cost assignment vs cost allocation

Cost Allocation – Meaning, Importance, Process and More

Cost Allocation or cost assignment is the process of identifying and assigning costs to the various cost objects. These cost objects could be those for which the company needs to find out the cost separately. A few examples of cost objects can be a product, customer, project, department, and so on.

The need for cost allocation arises because some costs are not directly attributable to the particular cost object. In other words, these costs are incurred for various objects, and then the sum is split and allocated to multiple cost objects. These costs are generally indirect. Since these costs are not directly traceable, an accountant uses their due diligence to allocate these costs in the best possible way. It results in an allocation that could be partially arbitrary, and thus, many refer cost allocation exercise as the spreading  of a cost.

Examples of Cost Allocation

• Cost Allocation – Importance

Cost Allocation Method

Define costs, identify cost objects, basis of allocation, accumulate costs into cost pool.

For example, a company’s CEO uses his car for personal and official purposes. So, if the CEO decides to allocate costs, then they will divide the cost (fuel, maintenance, etc.) for business and personal use based on usage.

The following examples will help us understand the cost allocation concept better:

• A company has a building in which there are various departments. One can allocate depreciation costs to the department on the basis square ft area of each department. This cost will then be further assigned to the products on which the department works.
• An accountant can attribute electricity that a production facility consumes to different departments. Then the accountant can assign the department’s electricity cost to the products that the department works on.
• An employee works on three products for a month. To attribute their salary to three products, an accountant can use the number of hours the employee gave to each product.

Cost Allocation – Importance

The following points reflect the importance of allocating costs:

• Allocating cost is essential for financial reporting, i.e., to correctly assign the cost among the cost objects.
• It allows the company to calculate the true profitability of the department or function. This profitability could serve as the basis for making further decisions for that department or service.
• If cost allocation is correct, it allows the business to identify and understand the costs at each stage and their impact on the profit or loss. On the other hand, if the allocation is incorrect, the company may end up making wrong or inconsistent decisions concerning the distribution of resources amongst various cost objects.
• The concept is also useful for finding the transfer prices when there is a transaction between subsidiaries.
• It helps a company make better economic decisions, such as whether or not to accept a new order.
• One can also use the concept to evaluate the performance of the staff.
• It helps in better explaining to the customers the costs that went into the pricing of a product or service.
• Allocation cost helps a company know where the money is going and how much. It will assist the company in using the resources effectively. Pool costs, if not allocated, may give an unbalanced view of the cost of various objects.

As such, there is no specific method to allocate costs. So, an accountant needs to use his or her due diligence to assign a cost to the cost object. Of course, they are considering the practice adopted in a similar industry. For instance, the accountant may decide to allocate expenses based on headcount, area, weightage, and so on.

Also Read: Cost Object – Meaning, Advantages, Types and More

Irrespective of the method an accountant uses, their objective should be to allocate the cost as fairly as possible. Or to allocate cost in a way that is in line with the nature of the cost object. Or to lower the arbitrariness in awarding costs.

Several efforts are underway to better cost allocation techniques. For instance, the overhead allocation for manufacturers, which was on plant-wide rates, is now based on departmental standards. Also, accountants use machine hours instead of direct labor hours for allocation.

Moreover, some accountants are also implementing activity-based costing to better the allocation. So, there can be several ways to allocate costs. But, whatever form the company selects, it is essential to document the reasons backing that method, and that need to be followed consistently for several periods.

A company can ensure documentation by developing allocation formulas or tables. Moreover, if a company wants, it can also pass supporting journal entries to transfer costs to the cost objects or do it via the chargeback module in the ERP system.

Also Read: Cost Hierarchy – Meaning, Levels and Example

Nowadays, cost allocation systems are available to assist in cost allocation. Such systems track the entity that produces the goods or services and the body that consumes those goods or services. The system also identifies the basis to distribute the cost.

The process to Allocate cost

As said above, there are no specific methods for allocating costs. Similarly, there is no particular process for it, as well. However, the process we are detailing is one of the most popular, and many companies use it for allocating costs. Following is the process:

Before allocating the cost, a company must define the various types of costs. Generally, there are three types of costs – direct, indirect, and overhead. Direct costs are those that one can easily attribute to a product or service, such as wages to factory workers or raw material for the specific product.

Indirect costs are ones that a company needs to incur for its operations, such as administration costs. Primarily, these are the costs that a company needs to allocate as it is difficult to attribute them directly to a product or service or any other cost object.

Another type of cost is an overhead cost , which is also an indirect cost. These costs are incurred for the production and selling of goods or services. Such costs do not vary based on production or sales. A company needs to pay them even if it is not producing or selling anything. Research and development costs, rent, etc., are good examples of such a cost.

The company or the accountant must know the cost objects for which they need to allocate the cost. It is crucial as we can’t assign costs to something on which we have no information. A cost object could be the product, customer, region, department, etc.

Along with the cost object , the company must also determine the basis on which it would allocate the cost. This basis could be the number of hours, area, headcount, and more. For example, if headcount is the basis of allocation for insurance costs and a company has 500 employees, then the department with 100 employees will account for 20% of the insurance cost. Experts recommend choosing a cost allocation base that is a crucial cost driver as well.

A cost driver is a variable whose increase or decrease leads to an increase or decrease in the cost as well. For instance, the number of purchase orders could be a cost driver for the cost of the purchasing department.

An accountant may create many categories to pool costs, which are to be allocated subsequently. It is the account head where the costs should be accumulated before assigning them to the cost objects. Cost pools can be insurance, fuel consumption, electricity, rent, depreciation, etc. The selection of the cost pool primarily depends on the use of the cost allocation base.

Continue reading – Costing Terms .

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• Types of Costs and their Classification
• Cost Accounting and Management Accounting
• Types of Cost Accounting
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• Types of Costing

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

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What is Cost Assignment?

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Cost assignment.

Cost assignment is the process of associating costs with cost objects, such as products, services, departments, or projects. It encompasses the identification, measurement, and allocation of both direct and indirect costs to ensure a comprehensive understanding of the resources consumed by various cost objects within an organization. Cost assignment is a crucial aspect of cost accounting and management accounting, as it helps organizations make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

There are two main components of cost assignment:

• Direct cost assignment: Direct costs are those costs that can be specifically traced or identified with a particular cost object. Examples of direct costs include direct materials, such as raw materials used in manufacturing a product, and direct labor, such as the wages paid to workers directly involved in producing a product or providing a service. Direct cost assignment involves linking these costs directly to the relevant cost objects, typically through invoices, timesheets, or other documentation.
• Indirect cost assignment (Cost allocation): Indirect costs, also known as overhead or shared costs, are those costs that cannot be directly traced to a specific cost object or are not economically feasible to trace directly. Examples of indirect costs include rent, utilities, depreciation, insurance, and administrative expenses. Since indirect costs cannot be assigned directly to cost objects, organizations use various cost allocation methods to distribute these costs in a systematic and rational manner. Some common cost allocation methods include direct allocation, step-down allocation, reciprocal allocation, and activity-based costing (ABC).

In summary, cost assignment is the process of associating both direct and indirect costs with cost objects, such as products, services, departments, or projects. It plays a critical role in cost accounting and management accounting by providing organizations with the necessary information to make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

Example of Cost Assignment

Let’s consider an example of cost assignment at a bakery called “BreadHeaven” that produces two types of bread: white bread and whole wheat bread.

BreadHeaven incurs various direct and indirect costs to produce the bread. Here’s how the company would assign these costs to the two types of bread:

• Direct cost assignment:

Direct costs can be specifically traced to each type of bread. In this case, the direct costs include:

• Direct materials: BreadHeaven purchases flour, yeast, salt, and other ingredients required to make the bread. The cost of these ingredients can be directly traced to each type of bread.
• Direct labor: BreadHeaven employs bakers who are directly involved in making the bread. The wages paid to these bakers can be directly traced to each type of bread based on the time spent working on each bread type.

For example, if BreadHeaven spent $2,000 on direct materials and $1,500 on direct labor for white bread, and $3,000 on direct materials and $2,500 on direct labor for whole wheat bread, these costs would be directly assigned to each bread type.

