

Step 1: Identify the Costs That Need to Be Allocated

The first step in cost allocation is identifying the costs that need to be allocated. This includes both direct and indirect costs. Direct costs can be easily traced to specific products or services, while indirect costs, such as rent and utilities, cannot.

Step 2: Choose the Appropriate Method of Cost Allocation

Once you have identified the costs that need to be allocated, the next step is to choose the appropriate cost allocation method. The most common methods include direct cost allocation, step-down allocation, sequential allocation, and activity-based costing. The method chosen will depend on the nature of the costs and the objectives of the cost allocation process.

Step 3: Determine the Allocation Base

The allocation base is the basis on which the costs will be allocated. This can be the number of units produced, the number of employees, or any other relevant factor that can be used to determine the cost of goods or services.

Step 4: Allocate the Costs

Once you have determined the allocation base, the next step is to allocate the costs. This can be done by dividing the total cost by the number of units, employees, or another relevant factor and multiplying this by the number of units, employees, or another relevant factor for each product, service, or department.

Step 5: Review and Adjust the Cost Allocation

Once the costs have been allocated, the final step is to review and adjust the cost allocation as necessary. This may involve reallocating costs based on new information or changes in the business.

Which Industries Can Cost Allocation Be Applied?

With the proper guidance, cost allocation can be applied to almost any industry. It’s all about the data you have and how you use it.

Let’s take a look at some of the industries that could benefit from cost allocation:

The healthcare industry is one of the most expensive in the world. It is also one of the most heavily regulated. These factors make cost allocation a necessity for many healthcare providers.

Healthcare organizations have many different costs, but the most significant sources are labor and supplies. Labor costs can be very high in this industry because it requires highly skilled people to perform various tasks, including surgery, patient care, and patient education. Supplies like bandages and IV bags are also expensive because they have to be sterile and meet regulatory requirements.

A hospital’s supply department has much control over its budget, but it also has little control over what happens in other departments, such as surgery or patient care. This makes it difficult to allocate costs accurately when they don’t know how much they will spend on supplies or how many patients they’ll see each year.

Cost allocation helps solve these problems by allowing managers to see which departments are consuming the most resources. They can adjust accordingly without guessing what’s happening behind closed doors (or behind locked doors).

Manufacturing

The manufacturing industry is one of the most common places where cost allocation can be applied. In this industry, it is crucial to know how much it costs to make each product and how much it costs to produce goods (including materials and labor) for sale.

With this information, manufacturers can determine how much they need to charge for their products to cover all of their expenses, including overhead costs like rent or electricity bills.

Cost allocation can also help manufacturers determine which products are more profitable than others so that they can focus on those areas instead of wasting time and money on less popular lines of goods. For example, suppose a company produces clothing and electronics but finds its clothing line more popular among consumers than its electronics line.

In that case, it may want to stop producing electronics altogether because there would need to be more demand for these products for them to make any money off of them.

This is an industry that benefits from cost allocation. Energy companies have long been able to allocate costs to different projects and branches, but they often face challenges when assigning overhead expenses. That’s because overhead costs are shared among the company’s functions, making them difficult to track.

Cost allocation software can help energy companies assign overhead expenses in a way that makes sense for each project or branch. The software also allows them to better understand where their money is going and gives them more flexibility in budgeting and forecasting future expenses.

Retailers are a great example of an industry that can benefit from cost allocation.

Retailers are often sold on the idea of one-stop shopping: you go to a store and buy everything you need, from clothing to food to furniture. But in reality, there are many different types of retailers, such as grocery stores, department stores, clothing stores, etc. And each has its own distinct set of costs for running that type of business. So how do these retailers know how much each product line contributes to their overall profits? They use cost allocation.

Cost allocation is a technique for allocating overhead costs across product lines based on their relative importance to the company’s overall performance. This way, retailers can determine which products contribute most (or least) to their bottom line and make decisions accordingly.

Information Technology

Information technology (IT) is one of the most significant cost allocation areas. IT costs are often divided into two categories: direct costs and indirect costs. The former refers to those costs that can be directly attributed to a particular project or product, while the latter refers to those costs that cannot be directly attributed.

Cost allocation in IT has many benefits. It helps managers determine how much it costs to develop a new product or service and where inefficiencies lie in their IT departments.

It also allows them to understand better how much revenue they’re generating from each product or service line, which will help them make better decisions about future investments in the company’s infrastructure.

Construction

This is one of the most apparent industries to apply cost allocation. Construction projects are often massive and complex, with many different stakeholders involved in the planning, execution, and completion of a project. It’s common for construction projects to have hundreds or thousands of contracts with hundreds or thousands of different suppliers.

Cost allocation helps ensure that those involved in the project are paid what they’re owed without overpaying anyone else who participated. It’s also used to ensure that a company only spends a little money on a project by ensuring that every expense is only charged once.

Transportation

This is the industry that can benefit the most from cost allocation.

Transportation has many parts that must work in unison to transport goods or passengers. It can be difficult to determine which part of a vehicle’s operation should be allocated to specific parts, and it usually requires a lot of math.

Cost allocation can make it easier for companies in this industry to understand which parts are costing them more than they expected so that they can make changes accordingly.

Food and Beverage

Food and beverage companies can benefit significantly from cost allocation. These companies are typically comprised of many different departments that must be managed to ensure the entire business runs smoothly. Each department has specific costs that it incurs, so allocating those costs among all of the departments will help you understand where your money is going and how it can be used most effectively.

Cost allocation is also helpful when dealing with food or beverage products because it allows you to track the costs associated with each product line and make sure you profit on every product line. This way, you know what kinds of products are selling well, which ones aren’t selling as well, and how much money each product line has made for your company.

Real Estate

This is one of the most common industries to use cost allocation methods. Real estate developers often create multiple project phases, which must be accounted for separately. The costs of these phases are usually allocated to determine how much profit (or loss) will be made in each phase.

This lets developers decide which phases should be completed first and what incentives may be offered to convince buyers to purchase units from those phases.

Utilities are another excellent example of an industry where cost allocation can be used.

They must deal with various costs, including purchasing raw materials, paying for labor, and buying equipment. The type of utility and the sector it operates in determine the cost of each of these. For example, a water utility may have very high costs for purchasing raw materials but low costs for labor and employee benefits because they only need a few employees or benefit packages.

Cost allocation can help utilities determine how much money they should spend on each part of their business so that they’re not overspending on one part while underinvesting in another.

Pros of Cost Allocation

Cost allocation is a common business practice. Companies use it to help determine the profitability of individual products, services, and departments within a company. Here are the pros of cost allocation:

Improved Decision Making

Cost allocation helps businesses make informed decisions by accurately determining the cost of goods or services. Companies can make informed decisions on pricing, production, and marketing strategies with a better understanding of the costs associated with producing a product or offering a service.

Better Resource Allocation

Cost allocation helps businesses to determine the costs associated with different departments, products, or services. This information can then be used to allocate resources more efficiently and allocate more resources to more profitable areas.

Increased Profitability

By allocating costs accurately, businesses can identify less profitable areas and make changes to improve profitability. This could involve reducing costs, improving efficiency, or adjusting pricing.

Better Budget Planning

Cost allocation helps businesses to create more accurate budgets. Companies can plan their budgets more effectively as they understand the costs associated with each product, service, or department.

Improved Internal Control

Cost allocation helps businesses to maintain better internal control over their operations. By allocating costs accurately, companies can track expenses and identify improvement areas. This helps to prevent fraud and embezzlement and increases accountability within the company.

Better Understanding of Overhead Costs

Overhead costs can be challenging to understand and allocate accurately. Cost allocation helps businesses to understand these costs better and allocate them to the proper departments or products. This allows companies to make informed decisions on pricing and production.

Improved Cost Reporting

Cost allocation helps businesses to produce more accurate cost reports. This allows companies to make informed pricing, production, and marketing strategies decisions. Cost reports are also essential for tax purposes and to meet regulatory requirements.

