Cost allocation is the assigning of a common cost to several cost objects. For example, a company might allocate or assign the cost of an expensive computer system to the three main areas of the company that use the system. A company with only one electric meter might allocate the electricity bill to several departments in the company. Cost allocation implies that the assigning of the cost is somewhat arbitrary. Some people describe the allocation as the spreading of cost, because of the arbitrary nature of the cost allocation. Efforts have been made over the years to improve the bases for cost allocation. In manufacturing, the overhead allocations have moved from plant-wide rates to departmental rates, from direct labor hours to machine hours to activity based costing. The goal is to allocate or assign the costs based on the root causes of the common costs instead of merely spreading the costs.
Direct costs can be physically traced to each department. Indirect costs must be allocated. Many companies develop allocation methods to assign service department costs to the producing departments. All organizations accumulate costs for their products or services for financial reporting purposes. An accounting system will assign to a department’s output all its direct costs plus all the indirect costs allocated to it. A cost driver that has a logical, cause-effect relationship to the cost will be used as a cost-allocation base.
Linking costs with cost objectives is accomplished by selecting cost drivers. When used for allocating costs, a cost driver is often called a cost-allocation base. Major costs, such as newsprint for a newspaper and direct professional labor for a law firm, may each be allocated to departments, jobs, and projects on an item-by-item basis, using obvious cost drivers such as tonnes of newsprint consumed or direct-labor-hours used. Other costs, taken one at a time, are not important enough to justify being allocated individually. These costs are pooled and then allocated together.
A cost pool is a group of individual costs that is allocated to cost objectives using a single cost driver. For example, building rent, utilities cost, and janitorial services may be in the same cost pool because all are allocated on the basis of square meters of space occupied or a university could pool all the operating costs of its registrar’s office and allocate them to its colleges on the basis of the number of students in each faculty. In summary, all costs in a given cost pool should be caused by the same factor. That factor is the cost driver. Many different terms are used by companies to describe cost allocation in practice. You may encounter terms such as allocate, attribute, reallocate, trace, assign, distribute, redistribute, load, burden, apportion, and reapportion, which can be used interchangeably to describe the allocation of costs to cost objectives.
The allocation of costs is necessary when the linkage between the costs and the cost objective is indirect. In this case, a basis for the allocation, such as direct-labour-hours or tonnes of raw material, is used even though its selection is arbitrary. A cost allocation base has been described as incorrigible, since it is impossible to objectively determine which base perfectly describes the link between the cost and the cost objective. Given this subjectivity in the selection of a cost-allocation base, it has always been difficult for managers to determine “When should costs be allocated?” and “On what basis should costs be allocated?” The answers to these questions depend on the principal purpose or purposes of the cost allocation.
Costs are allocated for three main purposes:
- To obtain desired motivation. Cost allocations are sometimes made to influence management behavior and thus promote goal congruence and managerial effort. Consequently, in some organizations there is no cost allocation for legal or internal auditing services or internal management consulting services because top management wants to encourage their use. In other organizations there is a cost allocation for such items to spur managers to make sure the benefits of the specified services exceed the costs.
- To compute income and asset valuations. Costs are allocated to products and projects to measure inventory costs and cost of goods sold. These allocations frequently service financial accounting purposes. However, the resulting costs are also often used by managers in planning, performance evaluation, and to motivate managers.
- To justify costs or obtain reimbursement. Sometimes prices are based directly on costs, or it may be necessary to justify an accepted bid. For example, government contracts often specify a price that includes reimbursement for costs plus some profit margin. In these instances, cost allocations become substitutes for the usual working of the marketplace in setting prices.