• Indirect cost assignment (Cost allocation):

Indirect costs, such as rent, utilities, equipment maintenance, and administrative expenses, cannot be directly traced to each type of bread. BreadHeaven uses a cost allocation method to assign these costs to the two types of bread.

Suppose the total indirect costs for the month are $6,000. BreadHeaven decides to use the number of loaves produced as the allocation base , as it believes that indirect costs are driven by the production volume. During the month, the bakery produces 3,000 loaves of white bread and 2,000 loaves of whole wheat bread, totaling 5,000 loaves.

The allocation rate per loaf is:

Allocation Rate = Total Indirect Costs / Total Loaves Allocation Rate = $6,000 / 5,000 loaves = $1.20 per loaf

BreadHeaven allocates the indirect costs to each type of bread using the allocation rate and the number of loaves produced:

• White bread: 3,000 loaves × $1.20 per loaf = $3,600
• Whole wheat bread: 2,000 loaves × $1.20 per loaf = $2,400

After completing the cost assignment, BreadHeaven can determine the total costs for each type of bread:

• White bread: $2,000 (direct materials) + $1,500 (direct labor) + $3,600 (indirect costs) = $7,100
• Whole wheat bread: $3,000 (direct materials) + $2,500 (direct labor) + $2,400 (indirect costs) = $7,900

By assigning both direct and indirect costs to each type of bread, BreadHeaven gains a better understanding of the full cost of producing each bread type, which can inform pricing decisions, resource allocation, and performance evaluation.

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What is Cost Structure?

Fixed vs. variable costs, fixed costs, variable costs, direct vs. indirect costs, direct costs, indirect costs, cost allocation, example of cost allocation, the importance of cost structures and cost allocation, additional resources, cost structure.

The different types of cost structures incurred by a business

Cost structure refers to the various types of expenses a business incurs and is typically composed of  fixed and variable costs . Costs may also be divided into direct and indirect costs. Fixed costs are costs that remain unchanged regardless of the amount of output a company produces, while variable costs change with production volume.

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.

Operating a business must incur some kind of costs, whether it is a retail business or a service provider. Cost structures differ between retailers and service providers, thus the expense accounts appearing on a  financial statement  depend on the cost objects, such as a product, service, project, customer or business activity. Even within a company, cost structure may vary between product lines, divisions or business units, due to the distinct types of activities they perform.

Key Highlights

• Cost structure refers to the various types of expenses a business incurs and is typically composed of fixed and variable costs, or direct and indirect costs.
• Fixed costs are incurred regularly and are unlikely to fluctuate over time. Variable costs are expenses that vary with production output.
• Direct costs are costs that are directly related to the creation of a product and can be directly associated with that product. Direct costs are usually variable costs, with the possible exception of labor costs. Indirect costs are costs that are not directly related to a specific cost object. Indirect costs may be fixed or variable.
• Having a firm understanding of the difference between fixed and variable and direct and indirect costs is important because it shapes how a company prices the goods and services it offers.

Fixed costs are incurred regularly and are unlikely to fluctuate over time. Examples of fixed costs are overhead costs such as rent, interest expense, property taxes, and  depreciation  of fixed assets. One special example of a fixed cost is direct labor cost. While direct labor cost tends to vary according to the number of hours an employee works, it still tends to be relatively stable and, thus, may be counted as a fixed cost, although it is more commonly classified as a variable cost where hourly workers are concerned.

Variable costs are expenses that vary with production output. Examples of variable costs may include direct labor costs,  direct material cost , and bonuses and sales commissions. Variable costs tend to be more diverse than fixed costs. For businesses selling products, variable costs might include direct materials, commissions, and piece-rate wages. For service providers, variable expenses are composed of wages, bonuses, and travel costs. For project-based businesses, costs such as wages and other project expenses are dependent on the number of hours invested in each of the projects.

As alluded to earlier, direct costs are costs that are directly related to the creation of a product and can be directly associated with that product. Direct material is an example of a direct cost.

Direct costs are almost always variable because they are going to increase when more goods are produced. As discussed earlier, an exception to this is labor. Employee wages may be fixed and unlikely to change over the course of a year. However, if the employees are hourly and not on a fixed salary then the direct labor costs can increase if more products are manufactured.

Indirect costs are costs that are not directly related to a specific cost object like a function, product or department. They are costs that are needed for the sake of the company’s operations and health. Some other examples of indirect costs include overhead , security costs, administration costs, etc. The costs are first identified, pooled, and then allocated to specific cost objects within the organization.

Indirect costs may be either fixed or variable costs. An example of a fixed cost is the salary of a project supervisor assigned to a specific project. An example of a variable indirect cost would be utilities expense. This expense may fluctuate depending on production (for example, there would be an increase in utility expense if a manufacturing plant is running at a higher capacity utilization ).

Having a firm understanding of the difference between fixed and variable and direct and indirect costs is important because it shapes how a company prices the goods and services it offers. Knowing the actual costs of production enables the company to price its products efficiently and competitively.

Cost allocation is the process of identifying costs incurred, and then accumulating and assigning them to the right cost objects (e.g. product lines, service lines, projects, departments, business units, customers, etc.) on some measurable basis. Cost allocation is used to distribute costs among different cost objects in order to calculate the profitability of different product lines.

A cost pool is a grouping of individual costs, from which cost allocations are made later. Overhead cost, maintenance cost and other fixed costs are typical examples of cost pools. A company usually uses a single cost-allocation basis, such as labor hours or machine hours, to allocate costs from cost pools to designated cost objects.

A company with a cost pool of manufacturing overhead uses direct labor hours as its cost allocation basis. The company first accumulates its overhead expenses over a period of time (for example, a year) and then divides the total overhead cost by the total number of labor hours to find out the overhead cost “per labor hour” (the overhead allocation rate ). Finally, the company multiplies the hourly cost by the number of labor hours spent to manufacture a product to determine the overhead cost for that specific product line.

To maximize  profits , businesses must find every possible way to minimize costs. While some fixed costs are vital to keeping the business running, a  financial analyst  should always review the financial statements to identify possible excessive expenses that do not provide any additional value to core business activities.

When an analyst understands the overall cost structure of a company, they can identify feasible cost-reduction methods without affecting the quality of products sold or service provided to customers. The financial analyst should also keep a close eye on the cost trend to ensure stable cash flows and no sudden cost spikes occurring.

Cost allocation is an important process for a business because if costs are misallocated, then the business might make wrong decisions, such as over/underpricing a product, or invest unnecessary resources in non-profitable products. The role of a financial analyst is to make sure costs are correctly attributed to the designated cost objects and that appropriate cost allocation bases are chosen.

Cost allocation allows an analyst to calculate the per-unit costs for different product lines, business units, or departments, and, thus, to find out the per-unit profits. With this information, a financial analyst can provide insights on improving the profitability of certain products, replacing the least profitable products, or implementing various strategies to reduce costs.

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Cost Allocation: Methods & Calculations for Improved Profitability

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What was that invoice for and where did that other bill come from? 

Unfortunately, for numerous professional services companies, these questions are asked way too often. Fortunately, there is one way to prevent this situation from happening — it’s called cost allocation .

After reading this article, you should be able to: 

• Define cost allocation and the factors that affect it.
• Identify the cost objects that need to be taken into account in the process.
• Use the cost allocation formula and cost allocation method to assign expenditures to departments and projects with accuracy.

Cost Allocation Definition

Cost allocation is the process of matching the cost objects with the departments or operations that generate them. It is mostly used for calculating the financial performance of a company or its parts, such as teams or projects, and determining where given cost objects came from.

For example, in a typical services company, costs can be allocated to non-production departments (i.e. marketing, sales, administration), as well as projects and teams. 

What is cost allocation used for? 

What’s the point of calculating all of these things? 

While cost allocation is very helpful when it’s time to sum up employee performance, results of particular project managers, or finances that may interest stakeholders, there are other perks.