Better Negotiations

Cost allocation helps businesses to understand their costs better, which can be used in negotiations with suppliers and customers. Companies can better understand costs and negotiate better prices, terms, and conditions with suppliers and customers. This helps businesses to maintain better relationships and increase profitability.

Cons of Cost Allocation

Cost allocation can be an excellent tool for helping you understand where your money is going and how to save it, but this method has some drawbacks.

Time-Consuming Process

Cost allocation can be time-consuming and requires significant effort from various departments within the company. This can divert resources from other important tasks and may slow down other processes.

Increased Complexity

Cost allocation can be complex, especially for large organizations with multiple departments and products. This complexity can result in errors and misunderstandings, negatively impacting the accuracy of cost reports and other important financial information.

Implementing a cost allocation system can be expensive and require a significant investment in technology, software, and training. This cost can be a barrier for smaller organizations or those with limited resources.

Unreliable Data

Cost allocation is only as accurate as the data used in the process. Poor quality data, errors in data entry, and outdated data can all result in inaccurate cost reports and inefficient resource allocation.

Resistance to Change

Some employees may resist implementing a cost allocation system, especially if they feel the process may negatively impact their department or lead to job loss.

Limited Flexibility

Cost allocation systems are often rigid and lack the flexibility to adapt to changes in business conditions. This can result in inefficiencies and limit the ability of the company to respond to new opportunities or challenges.

Potential for Misallocation

If not implemented correctly, cost allocation can misallocate costs, negatively impacting decision-making and profitability.

Dependence on Cost Allocation

Overreliance on cost allocation can lead to a lack of creativity and initiative within departments. Employees may become too focused on cost allocation and need to be more focused on driving innovation and growth for the company. This can limit the ability of the company to adapt to changing market conditions.

Frequently Asked Questions- Cost Allocation in Accounting

What are the main objectives of cost allocation.

The main objectives of cost allocation are to accurately determine the cost of goods or services, improve resource allocation, increase profitability, create more accurate budgets, improve internal control, and provide better cost reporting.

What Is Direct Cost Allocation?

Direct cost allocation refers to assigning costs directly to specific products or services. This method is used when the costs can be easily traced to specific business areas.

What Is Step-Down Allocation?

Step-down allocation refers to allocating costs from one department to another department or product. This method is used when costs cannot be directly traced to specific products or services.

What Is Sequential Allocation?

Sequential allocation refers to allocating costs based on the sequence in which they are incurred. This method is used when costs cannot be directly traced to specific products or services.

What Is Activity-Based Costing?

Activity-based costing refers to allocating costs based on the activities involved in producing a product or offering a service. This method is used when multiple activities are involved in creating a product or service.

Why Is Cost Allocation Important for Businesses?

Cost allocation is essential for businesses as it helps them understand the costs associated with each business area and make informed pricing, production, and resource allocation decisions. This leads to improved profitability and better resource allocation.

How Does Cost Allocation Impact Resource Allocation?

Cost allocation helps companies determine the costs associated with each department, product, or service, which are used to allocate resources more efficiently. By allocating resources based on accurate cost

How Does Cost Allocation Impact Pricing Decisions?

Cost allocation helps companies understand the costs associated with each product or service used to make informed pricing decisions. By accurately determining the cost of goods or services, companies can ensure that their pricing is based on a solid understanding of the costs involved.

The Comprehensive Guide to Cost Allocation in Accounting – Conclusion

Allocation of costs is a critical component of any business. By allocating costs, you can ensure that your company makes the best use of its resources and operates efficiently.

The ability to allocate costs allows you to make strategic decisions about your business’s operations and management and take appropriate actions regarding financial reporting.

The Comprehensive Guide to Cost Allocation in Accounting – Recommended Reading

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 Updated: 5/19/2023

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Cost Allocation: The Key to Understanding Financial Efficiency

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cost allocation

Cost Allocation Definition

Cost allocation is a financial accounting process that involves assigning various costs incurred by a business to the specific activities or elements used or benefitted from incurring these costs. Its purpose is to accurately represent the financial contribution of different parts of a business, providing insights into areas of efficiency or inefficiency, ultimately contributing to pricing and strategic decisions.

Methods of Cost Allocation

There are several methods of cost allocation that organizations can employ, each with their own merits and applications based on the specific circumstances, requirements, and objectives of the business.

Direct Allocation

Direct allocation, sometimes referred to as the direct method, is the most straightforward approach to cost allocation. Simply put, this method entails assigning costs directly to the appropriate cost objects, such as departments, products, or services, without taking into account whether those costs were incurred by multiple cost objects.

This method is predominantly used in situations where it is relatively easy to identify the specific cause-and-effect relationship between incurred costs and cost objects. Thus, it is particularly suitable for settings where resources are worn-out by specific departments, products, or services.

Step-Down Allocation

In contrast to direct allocation, the step-down method, also known as the sequential method or the stair-step method, allows for a more comprehensive spread of costs. This method begins with allocating the costs of the service department that provides the most services to other service departments. The total cost of each service department, including the allocated costs, is allocated step-by-step until all service departments have been allocated.

The step-down method is useful in situations where there are multiple service departments and some serve others more than they are served. It allows for a more distinct tracing of costs, improving the accuracy of indirect cost allocation. However, it can be somewhat arbitrary in terms of deciding which department's costs should be allocated first.

Reciprocal Allocation

The reciprocal allocation method, also known as the simultaneous or algebraic method, is the most accurate and complex of the allocation methods. It accurately accounts for the mutual services provided among service departments.

The use of reciprocal allocation is recommended in situations where an organization has service departments that provide significant amounts of mutual services to each other. Although it requires a certain level of mathematical sophistication, this level of detail and precision can yield more accurate cost assignments and can facilitate better decision-making.

Remember, the key is for an organization to select the method that best fits its unique settings, demands, and operational stipulations. Each method has its own strengths and weaknesses, and hence a well-informed decision is critical to optimally assign costs and enhance economic efficiency.

Criticality of Cost Allocation

Understanding the criticality of cost allocation goes beyond just marking it as a method of sharing costs. It plays a substantial role in the effective operation of a business in various ways:

Accurate Product Cost

One of the main benefits of cost allocation is achieving accurate product cost. With costs properly allocated, the actual costs incurred in producing a given product or service are easily identifiable. This not only facilitates pricing decisions, but also measures the profitability of each product or service. An inaccurate cost allocation can lead to distorted product costs. This could mean over-pricing, which can discourage customers, or under-pricing, which could lead to business losses.

Operational Efficiency

Cost allocation assists in measuring operational efficiency. For example, if a particular department is consistently exceeding its allocated budget, it might be a sign that the operations in that department are not as efficient as they should be. Management can then delve into the department's operations to identify and rectify the inefficiencies. By allocating and reviewing costs, businesses can highlight areas of wastage, inefficiency, and potential improvement.

Meaningful Financial Reports

Lastly, cost allocation supports the generation of meaningful financial reports. Such reports provide deep insights to stakeholders – be it managers, investors, or creditors. They relay important information about business performance, profit generation, asset utilisation and cost management. Without proper cost allocation, these reports could be misleading, making it difficult for stakeholders to make informed decisions.

In conclusion, cost allocation is not merely an accounting formality, but a tool that can significantly impact a company's ability to accurately price products, operate efficiently, and provide meaningful financial information. Its criticality in business operations cannot be overstated.

Cost Pools and Cost Drivers in Cost Allocation

In cost allocation, consistency and accuracy are paramount. And two concepts play a significant role in ensuring this: Cost Pools and Cost Drivers .

Role of Cost Pools in Cost Allocation

Cost pools are essentially aggregations of individual costs that relate to a specific task or factor. They play an essential role in simplifying the cost allocation process. Rather than assigning may individual costs to specific products, services, or departments, firms organize these costs into cost pools that can be allocated based on a common denominator – the cost driver.

