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. The following are only a few of the many cost allocations that occur in some companies or organizations:
What is a Cost Allocation?Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs. Examples of cost objects are a product, a research project, a customer, a sales region, and a department. Cost allocation is used for financial reporting purposes, to spread costs among departments or inventory items. Cost allocation is also used in the calculation of profitability at the department or subsidiary level, which in turn may be used as the basis for bonuses or the funding of additional activities. Cost allocations can also be used in the derivation of transfer prices between subsidiaries. Example of Cost AllocationThe African Bongo Corporation (ABC) runs its own electrical power station in the hinterlands of South Africa, and allocates the cost of the power station to its six operating departments based on their electricity usage levels. Cost Allocation MethodsThe very term "allocation" implies that there is no overly precise method available for charging a cost to a cost object, so the allocating entity is using an approximate method for doing so. Thus, you may continue to refine the basis upon which you allocate costs, using such allocation bases as square footage, headcount, cost of assets employed, or (as in the example) electricity usage. The goal of whichever cost allocation method you use is to either spread the cost in the fairest way possible, or to do so in a way that impacts the behavior patterns of the cost objects. Thus, an allocation method based on headcount might drive department managers to reduce their headcount or to outsource functions to third parties. Cost Allocation and TaxesA company may allocate costs to its various divisions with the intent of charging extra expenses to those divisions located in high-tax areas, which minimizes the amount of reportable taxable income for those divisions. In such cases, an entity usually employs expert legal counsel to ensure that it is complying with local government regulations for cost allocation. Reasons Not to Allocate CostsAn entirely justifiable reason for not allocating costs is that no cost should be charged that the recipient has no control over. Thus, in the African Bongo Corporation example above, the company could forbear from allocating the cost of its power station, on the grounds that none of the six operating departments have any control over the power station. In such a situation, the entity simply includes the unallocated cost in the company's entire cost of doing business. Any profit generated by the departments contributes toward paying for the unallocated cost. What is the purpose of using a cost allocation system?A cost allocation methodology identifies what services are being provided and what these services cost. It also establishes a basis for allocating these costs to business units or cost centers based on their appropriate share of such cost.
What are four purposes of cost allocation?The four main purposes for allocating costs are to predict the economic effects of planning and control decisions, to motivate managers and employees, to measure the costs of inventory and cost of goods sold, and to justify costs for pricing or reimbursement.
What is the meaning of cost allocation?Cost allocation is the process of identifying, aggregating, and assigning costs to cost objects. A cost object is any activity or item for which you want to separately measure costs. Examples of cost objects are a product, a research project, a customer, a sales region, and a department.
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