 On a daily basis, cost allocation can also help you: 

• Ensure budgets are on track — both the budget of the entire company, as well as the finances of particular departments or projects. 
• Identify the aspects of operations that generate excessive costs and act on that information. 
• Check whether the company is spending money on the right endeavors.

In other words, cost allocation is the process of identifying the sources of the company’s costs and evaluating their importance.

Types of Costs in Cost Allocation

Cost allocation involves all the people and assets in the organization. Therefore, it includes dozens of different types of costs that project managers and executives need to take into consideration while managing project budgets and other finances. 

Let’s take a look at the types of costs in cost allocation. 

Basic Costs in Cost Allocation

In the simplest classification system possible, costs in a cost allocation are divided into 3 categories: 

Direct Costs 

Direct costs in cost allocation are spendings that have already been attributed to certain departments, projects, or teams, and there are no doubts as to their origin. These costs contribute to the profit billable operations are supposed to generate as they are required in the production processes. 

For example, in a service company, direct costs are usually included in the project budget, or even a project timeline in general. They usually refer to wages and salaries, but they may also include other resources required for the project. Therefore, allocating this type of cost is a piece of cake, as they are generated directly by the department, services, or other cost objects they are related to.

Indirect Costs 

The definition of indirect costs in cost allocation is a bit more complicated, especially for endeavors closely related to professional services. These costs are not associated with any organizational unit in particular; they are simply needed to keep the company running and growing. 

Indirect costs usually include support staff wages and spendings made by the support staff that help the production department do its job. These include cost objects such as marketing and sales specialists, administrative employees, and any other support departments. Indirect costs also often include internal projects. 

However, there is one more type of indirect cost in cost allocation that we need to consider — the overhead costs. 

Overhead Costs

Overhead costs cover all the costs that need to be continually paid regardless of the company’s business performance. 

Project Overheads vs Organizational Overheads

Overhead costs are usually divided into 2 categories:

• Project overheads, for example, equipment, subscriptions, and programs.
• Organizational overheads, such as utilities, bills, rent, etc.
• Cost of services needed to keep the company running, e.g. security expenses and business management.

Cost Allocation Method

At this point, you may ask yourself, “how can I allocate costs on my own?” Fortunately, the answer to this question is not as complicated as it may seem — here’s a cost allocation method that can help you. 

Cost Allocation Method Example

Some organizations, particularly services companies, profit only from their projects, and they don’t need to allocate the costs for the entire business — they just need to share the costs between the profitable operations and departments, as well as other cost objects. Here’s what the process of identifying them looks like. 

1. Define Which Costs You Want to Allocate

Begin by calculating the costs you want to allocate in the first place. For example, if you want to allocate the cost of utilities in your office, add them up to get a bigger picture. 

For the sake of this cost allocation example, let’s assume that The Best Company is focused on allocating the costs of its support departments to the project for the month (also known as business overhead). The costs include:

• The costs of the marketing department: $40,000 
• The costs of administration: $15,000
• The costs of the sales department: $45,000 

Together, all these departments account for $100,000 of additional overhead expenses that need to be allocated. 

2. Determine the Base for Sharing the Costs

Depending on the type of business, you can divide the costs based on different factors. The most popular ones include: 

• Billable hours tracked in the services 
• Generated income 
• Generated profit

For this example, we’ll use the first of these indicators — billable hours. This method is considered the simplest way of allocating costs proportionally.

The Best Company has 2 projects — Project A and Project B. 

To complete all the activities planned in Project A for the month, the project managers and their team members will need 1,800 hours. For Project B, the number of hours needed is 1,200. Both projects combined require 3,000 hours to complete. Therefore, Project A accounts for 60% of all billable hours in the company, while Project B includes 40% of them. These are the proportions we’re going to use in this cost allocation method.

3. Allocate the Costs Proportionally

If Project A includes 60% of all billable hours while Project B accounts for 40% of them, we can now use the numbers to determine the distribution of costs between them. Let’s focus on identifying how they should each contribute to costs.

According to the examples above, the total amount of costs to be shared among billable operations is $100,000. Project B requires more hours, therefore it should account for a larger chunk of the costs — exactly 60% of them. As a result, $60,000 of the costs are allocated to the project. 

Project B, meanwhile, requires 40% of all the billable hours. Therefore, it should pay 40% of the costs — $40,000.

Benefits of Cost Allocation 

While cost allocation is a burden, it’s also a huge business advantage. 

With cost allocation, you can:

• Determine whether your projects are profitable. 
• Learn what part each project plays in covering the organizational costs. 
• Check whether the company’s rates are high enough to cover all the costs and generate profits. 
• Determine whether indirect costs are eating up the majority of the company’s profits.
• Identify the actual cost of services you provide to your customers. 
• Find out which departments are spending more or less money, and what they use it for.
• Assign any lost spending to the people, teams, or departments responsible for them. 
• Calculate the real profitability of your business as a whole.

Ready to get started?

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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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Cost Allocation

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

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.

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?

Cost allocation is a process businesses use to identify costs. Here's everything you need to know.

Table of Contents

Entrepreneurs, small business owners and managers need accurate, timely financial data to run their operations. Specifically, understanding and connecting costs to items or departments helps them create budgets, develop strategies and make the best business decisions for their organizations. This is where cost allocation comes in. Detailed cost allocation reports help businesses ensure they’re charging enough to cover expenses and make a profit. 

While a detailed cost allocation report may not be vital for extremely small businesses, more complex businesses require cost allocation to optimize profitability and productivity.

What is cost allocation?

Cost allocation is the process of identifying and assigning costs to business objects, such as products, projects, departments or individual company branches. Business owners use cost allocation to calculate profitability. Costs are separated or allocated, into different categories based on the business area they impact. These amounts are then used in accounting reports . 

For example, say you’re a small clothing manufacturer. Your product line’s cost allocation would include materials, shipping and labor costs. It would also include a portion of the operation’s overhead costs. Calculating these costs consistently helps business leaders determine if profits from sales are higher than the costs of producing the product line. If not, it can help the owner pinpoint where to raise prices or cut expenses .

For a larger company, cost allocation is applied to each department or business location . Many companies also use cost allocation to determine annual bonuses for each area.

Types of costs

If you’re starting a business , the cost allocation process is relatively straightforward. However, larger businesses have many more costs that can be divided into two primary categories: direct and indirect costs:

• Purchased inventory
• Materials used to make inventory
• Direct labor costs for employees who make inventory
• Payroll for those who work in operations
• Manufacturing overhead, including rent, insurance and utilities costs
• Other overhead costs, including expenses that support the company but aren’t directly related to production, such as marketing and human resources

What is a cost driver?

A cost driver is a variable that affects business costs, such as the number of invoices issued, employee hours worked or units of electricity used. Unlike cost objects, such as units produced or departments, a cost driver reflects the reason for the incurred cost amounts. 

How to allocate costs

While cost objects vary by business type, the cost allocation process is the same regardless of what your company produces. Here are the steps involved.

1. Identify your business’s cost objects.

Determine the cost objects to which you want to allocate costs, such as units of production, number of employees or departments. 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 for which you must allocate costs.

2. Create a cost pool.

Next, create a detailed list of all business costs. Categories should cover utilities, business insurance policies, rent and any other expenses your business incurs.

3. Choose the best cost allocation method for your needs.

After identifying your business’s cost objects and creating a cost pool, you must choose a cost allocation method. Several methods exist, including the following standard ones: 

• Direct materials cost method: This cost allocation method assumes all products have the same allocation base and variable rate.
• Direct labor cost method: This cost allocation method is most helpful if labor costs can be allocated to one product or if expenses vary directly with labor costs.
• High/low method. This cost allocation method is best if you have more than one cost driver and each driver has different fixed or variable rates.
• Step-up or step-down method: With this cost allocation method, departments are first ranked and then the cost of services is allocated from one service department to another in a series of steps. 
• Full absorption costing (FAC): This cost allocation method combines direct material and direct labor costs with a predetermined FAC rate based on company historical data or industry standards.
• Variable costing: Consider this cost allocation method if your business has many variable cost allocations (costs that vary by quantity) and uses significant direct labor.