Role of Cost Drivers in Cost Allocation

Cost drivers are the actual basis upon which these costs are allocated. They are units of activity or volume that cause a business to incur costs. Typical cost drivers include direct labor hours, machine hours, or units produced. Cost drivers serve as a measure of resource consumption and establish an ongoing basis of measurement for the cost pool.

Connection Between Cost Pools and Cost Drivers

The allocation of cost pools across different departments or products is driven by these cost drivers. In essence, cost drivers provide the linkage between the collected costs (cost pools) and the segments to which those costs are assigned. They provide a consistent basis for distributing costs in the cost pool to the relevant cost objects.

Selecting Appropriate Cost Drivers

Choosing the right cost driver is crucial for accurate cost allocation. Firms should select cost drivers that have a strong correlation with the root cause of costs. This is often derived through a cause-and-effect relationship. For instance, if a factory's costs are primarily driven by machine operations, then 'machine hours' might be an appropriate cost driver.

Likewise, if a service-based organization incurs more costs due to labor, 'labor hours' could serve as the key cost driver. Firms need to ensure that chosen cost drivers reflect a degree of variance. If certain costs have little variability, regardless of changes in the driver, that driver may not be appropriate.

In summary, cost pools and cost drivers are critical elements of the cost allocation process. They enable firms to aggregate related costs and to distribute them in a consistent, fair manner based on a measurable factor. The careful selection of cost drivers ensures that costs are allocated in a way that accurately reflects the realities of an organization's operations.

Cost Allocation in Decision Making

Cost allocation in decision making is integral to multiple areas of a business. A few of these areas, such as pricing, budgeting, and investment decisions, leverage cost allocation heavily.

Role of Cost Allocation in Pricing

In most businesses, pricing decisions directly involve cost allocation. To competitively price a product or a service, firms must divide the total costs into units of a product or service. This process allows them to determine the minimum price to cover the costs and achieve the desired profit margin.

For instance, a manufacturing company using varied types of raw materials, labor, and machinery might initially find it difficult to ascertain the price of one finished unit. Cost allocation, however, provides a mechanism to allot each cost element to each unit. Thus, unit costs drive the ultimate pricing decisions and influence the firm's competitiveness in the market place.

Impact of Cost Allocation on Budgeting

Cost allocation affects budgeting, virtually shaping every financial decision a company makes. Businesses, with clarity on cost division across departments, processes, or products, can plan budgets more effectively. They can identify which areas are cost-intensive and adjust the budget proportionately. Without the right cost allocation, a budget may not accurately reflect the financial resources needed or generated by different business segments.

For example, an IT company might allocate shared costs like server expenses, software license fees, and maintenance costs based on the users or usage in different departments. This allocation helps formulate realistic budgets, ensuring cost efficiency and operational effectiveness.

Cost Allocation and Investment Decisions

Investment decisions constitute another crucial area where cost allocation aids informed decision-making. When evaluating the profitability of an investment opportunity, whether it’s a new project, acquisition, or expansion, companies must understand the associated costs thoroughly.

By correctly allocating costs, companies can more accurately calculate potential returns, leading to more informed investment decisions. Misplacing or underestimating costs might mistakenly make an unprofitable investment appear profitable, resulting in detrimental financial outcomes.

In summary, the process of cost allocation serves to bridge the gap between operational activities and financial management. This linkage is vital in making strategic business decisions, from setting product prices to planning budgets to making investment decisions. Therefore, understanding cost allocation is fundamental to business' financial success.

Challenges and Criticisms of Cost Allocation

Despite their usefulness, implementing cost allocation methods can often be fraught with several challenges. Some of these obstacles are intrinsic to the process of allocation, such as the complexity of accurately tracing costs to specific cost objects and the subjectivity inherent in some allocation bases.

Arbitrary Allocation

One frequent criticism is the arbitrariness of some allocative decisions. For instance, in the allocation of indirect costs, the choice of allocation base (e.g., labor hours, machine hours, etc.) can be somewhat subjective. Some critics argue that this introduces a degree of arbitrariness that may distort the true cost picture.

While there is no perfect solution to this problem, efforts can be made to ensure that the chosen allocation bases are logical and justifiable given the nature of the costs being allocated. Some organizations may also choose to use multiple allocation bases for different types of costs to minimize this arbitrariness.

Overemphasis on Full Costing

Another criticism of cost allocation is its overemphasis on full costing. Full costing attempts to assign all costs, both direct and indirect, to cost objects. However, this approach can lead to the inclusion of irrelevant costs in decision-making processes, which might not add any value. For example, the inclusion of fixed costs, which are incurred regardless of the level of output, may not be helpful in short-term pricing decisions.

In response to this, some firms might opt to use variable costing as a supplement, which includes only those costs that change with production volume. This can provide a more relevant basis for operational and tactical decision-making.

The Use of Assumptions

Different cost allocation methods rely on different assumptions. These assumptions may not always hold true and can lead to inaccurate cost data. For example, the assumption of cost homogeneity in a cost pool may lead to inappropriate allocations if the costs in the pool are driven by different activities.

To mitigate this, it's essential to carefully examine and validate the assumptions underlying a chosen allocation method. Continuous review and refinement of cost pools and allocation bases can also help in keeping allocations realistic and meaningful.

Inaccurate Estimations

Cost allocations also rely heavily on estimations. Inaccurate estimations can lead to over or under-allocation of costs.

To address this challenge, organizations can develop robust estimation methods and validate their cost estimates periodically. This will not only reduce inaccuracies but also enhance the credibility of the cost data generated.

In conclusion, while cost allocation is not without its challenges and criticisms, these can be managed and mitigated through thoughtful and informed management practices. Regular reviews and audits, coupled with the use of technological tools for data collection and analysis, can further enhance the accuracy and relevance of cost allocation in an organization.

Principles of Cost Allocation within a Business Entity

Cost allocation within a business entity should uphold certain principles for the process to be fair, efficient, and effective. The guiding principles of cost allocation are causality, benefits received, fairness, and ability to bear.

Causality refers to the direct correlation between costs incurred and the activities leading to them. When a certain activity or set of activities within an organization results to specific costs, the principle of causality suggests that these costs should be allocated to that activity or activities. This kind of cost allocation allows businesses to link each cost with the function that drives it, making it easier to manage costs and improve profitability.

Benefits Received

The principle of 'benefits received' posits that costs should be shared among departments or units depending on the extent to which they benefit from the cost pool. If a department derives more value from a resource or service, then it should bear a higher proportion of the cost. Consequently, such a sideways view of cost allocation can incentivize departments to be more efficient in how they use shared resources or services.

Fairness is a crucial principle in cost allocation. The goal is to distribute costs in a manner that all departments or units perceive as just. This rarely means each department pays an equal share of the costs; rather, the distribution takes into account factors like usage, value derived, and department size. Unfair allocation could demoralize departments or units, leading to internal conflicts and reduced productivity.

Ability to Bear

The 'ability to bear' principle suggests that costs should be allocated considering the unit's capacity to absorb the cost. Here, larger or more profitable departments may shoulder a larger share of the costs. However, it is important that the application of this principle does not stifle the growth potential of smaller or less profitable units.

These principles aim to allocate costs in a way that reflects the operational realities of an organization while promoting fairness and operational efficiency. By adherently diligently to these principles, an organization can ensure a seamless and fair cost allocation process.

Cost Allocation and Its Implications on CSR and Sustainability

Correlation between Cost Allocation and CSR Efforts

Cost allocation plays a significant role in a company's Corporate Social Responsibility (CSR) efforts. Resources, both tangible and intangible, are frequently limited within organizations. The allocation of these resources can either inhibit or promote CSR activities. If CSR is not viewed as a business priority, resources may not be allocated sufficiently to develop and implement effective initiatives. Conversely, if an organization is committed to its CSR responsibilities, it will allocate costs accordingly to ensure its efforts are adequately funded and supported.