4. Allocate costs.

Now that you’ve listed cost objects, created a cost pool and chosen a cost allocation method, you’re ready to allocate costs. 

Here’s a cost allocation example to help you visualize the process: 

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: Direct costs: $5 direct materials + $2 direct labor = $7 direct costs per pair Indirect costs: Overhead allocation: $5,000 ÷ 3,000 pairs = $1.66 overhead costs per pair Direct costs: $7 per pair + Indirect costs: $1.66 per pair Total cost: $8.66 per pair

As you can see, cost allocation helps Dave determine how much he must charge wholesale for each pair of eyeglasses to make a profit. Larger companies would apply this same process to each department and product to ensure sufficient sales goals.

5. Review and adjust cost allocations.

Cost allocations are never static. To be meaningful, they must be monitored and adjusted constantly as circumstances change.

What are the benefits of cost allocation?

Accurate, regular cost allocation can bring your business the following benefits: 

• Helps you run your business: The information you glean from cost allocation reports helps you perform vital functions like preparing income tax returns and creating financial reports for investors, creditors and regulators. 
• Informs business decisions: Cost allocation is an excellent business decision tool that can help you monitor productivity and justify expenses. Cost allocation gives 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. 
• Helps produce accurate business reports: Tax accounting, financial accounting and management accounting all require some kind of cost allocation. This information is the foundation of accurate business reports. 
• Can reveal accurate production costs: Knowing what it costs to create a product, including all expenses allocated to it, is essential to making good pricing decisions and allocating resources efficiently.
• Helps you evaluate staff: Cost allocation can help you assess the performance of different departments and staff members. If a department is not profitable, staff productivity may need improvement. 

Common cost allocation mistakes

To get the most from cost allocation, avoid these common mistakes:

• Equal or inflexible allocation : Cost allocation is not as simple as allocating any given cost over different product lines or departments. Some cost objects require more time, expense or labor than others, for example.
• Missing costs: Costing is meaningless if it doesn’t include all expenses. Don’t forget costs, such as overhead, time spent and intangible expenses.
• Failing to adjust as needed: Costs and priorities in business are changing constantly. Be sure your cost allocations are monitored and adjusted to meet your information needs.
• Not considering fluctuating revenue with indirect costs: If your business is seasonal or fluctuates over time, it’s important to account for that when allocating costs. 

Cost allocation and your business

Even if you operate a very small business, it’s essential to properly allocate your expenses. Otherwise, you could make all-too-common mistakes, such as charging too little for your product or spending too much on overhead. Whether you choose to start allocating costs on your own with software or with the help of a professional small business accountant , cost allocation is a process no business owner can afford to overlook.

Dachondra Cason contributed to this article. 

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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?

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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Cost Allocation

Written by True Tamplin, BSc, CEPF®

Reviewed by subject matter experts.

Updated on June 08, 2023

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Table of contents.

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. They include:

• Fixed costs . These are expenses that remain the same no matter how many units of production have been made or sold. For example, a business spends $100,000 on rent every month. Even if the company can only produce and sell 50 units of a product in one month (when they normally make and sell 100), this cost remains at $100,000 for that given time period.
• Variable costs . These expenses depend on the amount of production or sales made within a given period, such as raw materials used for making products. For example, it costs a furniture shop $50 to make a chair—$20 for raw materials such as wood, cane, metal, leather, and fabrics, and $30 for the direct labor involved in making one chair.

Below shows how the variable costs change as the number of chairs made varies.

As the production output of chairs increases, the bakery’s variable costs also increase. When the furniture shop does not make any chair, its variable costs drop to zero.

• Indirect costs . These are expenses that cannot be directly linked to the making or selling of goods or services, such as administrative salaries, office expenses, security expenses, and utilities.
• Direct Costs. These are costs that can be directly linked to the making or selling of goods or services. For example, if a company pays for equipment rental to produce their product, this cost is considered direct because it links back to how many units have been produced.

Why Is Cost Allocation Important?

Cost allocation is an important part of any business. The following points reflect why you should always be sure to allocate all your expenses:

• It helps in accurate decision-making. When costs are known, it is easier to determine which strategies will most benefit the business or individual.
• Allocating cost enables comparison between different products and services.

For example, comparing the cost of producing one product versus another can help decide which should be produced more often based on its profitability compared with other goods or services offered by a company.

• It helps in understanding which departments are more profitable than others. Identifying the cost of different areas of business allows for better decision-making at the departmental level, and overall.
• It can help identify problem areas within a company to allow for improvements or changes that might be beneficial for future production or sales.

Taking these factors into account when allocating cost allows businesses and individuals to understand better how much money they need coming in (revenue) compared with how much they must spend (costs).

This makes setting prices easier since there is an understanding of what each unit sold brings in revenue-wise.

Common Mistakes People Make When Allocating Costs

• Not accounting for overhead . Overhead is a general term that refers to indirect expenses, which are not directly attributed to the cost of goods sold (COGS) or fixed costs.
• Not taking into account which projects are currently generating revenue and which ones aren’t.
• Not allocating indirect expenses equally among departments and projects within a company.
• Not considering how fluctuating revenue affects indirect expenses. If you’re seeing a lot of variability in revenue over time, you need to account for that when allocating costs.
• Using the incorrect allocation method. There are many different methods for allocating costs and using more than one can help you get a better idea of where your business is spending its money.

Process of Cost Allocation

The following is an overview of how to allocate costs and some tips on what you should take into consideration when doing so.

Step One: Identify Your Costs

The first step is to identify all of your costs. This includes both direct and indirect expenses, as well as fixed or variable costs.

Step Two: Allocate Indirect Costs Between Departments or Products

Indirect costs should be allocated between departments, projects, and products based on a fair allocation plan that reflects their use in those areas.

For example, suppose your company produces two products, products A and B.

In that case, you will need to construct a cost-allocation plan that reflects the allocation of overhead expenses between these areas.

Step Three: Allocate Fixed Costs Among Departments or Projects

Fixed costs are allocated among departments or projects based on how they benefit each area.

For example, if Product A produces a specific product that is used for Product B, it would be appropriate to allocate the fixed costs associated with producing Product A between these two products.

Step Four: Allocate Variable Costs Among Departments or Projects

Variable costs are allocated among departments or projects based on how much of each cost driver they use.

For example, if your company produces two products, A and B (and each product has its own direct labor cost), you would first need to determine how many units of Product A are produced for every unit of Product B sold.

You can then use this information to allocate the variable costs associated with producing each product based on their respective rates.

Step Five: Use Cost-Volume-Profit Analysis to Determine the Best Allocation Method

If your company uses multiple products, services, or departments that incur indirect costs, cost allocation is important in determining which method will work best for reporting profits accurately.

For example, suppose you’re using a full absorption costing (FAC) system and another department within your company is using a direct labor cost system.

In that case, you may need to use more than one allocation method.

Step Six: Use Cost Allocation for Decision Making & Reporting

Cost allocation is important for both decision-making and reporting purposes.

Using cost allocation, you can determine which areas of your company are over or under-spending and how changes to specific processes will affect the overall profitability of a product or department.

Common Cost Allocation Methods

Cost allocation faqs, what is cost allocation.

Cost allocation is the process of assigning expenses to one or more cost objects. A cost object can be a product, project, department, business unit, or another grouping within an organization with costs associated with it.

How is cost allocation done?

There are many ways to allocate expenses, including the high/low method and step-up/down. There’s also a simple way called the direct materials cost method that uses an allocation base of the same value as the variable rate. Using FAC or Variable costing can provide more accurate reporting on your company’s financials.

What are the benefits of cost allocation?

Cost allocation allows you to determine where costs can be reduced and provides accurate reporting on company financials based on its relative performance. Allocating indirect expenses is also important for decision-making purposes. With this information, you can determine which areas of your business need improvement and how changes in production will affect overall profitability. Cost allocation can also show you which departments or products are spending too much money on indirect expenses, and which ones aren’t using enough of them. This enables you to make more informed staffing decisions in the future based on how your company’s needs change over time. Finally, cost allocation allows companies to compare their performance against similar businesses.

What are common mistakes people make when allocating costs?