Inappropriately allocating costs could lead some stakeholders to wrongly believe that an organization is not committed to its CSR responsibilities. Therefore, cost allocation not only influences the actual implementation of CSR measures but also political and public perceptions of an organization’s ethical and social responsibilities.

Impact of Cost Allocation on Sustainability Measures

Sustainability measures are another key area impacted by cost allocation. When it comes to sustainability reporting, cost allocation is essential. The amount of funds set aside for these initiatives can boost a company's green programs or alternatively limit their scope. This can vary from energy-efficient modifications to the infrastructure, reduction in waste production to policy changes that minimize an organization’s environmental footprint.

The strategic decision-making process is a critical area where the effects of cost allocation are evident. If sustainability is significant for an organization, the costs associated with these measures will likely be prioritized in strategic decisions. Leaders must consider both short-term financial implications and long-term societal and environmental impacts. Particularly, these decisions bear a direct influence on the company's reputation and sustainability.

Moreover, cost allocation decisions have a bearing on the company's external communication as well. Specifically, when it comes to issuing sustainability reports, the allocation of costs provides an explicit representation of the company's commitment to sustainable practices.

Making strategic decisions with sustainability implications in mind could increase costs in the short-term but prove beneficial and cost-saving in the long run. Therefore, it is essential that decision-makers view cost allocation as not just a financial concern but a critical aspect of their CSR and sustainability efforts.

Cost Allocation as a Reflection of Organizational Priorities

Through the lens of CSR and sustainability, the implications of cost allocation are evident in the allocation decisions made by an organization. How a company chooses to allocate its costs is a reflection of its values and priorities. If sustainability and ethics are prioritized, cost allocation will support corresponding initiatives. If not, cost allocation can inadvertently communicate non-commitment to external stakeholders, potentially adversely affecting the organization's reputation and market position.

Cost Allocation across Different Industries

Although cost allocation is a universal concept in all kinds of businesses, the way it is implemented can differ significantly between industries.

The Manufacturing Industry

For the manufacturing sector, cost allocation is primarily linked with material costs, labor costs, and overhead expenses, which are apportioned to individual products. By allocating costs following these categories, companies are better positioned to price their products accurately. For instance, in direct material cost allocation, a manufacturing company can include the expenditures related to raw materials required to produce a particular product.

However, this straightforward approach can face complications when dealing with shared or indirect costs. For example, in a factory that builds both toasters and microwaves, how would one allocate the cost of shared raw materials, like steel or energy used in the factory? It becomes even more complex with overhead costs like salaries of administrative staff and, maintenance and depreciation of machinery, where a direct relationship between the cost and product isn’t apparent.

The Service Industry

On the other hand, within the service industry, cost allocation is traditionally more abstract. Labor cost is typically the most significant category, but costs associated with physical resources, like office spaces or computer equipment, also become relevant. Unlike manufacturing, services can't inventory their output in advance of demand. Service industries often allocate costs according to service hours provided or the number of clients served, but this also raises unique challenges.

For instance, a law firm may find it challenging to allocate the cost for a lawyer who handles various cases simultaneously. Similarly, a hospital might struggle with cost allocation for shared resources, such as an MRI machine used by multiple departments. These challenges necessitate creative and fair methods to spread costs and ensure profitability.

The Retail Industry

In the retail industry, purchasing and storing inventory comprise a significant portion of costs. Transportation costs, warehouse expenses and inventory buying costs are examples of costs that are allocated across various products. However, deciding on an allocation basis can be complex. While using sales volume might seem the easiest route, it might distort cost allocation for slow-moving or seasonal products.

As seen above, the cost allocation methods differ across industries due to their operational divergences, and each faces its unique set of challenges. Therefore, it's crucial for a business to understand the approach that works best for its industry and specific situation.

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Cost Allocation: Definition, and Example on How the Cost Allocation Works

To run a profitable business, you have to make sure that your prices are high enough to cover all your expenses and give you profits at the same time. Most business and company owners use cost allocation to allocate the costs of specific items.

That includes products, departments, materials, overhead costs, etc. Cost allocation is significant for businesses of any kind. However, it is mostly used by manufacturing businesses that carry a variety of costs. 

The cost allocation process becomes important when some costs can not be attributed to a particular cost object. These expenses are spent on different items in simple words, and then the sum is divided into multiple cost objects. These expenses are basically indirect costs. In this article, we are going to discuss cost allocation, its different aspects, and how does it actually work:

Definition of Cost Allocation:

Cost allocation is the process that plays a major role in identifying, assigning, and aggregating the expenses to cost objects. A cost object is anything that requires you to measure the costs separately. Here are some examples of cost objects: products, services, departments, activities, customers, etc. 

Cost Allocation is mostly used for reporting the financial details of a business or company. It helps to distribute the costs between departments and inventory items. Cost allocation can also be used for calculating the profits at a departmental or subsidiary level. And that can be used as a basis of bonuses or for the fundings for extra activities. 

Types of Costs:

Most running businesses carry a variety of costs while doing projects and deals. And the list of costs can be very long, from the material needed to make an item to the direct labor payroll cost for the employees who ran the machines and assembled the product. 

There are three main types of costs that a business or company must define before allocating the costs to their specified cost objects: 

1. Direct Costs:

Direct costs are anything that can be directly connected to cost objects. Tied to direct production, direct costs are the only expenses that do not require any allocation. Instead, they are used while calculating the costs of sold products and services.

Here are some of the most common direct costs of a business or company: Direct Labor, Direct Materials, and Production Supplies.

Direct Labor Costs : It includes the costs for employees who are responsible for manufacturing and assembling the product. Direct labor costs are basically payrolls.

Direct Materials Costs: It includes the costs of materials that were used for making the products, such as wood, cement, and bricks for construction companies. 

Production Supplies Costs: It includes any delivery cost. 

2. Indirect Costs:

Indirect costs are the expenses that are not directly related to cost objects such as production, department, activities, etc. These are the expenses that are necessary for running a healthy business or company.

Some of the common examples of indirect costs are security, electricity, administration, etc. Indirect costs should be identified first and then should be executed. And lastly, they should be allocated to other cost objects within the business. 

Indirect costs are divided into two parts: Fixed Costs and Variable Costs

Fixed Costs: Fixed costs are costs that are allocated to a specific product or department. An example would be a supervisor who is assigned to a specific department or project.

Variable Costs: The other category of indirect costs is variable costs. Common examples for variable costs would be goods sold, raw materials and inputs to production, packaging, wages, commissions, and certain utilities like electricity, gas, etc.

3. Overhead Costs: 

Overhead costs are the expenses that are used daily to run a business or company. Overhead costs are never directly or indirectly linked to production. But instead, these are the costs that a business carries, no matter if it is selling products or services or not.

Rent, insurance, office supplies, maintenance, etc., can be considered as overhead costs. These are some of the costs that a business or company carries regardless of its production quantity.

Overhead costs such as supplies can be variable. But on the other hand, costs such as insurance, payrolls, rents are some of the fixed costs that don’t change every month.

Similar to indirect costs, overhead costs must be allocated regularly to justify the production cost.

Importance of Cost Allocation:

Here are some of the benefits of Cost Allocation:

  • Cost allocation is important for financial reporting. It helps in assigning the cost of cost objects accurately
  • Cost allocation helps businesses and companies to calculate the real profitability of particular or different departments. This profitability report helps businesses to make decisions in favor of the development of the department
  • If the cost allocation is executed accurately, it will help the business to identify and understand the costs at each stage and their impact on the profit and loss. Similarly, if somehow the allocation is turned out to be incorrect, the business might make incorrect decisions regarding the allocation of the valuable resources among the various cost objects
  • It also works in favor of customers to get a better understanding of the product or service rates
  • It helps businesses and companies to make better decisions whether they should accept a new order or not
  • Cost allocation can also be used to increase the performance of your employees
  • It is also useful for finding the transfer price when there is a transaction between two or more subsidiaries
  • Cost allocation also helps businesses and companies to determine where their money is going and in what quantity. It helps businesses to use their resources responsibly. If the money is not distributed accurately, it can affect the business’s production as well as performance

How does Cost Allocation work?