One of the most common mistakes is to allocate indirect expenses based on current production volume. Other issues include not performing cost allocation at all or using arbitrary rates rather than industry standards. When deciding how to allocate these types of expenses, companies should consider their company’s size and what it will cost to produce a certain amount of output.

How is cost allocation performed?

Cost allocation can be done manually or through software. It’s important to keep detailed records of all your company’s expenses so you have accurate financial reports for decision-making purposes. If you don’t have cost records, the process of allocation can be time-consuming and difficult to determine. You may not know which department or product each expense is associated with, so your reports will lack accuracy.

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 or view his author profiles on Amazon , Nasdaq and Forbes .

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• Key Differences

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Difference Between Cost Allocation and Cost Apportionment

Based on the relation of the cost item with the cost center or unit, to which it is imposed, the cost item is allocated or apportioned and not as per the nature of the expense.

Take a read of this article excerpt, in which you can find the fundamental differences between allocation and apportionment of cost.

Content: Cost Allocation Vs Cost Apportionment

Comparison chart.

Definition of Cost Allocation

Cost Allocation, as the name suggest, is the direct allotment of cost to the traceable cost object. It is the process of associating the expenses incurred, to different departments of the organization.

When a particular cost item is easily recognizable with a cost unit, i.e. product, or cost center, then these costs are charged to the concerned cost center or unit, and the process is called as cost allocation. In finer terms, it is the full-fledged distribution of an overhead item to the department, rationally.

Therefore, a process, in which there is an outright charging of whole cost items to the concerned cost center, is termed as cost allocation. The two factors responsible for cost allocation are:

• Respective cost unit or cost center, causing the overhead to be incurred.
• Definite amount of cost is to be calculated.

For instance : Salary paid to the employees of the maintenance department, can be allocated to that department.

Definition of Cost Apportionment

When the cost items cannot be outrightly charged to or accurately traceable to a particular cost center, then such items of cost are prorated amongst various cost objects, on an equitable basis, this process is known as cost apportionment. It is the distribution of different items of cost in proportions to the cost unit or cost center on a suitable basis.

In simple terms, the expenses which are unallowable are dispersed over multiple departments, is known as apportionment.

For instance : Wages paid to the head of the factory, rent of factory, electricity, etc. cannot be charged to a particular department, then these can be apportioned amongst various departments.

The basis for apportionment of costs is determined after proper examination of the relationship between the base and different variables. It is important to predetermine an appropriate basis for apportionment, which guarantees the equitable share of common overheads for the departments. The basis should be periodically reviewed, to improve the accuracy. It is based on the principles of:

• Service Rendered
• Survey or Analysis Method
• Ability to bear

Key Differences Between Cost Allocation and Cost Apportionment

The difference between cost allocation and cost apportionment can be drawn clearly on the following grounds:

• Allocation of cost means a process in which the entire amount of overhead is charged to a specific cost center. On the contrary, Apportionment of cost can be understood as the distribution of proportions of cost items to the cost unit, i.e. product or service or the cost center.
• Allocation of the cost is possible only when the cost is recognized as particularly imputable to a specific cost center. Conversely, apportionment of the cost is needed when the cost cannot be allocated to a particular cost center. Instead, the cost is shared by two or more cost centers, as per the expected benefit received.
• As allocation of overhead is a sheer process of departmentalization of expenses, the overheads are directly assigned to the department. In contrast, cost apportionment involves the proportionate distribution of cost to different departments, on a reasonable basis.
• Cost allocation is applied when the overhead is associated with a particular department. As against this, cost apportionment is applied when the overhead is related to various departments.

Both allocation and apportionment of cost aim at identifying and assigning the cost to the cost center, but they are different. Cost Allocation is the process of assignment of cost item to the cost object, which is directly traceable. On the other hand, cost apportionment is for those indirect cost items, which are leftover in the process of cost allocation.

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Cost Allocation

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Ashish Kumar Srivastav

Reviewed by :

Dheeraj Vaidya

Cost Allocation Definition

Cost allocation is the method of identifying as well as assigning the elements of cost to each cost object, such as a product or a department for which cost is to be allocated, based on an appropriate cost driver, which serves as a base for allocation of the elements of the cost.

It becomes necessary, especially for large organizations, because of the existence of various departments. It becomes vital to keep track of the cost incurred in each department to fix accountability and maintain control over costs.

Table of contents

Cost allocation explained, disadvantages, cost allocation vs cost apportionment, recommended articles.

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

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

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

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

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

#1- Decision Making

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

#2 - Minimize Resource Wastage

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

#3 – Evaluation

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

#4 - Budgeting

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

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

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

• Identify the cost object for which the cost is to be allocated. It may include a product, department, project, customer, etc.
• Establish the cost of pools. Cost pools are the elements of cost for which allocation is to be done based on cost drivers. It may include costs such as factory rent, electricity, fuel, labor cost, etc.
• Identify the cost driver, which means the appropriate base based on which cost can be reasonably allocated. For example, for allocating the factory rent to the products, the relevant cost driver can be the number of units produced.

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

This process can be understood by way of the following example. A company produces two products, "A" and "B" on the premises of the same factory.

• Factory Rent = $1,00,000
• Units Produced of “A” = 30,000
• Units Produced of “B” = 20,000
• Total no. of units produced = 50,000

Let us see how can the cost allocation of factory rent be done for the two products.

• Cost Object = Product “A” and “B”
• Cost Pool = Factory Rent
• Cost Driver = No. of Units Produced

• = $1,00,000 * 30,000/50,000

• = $1,00,000 * 20,000/50,000

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

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

• When a company follows cost allocation for its various departments, each department tries to maintain efficiency in its operations and control costs.
•   It helps in determining the actual cost of a product produced or a service rendered.
• It enables a company to fix accountability on the various departments regarding the cost they incur.
• It is helpful in decision making as it can provide information as to what is the actual cost, which can be compared with the revenues and suggest if any changes are required in pricing.

Some disadvantages of the concept as follows:

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

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

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

• Cost allocation means the direct distribution of the cost heads to various departments based on a reasonable factor. It is a type of cost apportionment which allocates a cost to a cost object. The distribution is done to a department only when it is connected to a department.
• A cost is apportioned when it is not directly related to a particular department but is connected to various department
•  On the other hand, apportionment of cost means attributing various cost heads to departments based on a reasonable factor. Allocation is done in the ratio of benefits expected from the cost heads.

This article has been a guide to Cost allocation & its definition. We explain its methods, example, purpose, vs cost apportionment, advantages & disadvantage. You can learn more about from the following articles -

• Cost Allocation Methods
• Cost-Based Pricing
• Cost Estimate
• Cost Control
• Cost Structure

• A Comprehensive Guide to Cost Alloc...

A Comprehensive Guide to Cost Allocation [With Methods & Examples]

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Key Takeaways

• Cost allocation is the process of distributing expenses across different cost objects, such as departments or products to reflect their usage or benefit.
• Cost allocation helps in accurate budgeting, pricing, and financial analysis by fairly distributing expenses.
• To perform cost allocation, identify costs, choose allocation bases, and distribute expenses based on usage or activity.

Introduction

Smooth operations lie at the heart of a successful business, and proper resource allocation plays a crucial role in achieving this. Cost allocation involves determining how to distribute a company’s funds across various aspects of its operations. For instance, consider a fintech company that runs multiple applications; it has an app for online payments, another one for taxation, and one for budgeting. The company must allocate funds between each application to ensure better planning and performance analysis. Cost allocation helps to assess the usage of each application. For example, if the online payment app is most used, more resources will be allocated to ensure its smooth operation. This assists the company in understanding where its funds are being allocated and supports strategic financial decision-making.

In this blog, we will discuss cost allocation meaning in detail and learn how to effectively carry out cost allocation, including best practices and real-life examples.

What is Cost Allocation?

Cost allocation involves identifying and distributing a company’s costs across different cost objects, such as departments, products, or services, based on their usage or benefit. This process ensures that each segment accurately reflects the expenses incurred, leading to better financial analysis and decision-making. 