Now let’s see how does cost allocation actually work:

Identify the Costs:

As we discussed earlier, there are three types of cost: Direct Cost, Indirect Costs, and Overhead costs. Direct costs are directly related to the production process, such as labor costs, material costs, etc.

Indirect costs are the costs that are partially related to the production costs and are necessary to run a business. And lastly, overhead costs are the costs used regardless of the production of a business, such as rents, insurance, office supplies, etc. 

Identify the Cost Objects:

It is necessary to identify the cost objects before executing cost allocation. This is really important because we can not set a price for a product if we don’t have any information about it. Here are some examples of cost objects: products, services, departments, activities, customers, etc. 

Identify the Allocation Base:

Alongside the cost object, a company must identify a basis to allocate the costs. The basis could be the headcount, insurance, rent, number of hours, etc. 

Collect the Costs into a Cost Pool:

Once you have identified the costs, cost objects, and the allocation basis, not it’s time to categorize them into cost pools. This is the account head where the costs should be accumulated before being distributed to the cost objects. 

Example of Cost Allocation:

Here is an example of Cost Allocation:

Let’s assume A owns a manufacturing business and has an administrative office. The main office is 3,000 square feet, and the administrative office is 1,500 square feet.

The rent for the entire office is $10,000 each month. The rent must be allocated based on these two departments. 

Let’s start the calculation:

The total area would be: 

3,000 square feet + 1,500 square feet = 4,500 square feet

So the rent per square feet would be around: 

$10,000 ÷ 4,500 = $2.2

Now we have to calculate the main office rent:

$2.2 x 3000 = $6,600

Now we have to calculate the administrative office rent:

$2.2 x 1,500 = $3,300

So now the total cost that should be allocated for the rental cost would be: 

$6,600 + $3,300 = $9,900

Why should you consider using Cost Allocation?

Cost allocation is important for businesses of any size. If you have zero ideas of how much it costs to produce a product or service, how will you set a price for your products or services?

A proper cost allocation is very important for accurate financial reporting. Most business owners depend on financial reports to make decisions. If the reports are incorrect, it might affect the business negatively. So proper cost allocation is very important to run a healthy business. 

So, in this article, we discussed cost allocation and how it actually works. Cost allocation is an important process that keeps businesses in profit by allocating the costs to cost objects.

It also helps businesses find profitable gaps and areas where businesses can make a significant profit. It also helps owners make good decisions regarding the costs. 

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Cost Allocation

This page provides detailed guidance to help local governments in Washington State allocate indirect (overhead) costs, including key questions to consider and sample cost allocation plans and procedures.

It is part of MRSC’s Financial Policies Tool Kit , created in partnership with the State Auditor’s Office Center for Government Innovation .

What Is Cost Allocation?

Cost allocation refers to a process of accounting and recording the full costs of a government service by including its indirect costs or "overhead" in addition to its direct costs.

Direct costs are those that clearly and directly benefit a specific fund or program, such as supplies, materials, staff salaries and benefits, or consultant fees that support a single department or project.

Indirect costs , commonly referred to as "overhead costs" or central services, are for support services that are shared by multiple departments, programs and/or funds, such as accounting, payroll, administrative, or human resource salaries and benefits; information technology (IT) services for the entire municipality; or operating and maintenance costs for city hall or other buildings shared by multiple departments.

For example, the full cost of the Public Works Department includes its direct costs (wages, benefits, maintenance, and operations) plus the indirect costs/"overhead" of support services received from central services (such as accounting, payroll, and IT).

A cost allocation plan distributes these indirect costs to ensure that the respective funds are fairly and accurately paying for the services they receive.

Why Do Local Governments Allocate Costs?

There are a number of reasons that a local government should develop a cost allocation plan or system. A formal cost allocation system can help a jurisdiction:

  • Identify the actual cost of services being provided to the citizens.
  • Equitably share the costs of shared facilities and support services between departments, programs, and funds throughout the organization.
  • Ensure accuracy of cost-based user fees for public services such as utilities, development review, parks, or any other service where the user pays a fee for service.
  • Relieve pressure on the general fund by allocating certain general fund costs to enterprise or other funds that receive a benefit from support services.
  • Comply with state law and minimize audit issues. RCW 43.09.210 requires that all service rendered by one department to another shall be paid for at its true and full value by the department receiving the service, and that no department shall benefit in any financial manner whatever by an appropriation or fund made for the support of another.
  • Get reimbursement for allowable overhead costs from federal and state grants, to the extent that this is allowed by the grant. This usually requires a formal cost allocation plan with internal controls to assure accuracy. Federal monies require strict adherence to OMB’s Uniform Guidance (2 CFR 200) .

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

Step 1: Identify Shared Facilities or Support Services

Your jurisdiction should allocate costs for any services, staff, facilities, or equipment that benefit other funds or departments. Identify within central services or internal service departments any specific services that support multiple funds or departments (such as payroll, accounts payable, utility billing, and facilities and grounds maintenance).

For the purposes of this cost allocation methodology, these costs are referred to as indirect costs or "overhead."

Key questions to consider:

  • What staff members or departments support multiple funds or programs? Common examples for smaller jurisdictions include finance directors, clerks/treasurers, payroll clerks, and facility maintenance staff. For larger jurisdictions, this may also include categories like city administrators, attorneys, human resources, and IT.
  • What contracted services support multiple funds or departments? For instance, do you contract with a technology firm to provide IT services to your entire jurisdiction? Have you hired a company to maintain shared facilities or grounds?
  • What facilities and equipment are used by multiple departments or programs? Are all of your departments and programs located in one central services or public works facility? Did you purchase a piece of equipment (such as a vehicle or a copier) that will be used by multiple departments?
  • How should costs be allocated to your enterprise (utility) funds? Utility funds and other funds with restricted revenue sources should only reimburse for the actual benefit received from the services provided by other funds such as the general fund, internal service funds, motor pools, IT services, and others.
  • Should you allocate costs associated with your elected officials? When considering whether to allocate these costs to restricted funds such as utilities, use extreme caution. The SAO will require documentation to support the fairness of these charges. Do the elected officials devote time every meeting to those enterprise activities? Consider using agenda items as the basis for allocating these costs.

Step 2: Identify Costs

Once you have identified these shared "overhead" functions, compile their total costs using timesheet data or other accounting of actual expenditures associated with this activity.

You can also allocate shared costs using budget projections, although in that case you should include a monitoring component at the end of the year to make sure the budget and the actual costs are within an acceptable range. If you are using projections, the cost allocation plan should define what the "acceptable range" is. For instance, the plan might state that the actual costs must be within 1% of the budgeted costs, or 5%, or somewhere in between.

For instance, below are two simple, fictional examples of cost allocation processes for payroll and facility maintenance.

Example A: Calculating Payroll Costs

The payroll department conducts payroll for all departments, so payroll costs can and should be allocated. To calculate the total cost of providing payroll services, you must calculate the number of hours that each staff member spends on payroll. The most accurate method of calculating this is to use timesheet data. Record the hours each staff member spent on the payroll function, along with their hourly pay rates and the prorated costs of benefits for those employees. Only include payroll hours - if the staff members providing payroll services also perform other duties, do not include the other duties.

If you do not have this level of timesheet data, it will be important to establish a process for hourly timesheet reporting over multiple pay periods to ensure accurate data collection. Conduct a periodic timesheet analysis to determine how the payroll staff spend their time over the course of a typical period (such as a quarter) and update this analysis at least once or twice a year.