Cost allocation is important as it ensures that expenses are accurately distributed across different departments, projects, or products, reflecting the true cost of operations. This helps businesses identify which areas are profitable and which are underperforming, enabling informed decision-making.

Cost Allocation Methods 

Different cost allocation methods are used depending on the business needs and the complexity of its operation. Here are some of the common cost allocation methods: 

Direct allocation 

The direct allocation method is the simplest and most straightforward approach to cost allocation. It involves directly assigning costs to the departments or products that incur them without any intermediate steps or redistribution. While this method is easy to implement, it may not always capture the full complexity of how resources are used, especially in organizations with intertwined services and departments.

Step-down allocation 

The step-down allocation method, also known as the sequential allocation method, allocates costs by progressively assigning them from one department to another. The process starts with the department that provides the most services to other departments and moves step-by-step downwards. This method recognizes the hierarchical nature of services provided between departments, offering a more systematic approach than direct allocation. 

Reciprocal allocation

The reciprocal allocation method takes into account the mutual services exchanged between departments before allocating costs. This method reflects the complex, interdependent relationships among departments, leading to a more accurate distribution of costs. It is particularly valuable for organizations with highly interdependent departments, as it provides a more accurate reflection of how costs are shared and resources are utilized across the organization.

Activity-based costing (ABC)

Activity-based costing (ABC) allocates costs based on the activities that drive them rather than simply on the basis of departments or products. This method identifies key activities within an organization and assigns costs to products or services based on their consumption of these activities. By focusing on cost drivers, ABC offers a more nuanced and precise allocation of overhead costs, making it especially useful for complex, multi-product companies.

Absorption costing

Absorption costing, also known as full costing, is a method where all manufacturing costs, both fixed and variable, are allocated to the product units. This method ensures that each unit of production carries a portion of all production costs, which is important for external financial reporting. This method is widely used in financial accounting and tax reporting because it complies with Generally Accepted Accounting Principles (GAAP) . 

Types of Allocated Costs

Cost allocation can be classified into different types based on how costs are distributed within an organization. Each type of allocated cost helps businesses understand and manage their expenses more effectively and efficiently. Here are the different types of allocated costs: 

Direct costs

Direct costs are expenses that can be directly attributed to a specific product, department, or project. Examples include raw materials, direct labor, and specific equipment used in production. These costs are straightforward to track and assign because they are directly involved in the production or execution of a specific activity. 

Indirect costs

Indirect costs are expenses that cannot be traced directly to a single product, department, or project. Instead, they support multiple areas of the business and are often allocated across various departments or products. Examples include utilities, rent, and administrative salaries. 

Fixed costs

Fixed costs are expenses that remain constant regardless of the level of production or business activity. These costs do not change with the volume of goods or services produced. Examples include rent, insurance, and salaries of permanent staff. Fixed costs are crucial for budgeting as they provide stability in expense planning, allowing businesses to forecast their financial needs more predictably.

Variable costs

Variable costs fluctuate with the level of production or business activity. These costs increase as production grows and decrease when production slows. Examples include raw materials, production supplies, and shipping costs. Understanding variable costs helps businesses manage their production budgets and pricing strategies effectively, as these costs directly impact overall profitability.

Operating costs

Operating costs are the ongoing expenses required to run the daily activities of a business. These include both fixed and variable costs necessary for maintaining business operations. Examples include rent, utilities, salaries, supplies, and maintenance. Tracking operating costs is essential for assessing the financial health of the business and ensuring that daily operations are funded adequately while maintaining profitability.

How to do Cost Allocation? 

Cost allocation involves a systematic process to distribute costs across different parts of a business. Here’s a step-by-step guide on how to do it:

Step 1: Identify costs – Start by identifying all the costs that need to be allocated. These can include direct costs (like raw materials) and indirect costs (like utilities and administrative expenses).

Step 2: Determine cost objects – Define the cost objects, which are the items, departments, products, or services to which the costs will be allocated. For example, cost objects could be different departments within a company or various products being manufactured.

Step 3: Select allocation bases – Choose appropriate allocation bases, which are the criteria used to distribute costs. This could be square footage for allocating rent, labor hours for distributing salaries, or machine hours for dividing equipment costs. The allocation base should closely reflect how the cost is consumed.

Step 4: Allocate costs – Apply the selected allocation bases to distribute the costs among the identified cost objects. For instance, if rent is being allocated based on square footage, the cost would be divided proportionally based on how much space each department occupies.

Step 5: Review and adjust: After allocating costs, review the allocations to ensure they are reasonable and reflect the actual use of resources. Make any necessary adjustments to improve accuracy.

Step 6: Record and report: Finally, calculate the allocated costs and record them accurately in the accounting system. Ensure these costs are properly reflected in financial reports . This detailed information will be utilized by stakeholders for budgeting, pricing strategies, financial analysis, and critical decision-making processes. 

Examples of Cost Allocation

Let’s take a closer look at the following example of cost allocation. This example provides a clear and detailed understanding of the costs associated with each product or service. By analyzing this example, you can understand how cost allocation works, how to optimize pricing strategies, and improve overall financial efficiency.

Example 1: Let’s consider a manufacturing company with two types of products: chairs and tables. The company incurs the following costs:

• Total cost of wood: $10,000
• Factory rent: $5,000
• Utilities: $2,000

The company needs to allocate these costs to chairs and tables:

Direct costs: The cost of wood is allocated based on usage. Chairs use 60% of the wood, and tables use 40%.

Chairs: $10,000 * 60% = $6,000

Tables: $10,000 * 40% = $4,000

Indirect costs: Factory rent and utilities are allocated based on the space each product line occupies in the factory. Chairs use 70% of the space, and tables use 30%.

Factory rent:

Chairs: $5,000 * 70% = $3,500

Tables: $5,000 * 30% = $1,500

Chairs: $2,000 * 70% = $1,400

Tables: $2,000 * 30% = $600

Total costs:

Chairs: $6,000 (wood) + $3,500 (rent) + $1,400 (utilities) = $10,900

Tables: $4,000 (wood) + $1,500 (rent) + $600 (utilities) = $6,100

Benefits of Cost Allocation

Cost allocation offers several benefits for businesses, enhancing financial management and decision-making. Each method of cost allocation has its own advantages and is selected based on the specific business needs and structure of the business. Here are some of the benefits: 

Accurate cost assessment

Cost allocation helps businesses accurately determine the cost of products, services, or departments by distributing expenses appropriately. This ensures a clear picture of the true costs involved, aiding in more precise pricing and profit-loss analysis.

Better budgeting and planning

By understanding how costs are allocated, businesses can create more accurate budgets and financial forecasts . This helps in planning for future expenses and allocating resources effectively to different areas of the business.

Improved decision-making

With clear cost information, stakeholders can make more informed decisions about pricing, cost control, and resource allocation. This can lead to better strategic decisions, such as which products or services to focus on or discontinue.

Enhanced financial reporting

Accurate cost allocation contributes to more transparent financial statements and reports. This can improve stakeholder confidence, as investors, lenders, and other stakeholders get a clear view of the company’s financial performance.

Performance evaluation

Cost allocation allows businesses to assess the performance of different departments, products, or projects. By comparing allocated costs against revenues, businesses can identify areas of inefficiency and opportunities for improvement.

Cost control

Understanding how costs are distributed helps in identifying areas where expenses can be reduced or controlled. This can lead to better management of overhead and operational costs, ultimately improving profitability.

Best Practices for Cost Allocation

Implementing best practices for cost allocation ensures accuracy, fairness, and transparency in financial reporting and decision-making. Here are some best practices to ensure appropriate cost allocation:

• Clearly identify and specify the cost objects to which costs will be allocated, such as departments or products.
• Choose allocation bases that reflect actual usage, like direct labor hours or square footage.
• Apply consistent cost allocation methods across similar cost types for reliability and comparability.
• Periodically assess and adjust cost allocation techniques to maintain accuracy.
• Keep detailed records of allocation methods and the rationale behind them to ensure transparency.
• Regularly review allocated costs to identify trends and control expenses.
• Automate and streamline cost allocation by utilizing accounting software.