Example B: Calculating Facility Maintenance Costs

Use the same method to calculate the maintenance costs for facilities that are shared by multiple departments. This example is for a hypothetical City Hall. Be sure to include the costs of materials and any contractors that provide janitorial or other facility maintenance services.

Step 3: Determine Allocation Factors

Next, determine a fair and equitable way to spread those costs among the various departments, funds, or programs that benefit from the shared services. Use numbers that are easy to gather or estimate and that can be easily updated in the future to keep the cost allocation plan current.

Remove any costs that should not be allocated, costs that can be assigned directly, and any other agreed upon revisions that do not diminish the "cost-basis" of the plan.

  • Payroll and personnel: Number of full-time equivalents (FTEs) or number of hours worked within each department or fund.
  • Accounts payable/purchasing: Number of transactions for each department or fund.
  • Financial reporting and budgeting: Budget appropriation levels or year-end fiscal totals.
  • Facility operations and maintenance: Square footage or number of employees in the building for each department or fund.
  • Information technology: Number of computers, servers, databases, etc. for each department or fund
  • How will you document the cost estimates? For instance, when allocating wages, salaries, and benefit costs for services such as payroll, budget development, or financial reporting, conduct a periodic timesheet analysis.

Example A (Continued): Determining Payroll Allocation Factor

Payroll costs largely depend on the number of employees your jurisdiction has, so the allocation factor is typically full-time equivalent (FTE) positions. This means that the cost of the payroll function is allocated to the different departments based on the number of FTEs within each department.

Example B (Continued): Determining Facility Maintenance Allocation Factor

Facility maintenance costs depend in large part on the size of the facility, so the allocation factor for facilities maintenance is typically square footage (SF). This means that the facility maintenance costs for City Hall are allocated based on the number of square feet that each department occupies.

Step 4: Allocate Costs

Next, allocate the costs by applying the allocation factors to each department, program, or fund based on their proportionate share (a "one-step" methodology). Again, be sure to thoroughly and consistently document your calculations.

Larger or more complex organizations would typically use either a "two-step" methodology (allocating overhead costs to direct users and to those departments that use the services of the direct users) or reciprocal allocation methodology (allowing for overhead to be allocated back and forth between departments).

Example A (Continued): Allocating Payroll Costs

The payroll overhead costs are being allocated on the basis of FTEs per department. The following chart shows what that might look like based on the size of the departments in this example.

Note that the Finance and Payroll Department cannot allocate all of the payroll costs to other departments and must retain some of those costs internally, because some of the time is spent on payroll for employees within the department.

In this example, Finance and Payroll would retain $1,270 of the payroll costs and allocate the remaining costs to the other departments.

Example B (Continued): Allocating Facility Maintenance Costs

The facility maintenance costs for City Hall are being allocated on the basis of square footage per department. The following chart shows what that might look like based on the how much space each department occupies within City Hall.

Step 5: Update and Monitor the Data and Methodology

You should periodically review your cost allocation formulas and data to make sure they continue to accurately reflect costs. Incorporating an annual review as a pre-budget development step will help enhance your budget forecasting numbers and update your cost methodology.

Key Questions to Consider:

  • What are your internal controls to ensure data accuracy and reviews? Incorporating internal control measures into the cost allocation plan demonstrates a commitment to accurate and reliable data.
  • Did you use estimates or budget projections (as opposed to actual costs) in your allocation process? If so, you should include a monitoring component at the end of the year to make sure that the estimated and actual costs are within the acceptable range as defined by your cost allocation plan. Any variances outside of the acceptable range will require adjustment.
  • How often will you update your calculations? You should review and update your data at least once a year, and perhaps more frequently for some figures such as public works timesheet information.

Examples of Cost Allocation Plans and Documents

Below are examples of cost allocation plans, studies, and related documents that may be useful, focusing in particular on small to mid-size jurisdictions.

Cost Allocation Plans, Policies, and Studies

  • Arlington Cost Allocation Policy (2017) - on pages 31-32 of the comprehensive financial policies
  • Bainbridge Island Cost Allocation Manual (2017) - Detailed goals, background, and methodology for the city’s cost allocation plan.
  • Bremerton Overhead Cost Allocation Memo (2012) - Recommendations from the city auditor on how to improve the city's cost allocation process
  • Monroe Cost Allocation Plan (2014) - Short, three-page cost allocation plan, changes city’s cost allocation method from estimated costs to a two-year "look back" method. Includes adopting resolution.
  • Napavine  Draft Central Services Cost Allocation Plan (2016) - Includes descriptions of central services and cost allocation methodology.
  • Poulsbo Indirect Cost Allocation Plan  (2012) - Easy-to-understand cost allocation methodology for all city departments and functions
  • Skagit County Central Services Cost Allocation Plan (2021) - Includes summary and detail components, financial information for internal funds, and reconciliation of net position.
  • Stevenson Cost Allocation Plan (2016) - Short, four-page cost allocation plan.

Cost Allocation RFPs

  • Kennewick RFP for cost allocation plan/comprehensive rate study (2010) - RFP for the development of a full cost allocation plan and a comprehensive fee and rate study for development-related services

Recommended Resources

Below are some useful resources from the State Auditor's Office (SAO) and Government Finance Officers Association (GFOA) to help you create an effective cost allocation system.

  • SAO Resources Database: Cost Allocation - Simple, three-page overview, including common cost allocation mistakes
  • SAO BARS GAAP Manual:  3.9.5 Overhead Cost Allocation
  • SAO BARS Cash Basis Manual:  3.9.5 Overhead Cost Allocation
  • GFOA:  Indirect Cost Allocation  (2014) - GFOA best practices
  • GFOA: Pricing Internal Services (2013) - GFOA best practices for cost allocation for internal services such as IT, payroll, legal, and HR
  • GFOA: Cost Analysis and Activity-Based Costing for Government (2004) - For-purchase publication

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Cost Allocation Base

cost allocation in accounting

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on February 27, 2023

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Table of Contents

Cost allocation base can be defined as a factor that is the common denominator for systematically linking a cost or group of costs to a cost object such as a department or an activity.

Where cost object is a product, the narrower term cost application base is often used.

Cost Allocation Base FAQs

What is a cost allocation base.

A cost allocation base is the unit, activity, or item that allocates costs in an organization. It can be used to measure and assign expenses to departments and activities accurately.

How does a cost allocation base work?

Costs are assigned to the appropriate department or activity based on the number of units of a resource consumed by each respective department or activity, such as labor hours or machine hours. The total amount of expenses for the period is then divided among the various departments and activities based on their usage patterns.

What types of costs can be allocated using a cost allocation base?

Most variable costs associated with production processes can be allocated using a cost allocation base, such as direct materials, wages and salaries, utilities, machinery, and equipment rental costs.

What are the benefits of using a cost allocation base?

Using a cost allocation base enables organizations to identify areas where costs can be reduced or controlled more efficiently. It also helps allocate accurate costs for each department or activity and provides the necessary data for pricing products and services accurately.

How often should a cost allocation base be updated?

Organizations should review their cost allocation bases regularly to ensure accuracy in allocating expenses. The frequency will depend on the size of the organization and how quickly resource consumption patterns change within that organization. Generally speaking, it is recommended to update your cost allocation base at least once a year.

About the Author

True Tamplin, BSc, CEPF®

True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.

True is a Certified Educator in Personal Finance (CEPF®), author of The Handy Financial Ratios Guide , a member of the Society for Advancing Business Editing and Writing, contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University , where he received a bachelor of science in business and data analytics.

To learn more about True, visit his personal website , view his author profile on Amazon , or check out his speaker profile on the CFA Institute website .

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  • Direct Costs and Indirect Costs
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Cost allocation is the process by which the indirect costs are distributed among 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.

Cost allocation is important for both pricing and planning and control decisions. If costs are not accurately calculated, a business might never know which products are making money and which ones are losing money. If cost are mis-allocated, a business may be charging wrong price to its customers and/or it might be wasting resources on products that are wrongly categorized as profitable.

Cost allocation is a sub-process of cost assignment , which is the overall process of finding total cost of a cost object. Cost assignment involves both cost tracing and cost allocation. Cost tracing encompasses finding direct costs of a cost object while the cost allocation is concerned with indirect cost charge.

Steps in cost allocation process

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.

Cost object

A cost object is an item for which a business need to separately estimate cost.

Examples of cost object include a branch, a product line, a service line, a customer, a department, a brand, a project, etc.

A cost pool is the account head in which costs are accumulated for further assignment to cost objects.

Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For example if a company uses just one allocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturing overheads. However, if it uses more specific cost allocation bases, for example labor hours, machine hours, etc. it might define narrower cost pools.

Cost driver

A cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost.

Examples of cost driver include:

  • Number of payments processed can be a good cost driver for salaries of Accounts Payable section of accounting department,
  • Number of purchase orders can be a good cost driver for cost of purchasing department,
  • Number of invoices sent can be a good cost driver for cost of billing department,
  • Number of units shipped can be a good cost driver for cost of distribution department, etc.

While direct costs are easily traced to cost objects, indirect costs are allocated using some systematic approach.

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.

T2F is a university café owned an operated by a student. While it has plans for expansion it currently offers two products: (a) tea & coffee and (b) shakes. It employs 2 people: Mr. A, who looks after tea & coffee and Mr. B who prepares and serves shakes & desserts.

Its costs for the first quarter are as follows:

Total tea and coffee sales and shakes sales were $50,000 & $60,000 respectively. Number of customers who ordered tea or coffee were 10,000 while those ordering shakes were 8,000.

The owner is interested in finding out which product performed better.

Salaries of Mr. A & B and direct materials consumed are direct costs which do not need any allocation. They are traced directly to the products. The rest of the costs are indirect costs and need some basis for allocation.

Cost objects in this situation are the products: hot beverages (i.e. tea & coffee) & shakes. Cost pools include rent, electricity, music, internet and wi-fi subscription and magazines.

Appropriate cost drivers for the indirect costs are as follows:

Since number of customers is a good cost driver for almost all the costs, the costs can be accumulated together to form one cost pool called manufacturing overheads. This would simply the cost allocation.

Total manufacturing overheads for the first quarter are $19,700. Total number of customers who ordered either product are 18,000. This gives us a cost allocation base of $1.1 per customer ($19,700/18,000).

A detailed cost assignment is as follows:

Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000

Manufacturing overheads allocated to Shakes = $1.1×8,000

by Irfanullah Jan, ACCA and last modified on Jul 22, 2020

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Home » Guidance » Cost Allocation and Indirect Cost Rate Frequently Asked Questions

Cost Allocation and Indirect Cost Rate Frequently Asked Questions

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Economic uncertainty and constraints are recurring challenges that State, Local, Tribal and Not-for-Profit organizations face. Cherry Bekaert and our team of subject matter experts (many of whom have walked in your shoes serving the public) are here to help you better understand your true cost, revealing insights that will help you plan for a sustainable economic future, and save you time so that you can stay focused on the bigger picture. To guide you forward, we’ve put together this FAQ document in the spirit of spreading information and understanding on the Cost Allocation Plan and Indirect Cost Rate concepts.

Q: When should an agency obtain a cost allocation plan?

A: All agencies that have multiple service lines should always have a cost allocation plan.

Q: How is the cognizant agency determined?

A: The cognizant agency is the agency providing the largest sum of funding. Note that your cognizant agency remains the same until funding from another agency is greater for five years, at which point your cognizant would change.

Q: Once you have a Negotiated Indirect Cost Rate Agreement (NICRA) approved with your cognizant agency, does it apply to grants from other federal agencies?

A: Yes, once you’ve received a NICRA, all other federal and state agencies must accept it, even if you are a subrecipient. See 2 CFR Part 200 Subpart E (200.414) .

Q: What’s the difference between an “Admin Cap” and the use of a NICRA?

A: The NICRA represents agency-wide indirect cost, such as finance, HR, etc., whereas the Admin Cap is defined as overhead to programs, e.g., supervisors overseeing a program(s). For example, a finance analyst that is responsible for overseeing a few grants (20% of their time) but spends the rest of their time (80%) processing payroll, 20% falls under the Admin Cap, and the remaining 80% would be part of the NICRA.

When an Admin Cap is present, refer to the Notice of Funding Availability (NOFA) to determine if a NICRA can be used in addition to the Admin Cap. If not specifically and implicitly stated that a NICRA can’t be used/is unallowed, then a NICRA is allowable in addition to the Admin Cap (i.e., it has to spell it out).

Q: Can you go back two years to claim indirect cost on past grants if you didn’t claim indirect cost to begin with?

A: Yes, and if you didn’t have a NICRA for those two years, you can still calculate one and apply it.

Q: Can your NICRA be used as the grants’ match component?

A: Yes, per OMB guidelines: 2CFR Part 200, 306.7 (C) Unrecovered indirect costs, including indirect costs on cost sharing or matching may be included as part of cost sharing or matching only with the prior approval* of the Federal awarding agency. Unrecovered indirect cost means the difference between the amount charged to the Federal award and the amount which could have been charged to the Federal award under the non-Federal entity’s approved negotiated indirect cost rate.

*Note: in order to use your NICRA as your match, it is required to notify the funder. The funder does not have the authority to deny use for match based on the guidelines.

Even if your grant disallows indirect cost, your NICRA can still be used as match.

Q: What if my cognizant says they don’t have to negotiate because I have less than $35M in direct federal funding?

A: If you have less than $35M in direct federal funding as a government agency or $10M as a nonprofit, you are not required to submit an Indirect Cost Rate Proposal (ICRP) to your cognizant. However, you are required to prepare the submission packet, including your rate, and it can be “kept on the shelf.” If a funder requires a negotiated rate, they must negotiate directly with you or accept the existing submission packet. They cannot force you to use de minimis; they must negotiate.

Q: Will application of the NICRA take funding away from the program?

A: This is a common concern and misconception. Indirect cost is incurred to run a program regardless from where that cost is funded. For most agencies, these indirect costs are subsidized by the General Fund (taxpayer dollars). It’s important to understand that indirect cost exists and may be covered by program funding or the General Fund. An agency can choose to apply the full NICRA or any percentage up to that rate, which allows the agency to make the strategic decision to fully apply the NICRA to the grant or knowingly subsidize from the General Fund.

Q: How long does the negotiation process typically take?

A: Three to six months, but the cognizant is required to negotiate within six months.

Q: Can your rate change year over year?

A: The indirect cost rate should be fairly consistent without the carry forward adjustment. The carry forward is what brings variance.

Q: How often do you have to negotiate a rate?

A: Annually, however OMB guidelines allow for a one-time extension of a current NICRA for a period of up to four years. The extension will be subject to review and approval of the cognizant agency.

Q: Can a cognizant tell me my rate seems too high?

A: No, the rate is based on audited financial statements, and they don’t have the authority to change the rate. They must accept the rate calculated as long as indirect costs included in the pool are deemed allowable by 2 CFR Part 200.

Often, perceptions are that a high rate is an indication of poor management and efficiency, therefore agencies are less inclined to negotiate the rate out of fear that the cognizant won’t approve. This is a common misconception. The rate is based on audited financials and the cognizant is more likely to approve because the agency has demonstrated an understanding of their true cost.

Q: Does having a NICRA make us more likely to win awards?

A: Yes, because it demonstrates awareness of direct and indirect cost so that you are more likely to utilize a grant to its fullest potential and have a successful program outcome. Even if your full indirect cost is not reimbursable due to grant restrictions, it informs the grantor you are aware of the subsidy necessary to fulfill the expectations of the grant.