How Can HighRadius Help in the Effective Cash Allocation Process? 

HighRadius offers a cloud-based Record to Report solution that helps accounting professionals streamline and automate the financial close process for businesses. We have helped accounting teams from around the globe with month-end closing, reconciliations, journal entry management, intercompany accounting, and financial reporting.

Our Financial Close Software is designed to create detailed month-end close plans with specific close tasks that can be assigned to various accounting professionals, reducing the month-end close time by 30%.The workspace is connected and allows users to assign and track tasks for each close task category for input, review, and approval with the stakeholders. It allows users to extract and ingest data automatically, and use formulas on the data to process and transform it. 

Our Account Reconciliation Software provides an out-of-the-box formula set that can configure matching rules and match line-level transactions from multiple data sources and create templates to automate various transaction processing required for month-end close. Our solution has the ability to prepare and post journal entries, which will be automatically posted into the ERP, automating 70% of your account reconciliation process. 

Our AI-powered Anomaly Management Software helps accounting professionals identify and rectify potential ‘Errors and Omissions’ throughout the financial period so that teams can avoid the month-end rush. The AI algorithm continuously learns through a feedback loop which, in turn, reduces false anomalies. We empower accounting teams to work more efficiently, accurately, and collaboratively, enabling them to add greater value to their organizations’ accounting processes.

1) What is the purpose of cost allocation?

The purpose of cost allocation is to distribute expenses accurately across different departments, products, or projects to determine their true cost and profitability. This helps in budgeting, pricing, financial reporting, and decision-making, ensuring fair and informed resource management.

2) What is a cost driver?

A cost driver is a factor that causes changes in the cost of an activity or product. It directly influences the amount of cost incurred, such as the number of machine hours used, the volume of production, or the level of activity. Identifying cost drivers helps in accurate cost allocation and budgeting.

3) What is an example of an allocated cost?

An example of an allocated cost is factory rent. If a company operates multiple departments, the rent cost is distributed among them based on criteria like floor space used. This allocation ensures each department bears a fair share of the overall rent expense, reflecting their use of shared resources.

4) What is the importance of cost allocation?

Cost allocation is crucial for accurately determining the cost and profitability of products, services, or departments. It supports effective budgeting, pricing, and financial reporting by ensuring expenses are fairly distributed, leading to informed decision-making and efficient resource management.

5) Which cost allocation method is best?

The direct allocation method is often considered the best for its simplicity and clarity. It assigns costs directly to specific products, services, or departments based on actual usage, ensuring straightforward and accurate cost tracking. This method is particularly useful for smaller organizations or simpler cost structures.

6) What is a cost allocation plan?

A cost allocation plan is a structured approach to distributing costs among various departments, projects, or products. It outlines the methods and bases used for allocating expenses, ensuring that costs are fairly and accurately assigned to reflect their actual consumption and usage.

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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: The Key to Understanding Financial Efficiency

✅ All InspiredEconomist articles and guides have been fact-checked and reviewed for accuracy. Please refer to our editorial policy for additional information.

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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• Building Your Business

What Is Cost Allocation?

Cost Allocation Explained in Less Than 5 Minutes

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 ."

What is cost allocation?

For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

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Author: Harold Averkamp, CPA, MBA

Definition of 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. Because of the arbitrariness, some people describe cost allocation as the spreading of a cost.

Accountants have made efforts to improve the cost allocation techniques. Over time, manufacturers’ overhead allocations have moved from a plant-wide rates to departmental rates. Some allocations that were allocated on the basis of direct labor hours are now based on machine hours. In order to improve those bases of allocations, some accountants are implementing activity based costing. The goal is to reduce the arbitrariness by identifying the various root causes of the overhead costs.

Examples of Cost Allocations

The following are only a few of the many cost allocations that occur in some companies or organizations:

• The cost of a manufacturing building is allocated to each of the years that the building is expected to be used. Each year’s depreciation is allocated to the departments that use the building. Each department’s allocated cost is then allocated/assigned to the products that are processed in the department.
• The electricity that is used in the production facility as measured by a single meter is allocated to the departments using the electricity. Each department’s electricity is then allocated/assigned to the products processed in the department.
• The cost of raw land that was purchased for $1 million is going to be developed into 80 residential lots of various sizes and 10 business lots of different sizes. The $1 million cost must be allocated to the resulting 90 lots in a meaningful way so that the developer can report the profit of selling two residential lots and the largest of the business lots. The basis for the allocation is likely to be the net realizable values of the lots.
• The annual salary and benefits of an employee that spends time in three main functions of a nonprofit organization.

Related Questions

• Is depreciation a direct or indirect cost?
• Are insurance premiums a fixed cost?
• What is the cost of goods sold?
• What is cost behavior?
• How do I determine the cost of missing inventory?
• What are LIFO layers?

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• Activity Based Costing
• Manufacturing Overhead
• Nonmanufacturing Overhead

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Why Allocating Costs Is Important for Your Small Business

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Our Small Business Expert

Business owners use cost allocation to assign costs to specific cost objects. Cost objects include products, departments, programs, and jobs. Cost allocation is necessary for any type of business, but it's more frequently used in manufacturing businesses that incur a wider variety of costs.

Overview: What is cost allocation?

Part of doing business is incurring costs. To ensure accurate financial reporting, it’s vital these costs are allocated to the appropriate cost object.

While bookkeepers and accounting clerks may need some guidance in properly allocating expenses, using accounting software can help to automate and simplify the entire process considerably.

To track and allocate costs, the cost needs to first be associated with a specific cost object. For example, your company pays $3500 property insurance annually for two buildings you currently own.

One building is 4,000 square feet, while the other building is 8,000 square feet. 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 doing business. These costs can range from the cost of materials needed to produce a finished product, to the direct labor wages paid to the employee running the machine used to assemble the product, to the overhead costs you incur every day simply by opening your doors.

Before you get started, familiarize yourself with the various types of costs your business is likely to incur.

1. Direct costs

A direct cost is anything that your business can directly connect to a cost object. Tied directly to production, direct costs are the only costs that need not be allocated, but instead are used when calculating cost of goods sold.

The most common direct costs that a business incurs include direct labor, direct materials, and manufacturing supplies. An employee working the assembly line is considered direct labor, a direct cost.

Same goes for the plastic needed to manufacture a toy, or the glue that holds pieces of the toy together. Direct costs are almost always variable because they vary based on production levels. However, if production remains constant, direct costs may remain constant as well.

2. Indirect costs

Indirect costs are costs incurred in the day to day operations of your business. Indirect costs cannot be tied back to one particular product, but are still considered necessary for production to occur or services to be delivered.

Indirect costs, such as utilities and line supervisor salaries are considered necessary for production, but are not tied to a specific product or service, so they’ll need to be allocated accordingly.

3. Overhead costs

Overhead costs, also known as operating costs are the everyday cost of doing business. Overhead costs are never tied to production, either directly or indirectly, but instead are the costs that your business incurs whether or not they’re producing goods or providing services.

For example, rent, insurance, and office supplies are considered overhead costs, which are costs incurred regardless of production levels.

Some overhead costs such as supplies and printing can be variable, while others, such as rent, insurance, and management salaries are all fixed costs, since the cost does not change from month to month. Like indirect costs, overhead costs will need to be allocated regularly in order to determine actual product cost.

Cost allocation examples

Cost allocation isn’t only necessary for manufacturing companies. There are plenty of reasons other companies may need to allocate costs.

Allocating an employee’s salary between two departments, allocating a utility bill between administrative and manufacturing facilities, or a nonprofit that needs to allocate costs between various programs are just a few reasons almost any business may need to regularly allocate costs.

When allocating costs, there are four allocation methods to choose from.

• Direct labor
• Machine time used
• Square footage
• Units produced

In the examples below, we used the square footage and the units produced methods to calculate the appropriate cost allocation.

Cost allocation example 1

Ken owns a small manufacturing plant, with administrative offices housed on the second floor. The square footage of the plant is 5,000 square feet, while the administrative offices are 2,500 square feet, with rent for the entire facility $15,000 per month. Rent must be allocated between the two departments.