Q: What is the most common area of the cost plan where organizations “leave money on the table”?

A: Bank Fees—many agencies do not include them. In many cases banking fees are offset from interest earned in the bank accounts so there is never an actual payment to the bank for these fees, resulting in the absence of a line-item cost in the budget. However, this cost is allowable and should be added to the cost that is spread. Also, agencies often aren’t aware that they can include the interest charged on loans/bonds or the attorney fees charged when setting up these loans.

Q: For smaller organizations, is it better for them to just get the 10% de minimis instead of doing a cost plan when you factor in time and cost of creating a cost plan?

A: It is our opinion that it is NEVER better to get the 10% de minimis. Smaller agencies can calculate a cost plan fairly simply without a lot of effort and realize a 30% to 50% indirect cost rate.

Q: Please explain matching/cost sharing.

A: Simply put, “match” is the non-federal share of costs that the grantee or the grantee’s partners are required to contribute to accomplish the purposes of the grant.

Funders have various reasons to require match. The primary reason is to share the costs of various government programs across jurisdictions or with the private sector. Funders sometimes structure match requirements to promote sustainability of projects past the life of the grant program.

Matching funds include:

  • Non-federal public or private funds
  • Funds that are not used as match for any other federal program
  • Unrecovered indirect costs
  • Match can be either an actual expenditure (cash) or a virtual cost (in-kind contribution).

We are here to help and your guide forward, so if you have additional questions or need advice and expertise, please reach out to [email protected] .

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  1. Cost Allocation

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  2. Cost Allocation Methods For Accurate Costing to Maximize Profits

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  3. Cost Allocation Methods

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  4. Cost Accounting: Definition and Types With Examples

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  5. Step down method of cost allocation

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  6. Cost Structure: Direct vs. Indirect Costs & Cost Allocation

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  1. Cost Accounting Part 5 Normal Costing

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  3. Cost sheet Sums 01 (Profit Cost, Cost of Production, Total Cost and Profit)

  4. Cost Accounting ( Allocation of Overhead )

  5. Cost Accounting 2 Section No 3

  6. COST ACCOUNTING

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  1. Cost Allocation

    Cost allocation is the process of identifying, accumulating, and assigning costs to costs objects such as departments, products, programs, or a branch of a company. It involves identifying the cost objects in a company, identifying the costs incurred by the cost objects, and then assigning the costs to the cost objects based on specific criteria.

  2. Cost allocation definition

    Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs. Examples of cost objects are a product, a research project, a customer, a sales region, and a department.

  3. Cost Structure: Direct vs. Indirect Costs & Cost Allocation

    Direct costs are costs that can be attributed to a specific product or service, and they do not need to be allocated to the specific cost object. Indirect costs are costs that cannot be easily associated with a specific product or activity because they are involved in multiple activities.

  4. What Is Cost Allocation? (+ Types of Costs & Examples)

    Your cost object is the square footage of each building, which will be used to allocate the cost to the correct building. 3 types of costs Most businesses incur a variety of costs while...

  5. Cost allocation methods

    How to Allocate Costs Various cost allocation methods are used to allocate factory overhead costs to units of production. Allocations are performed in order to create financial statements that are in compliance with the applicable accounting framework.

  6. Cost Allocation in Accounting: An In-Depth Look

    The cost allocation definition is best described as the process of assigning costs to the things that benefit from those costs or to cost centers. For Lisa's Luscious Lemonade, a cost center can be as granular as each jug of lemonade that's produced, or as broad as the manufacturing plant in Houston.

  7. Cost Accounting: Definition and Types With Examples

    Cost accounting is an accounting method that aims to capture a company's costs of production by assessing the input costs of each step of production as well as fixed costs, such as depreciation of ...

  8. What Is Cost Allocation?

    Cost allocation is a method used to assess the costs associated with cost objects in specific categories within a business. Cost objects might include a product or service you sell, a particular department within your company, or the costs of dealing with a supplier. Cost allocation is not just for large corporations looking to reduce expenses.

  9. Cost Allocation

    The rent for the two spaces is $10,000 per month. The company will allocate the rent expense between the two spaces. $10,000 (rent) / 2,500 square feet = $4 per square foot. Calculate the rental cost for the office. $4 x 1,000 = $4,000. This means that Christina will allocate $4,000 of the rent to the office.

  10. What Is Cost Allocation?

    Cost allocation is the process of identifying and assigning costs to the cost objects in your business, such as products, a project, or even an entire department or individual company...

  11. Cost Allocation

    Cost allocation is a process in which businesses and individuals identify the costs incurred by activity and distribute them to appropriate accounts. This allows for better decision-making when determining how much should be spent on different business areas. Types of Costs There are types of costs to consider during the process of cost allocation.

  12. The Comprehensive Guide to Cost Allocation in Accounting

    Allocation (also known as "cost allocation") is a process used to distribute the costs of a shared resource or expense among different departments, product lines, or activities within an organization. This process is necessary to accurately determine the cost of producing a product, providing a service, or running a business.

  13. What Is Cost Allocation? (Definition, Method and Examples)

    Cost allocation is the process of identifying, accumulating and assigning costs to specific cost objects. A cost object can be a specific product or product line, a particular service you offer, a production-related activity or a department or division in your company.

  14. Cost Allocation: The Key to Understanding Financial Efficiency

    Cost allocation is a financial accounting process that involves assigning various costs incurred by a business to the specific activities or elements used or benefitted from incurring these costs.

  15. 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.

  16. Cost Allocation: Definition, and Example on How the Cost Allocation

    Definition of Cost Allocation: Cost allocation is the process that plays a major role in identifying, assigning, and aggregating the expenses to cost objects. A cost object is anything that requires you to measure the costs separately. Here are some examples of cost objects: products, services, departments, activities, customers, etc.

  17. What is cost allocation?

    Cost allocation is the assigning of a cost to several cost objects such as products or departments. The cost allocation is needed because the cost is not directly traceable to a specific object. Since the cost is not directly traceable, the resulting allocation is somewhat arbitrary.

  18. Cost Allocation in Cost Accounting

    In cost accounting, the process of allocating indirect costs to a product involves judgment. Unlike direct costs (which are traced ), indirect costs are allocated, and that requires estimates. The process isn't easy, but it's vital. You need to allocate indirect costs carefully to understand the cost of an object, such as a product or service.

  19. MRSC

    Cost allocation refers to a process of accounting and recording the full costs of a government service by including its indirect costs or "overhead" in addition to its direct costs.

  20. Cost Allocation

    Direct costs are the expenses related to developing a product, like the amount of material needed, while indirect costs would be not directly tied to the product, like accounting. Activity Based Costing is a common costing allocation method that assigns indirect costs to products by recognizing the relationship between costs, activities and ...

  21. Cost Allocation Base

    Cost allocation base can be defined as a factor that is the common denominator for systematically linking a cost or group of costs to a cost object such as a department or an activity. Where cost object is a product, the narrower term cost application base is often used. Cost Allocation Base FAQs What is a cost allocation base?

  22. Cost Allocation

    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. Example. T2F is a university café owned an operated by a student.

  23. Cost Allocation Methodology Best Practices

    The cost allocated to Project A is $560 (100 user hrs. / 180 total user hrs. x $1,000). The cost allocated to Project B is $440 (80 user hrs. / 180 total user's hrs. x $1,000). Cost allocation based on effort. A research assistant spends 80% effort on Project A and 20% effort on Project B. The research assistant uses supplies totaling $3,000 ...

  24. Funding Essentials FAQs: Cost Allocation and Indirect Costs : Cherry

    A: Yes, per OMB guidelines: 2CFR Part 200, 306.7 (C) Unrecovered indirect costs, including indirect costs on cost sharing or matching may be included as part of cost sharing or matching only with the prior approval* of the Federal awarding agency. Unrecovered indirect cost means the difference between the amount charged to the Federal award and ...