The calculation would be:

$15,000 (rent) ÷ 7,500 (square feet) = $2 per square foot

Next, Ken, will calculate the rental cost for the plant:

$2 x 5,000 = $10,000

That means that Ken can allocate $10,000 to overhead expenses for the factory.

Next, Ken will calculate the rental cost for the administrative offices:

$2 x 2,500 = $5,000

The balance of the rent, $5,000, will be allocated to the administrative offices.

Cost allocation example 2

Carrie’s manufacturing company manufactures backpacks. In July, Carrie produced 2,000 backpacks with direct material costs of $5.50 per backpack, and $ 2.25 direct labor costs per backpack.

She also had $7,250 in overhead costs for the month of July. Using the number of units produced as the allocation method, we can calculate overhead costs using the following overhead cost formula:

$7,250 ÷ 2,000 = $3.63 per backpack

When added to Carrie’s direct costs, the cost to produce each backpack is $11.38, calculated as follows:

• Direct Materials: $ 5.50 per backpack
• Direct Labor: $ 2.25 per backpack
• Overhead: $ 3.63 per backpack
• Total Cost: $11.38 per backpack

If Carrie did not allocate the overhead costs, she probably would have underpriced the backpacks, resulting in a loss of income.

No, cost allocation is necessary for any business including service businesses and nonprofit organizations.

To track and allocate costs, the cost needs to be identified with a cost object, which costs are assigned to. Cost objects can include:

• Departments

Almost anything can be considered a cost object if you’re able to assign a cost to it.

Yes. While larger companies may have a greater need to allocate costs, smaller businesses can also benefit from allocating costs properly.

For example, even a small car repair shop will need to allocate parts and labor costs properly, while a small consulting business will need to allocate travel costs to the appropriate customer.

Why you should be allocating costs

Cost allocation is important for any business, large or small. How can you determine how much to charge for goods or services if you have no idea how much it costs to produce the goods or services you currently offer your customers?

Properly allocating costs is also essential for accurate financial reporting. Business owners rely on financial statements to make management decisions, and if the reports are inaccurate, it’s likely the decisions made will negatively affect the business.

Finally, allocating costs properly can help you identify profitable areas of your business and products or services that may be losing money, enabling you to make proactive decisions regarding both.

There’s no good reason not to allocate your business costs, so why not get started today?

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• ABOUT ELORUS

Mastering Cost Allocation for Service-Based Business Success

Running a service-based business is tough enough without guessing where your money goes. Whether you’re leading a marketing agency, a law firm, or a software development company, knowing how to properly allocate costs can save you a lot of headaches and keep your business running smoothly.

In fact, cost allocation isn’t just about tracking expenses. Rather, it’s about understanding your profitability and pricing your services right to increase financial success over the long haul.

In this article, we’ll cover the basics of cost allocation, its benefits, and how you can implement it in your service-based business.

What is cost allocation?

Cost allocation is all about distributing your business expenses to the areas that generate them. For a service-based company, this could mean spreading costs like office rent, employee salaries, or software subscriptions across different clients or projects. The goal is simple: to get a clear picture of what’s costing you money and what’s making you money.

Take a digital marketing agency, for example. You have multiple clients, and each project requires different resources. When you allocate costs properly—say, the time your employees spend, the tools they use, or even the office space they occupy—you’ll know how much each project truly costs. Without this clarity, it’s easy to undercharge or overestimate your profitability.

Core types of costs in service-based businesses

Before allocating costs, you need to understand the types of costs your business has. Generally, these fall into two main categories:

• Direct costs: These are expenses that directly tie to a specific project or client. Examples include employee salaries, tools like Adobe Creative Suite for a design project, and raw materials.
• Indirect costs (or overhead): These are shared costs that keep your business running but can’t be tied directly to one service or project. Things like rent, utilities, and office supplies fall into this bucket.

Knowing the difference between these two is essential for accurate cost allocation. Direct costs are usually easy to assign, while indirect costs require a bit more thought and the use of cost drivers .

What are cost drivers?

Cost drivers are factors that impact your overall costs. Simply put, they’re the “cause” behind your business expenses. In service-based industries, this often comes down to things like labor hours or the number of clients served. Understanding cost drivers helps you allocate indirect costs more accurately, ensuring you’re not spreading those expenses too thinly across your business.

Here are a few examples of cost drivers: 

• Labor hours : This describes the time your employees spend working on a project.
• Number of clients : Some overhead costs, like rent, might be spread across your client base depending on how many you serve.
• Project complexity : More complex projects often require more resources, both in terms of time and seniority, increasing overall costs.

The specific cost drivers you encounter may differ depending on your industry. 

Benefits of cost allocation for service-based businesses

So, why bother with all this cost allocation stuff? Because it can completely transform the way you manage your business.

Let’s talk now about the benefits it can provide:

Boosts profitability

Proper cost allocation gives you a clear picture of which clients or projects are the most profitable . This insight means you can focus on the work that brings in the highest margins and reduce inefficiencies elsewhere. 

Helps you set the right prices

Pricing your services can be tricky, especially when you’re unsure cost-allocation where your money is going. With cost allocation, you can confidently set competitive prices that cover your expenses without scaring away clients.

Informed business decisions

When you know what’s driving your costs, you’re in a much better position to make strategic decisions. For instance, is now a good time to invest in new tools? Hire more staff? Or, even let go of less profitable clients? A clear concept of cost drivers gives you the knowledge you need to move your business forward.

Better budgeting and planning

When you understand your costs, you can also create more accurate budgets and financial forecasts . This helps you plan for the future without unexpected surprises.

Cost allocation best practices

Now that you know the value of cost allocation, let’s talk about some best practices that can make this process smoother for your business:

Use automation tools

There’s no need to do all this manually. Tools like Elorus can help automate your cost-allocation process . It allows service-based companies to easily track business expenses and profitability for different clients and projects. In fact, Elorus can greatly simplify expense management and automate the time-tracking process for your projects.

Review and adjust regularly

Your business isn’t static, and neither should your cost allocation model. Make it a habit to review and update your cost drivers and allocations regularly, especially as your business grows or your services change.

Educate your team

Getting everyone on board with cost allocation, especially your finance and project management teams, ensures the process is accurate and streamlined. It’s a team effort! And making this extra effort upfront makes for smoother sailing later.

Stay flexible

As your business scales, cost allocation will get more complex. Ensure your systems and processes can adapt to new clients, services, and cost drivers. Part of this means updating your analysis periodically. And relying on automation tools like Elorus can help as well. 

Cost allocation example in a web development agency

Let’s say you’re running a web development agency that builds custom websites for clients. Each project is different, requiring unique levels of expertise, tools, and time. 

Here’s how you could apply cost allocation to one of your recent projects:

• Direct costs : First, you'd assign the obvious costs directly tied to the project. This would include the salaries of the developers and designers working on the website, any third-party tools or software you purchased specifically for the project (such as paid themes, plugins, or code libraries), and even hosting or testing services required during the development process.
• Indirect costs : Next, you’d tackle overhead expenses. These could include rent for your office space, utilities, and administrative staff salaries. Since these costs benefit the entire agency, not just one project, you’d allocate them using a cost driver , like the number of billable and non-billable hours the team spent on the project. So, if the project took 100 hours and your team worked a total of 1,000 hours that month, you could allocate 10% of your overhead costs to that project.

This level of detail ensures you’re accounting for every cost, allowing you to see exactly how profitable the web development project was. If you find that certain types of projects (like complex custom builds) have slimmer margins due to high costs, you can adjust your pricing or resource allocation for future work.

Boost your service-based business with cost allocation

Mastering cost allocation is vital for any service-based business that wants to be successful long-term. Breaking down your costs and assigning them where they belong means you get a clearer understanding of your profitability, make smarter pricing decisions, and ultimately boost your business’s financial health.

Whether you're running a small law firm or a large creative agency, putting these cost-allocation strategies to work will help you stay competitive and set your business up for long-term success. And don’t forget: tools like Elorus can help make the whole expense management process much simpler, saving you time and ensuring that every dollar is accounted for.

Grow your business with Elorus

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