The 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. After identifying the cost objects, the next step is to accumulate the costs into a cost pool, pending allocation to the cost objects. When accumulating costs, you can create several categories where the costs will be pooled based on the cost allocation base used.

1. If Carrie did not allocate the overhead costs, she probably would have underpriced the backpacks, resulting in a loss of income.
2. As business units begin seeing the cost of the services they consume, they can make more informed choices—such as trade-off decisions between service levels and costs, and benchmarking internal costs against outsourced providers.
3. If costs are allocated to the wrong cost objects, the company may be assigning resources to cost objects that do not yield as much profits as expected.

Other scenarios might include payroll cost allocation based on employee cost centers, or payment processing cost allocation based on transactions per location or franchise. To accurately calculate cost allocation, you must first identify the cost object, then begin to assess the actual cost. Cost allocation base can be defined as a factor that is the common denominator for systematically linking a cost or group of costs to a cost object such as a department or an activity. Once the calculation is established and cost distributions are calculated, journal entries are created to transfer costs from the providing or paying entity to the appropriate consuming entities. During each financial period, as periodic expenses are incurred, this calculation is repeated and allocating entries are made.

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The goal is to reduce the arbitrariness by identifying the various root causes of the overhead costs. Cost allocation is the process of identifying, accumulating, and assigning costs to costs objects such as departments, products, franked dividend definition programs, or a branch of a company. It involves identifying the cost objects in a company, identifying the costs incurred by the cost objects, and then assigning the costs to the cost objects based on specific criteria.

The balance of the rent, $5,000, will be allocated to the administrative offices. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets. Before you get started, familiarize yourself with the various types of costs your business is likely to incur. 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. For information pertaining to the registration status of 11 Financial, please contact the state securities regulators for those states in which 11 Financial maintains a registration filing.

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Cost allocations can also be used in the derivation of transfer prices between subsidiaries. For example, if you were cost allocating rent, it would be allocated to overhead expenses. 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. The 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.

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

Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice. All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Take your learning and productivity to the next level with our Premium Templates. 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. That means you might consider increasing prices to maintain a specific profit margin.

It also establishes a basis for allocating these costs to business units or cost centers based on their appropriate share of such cost. 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.

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. For example, rent, insurance, and office supplies are considered overhead costs, which are costs incurred regardless of production levels. 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. A direct cost is anything that your business can directly connect to a cost object.

Determining Costs

Cost allocation is the distribution of one cost across multiple entities, business units, or cost centers. An example is when health insurance premiums are paid by the main corporate office but allocated to different branches or departments. Some examples of cost objects are jobs, payroll, departments, projects, financial systems, IT, and programs. 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.

Cost allocation provides the management with important data about cost utilization that they can use in making decisions. It shows the cost objects that take up most of the costs and helps determine if the departments or products are profitable enough to justify the costs allocated. For unprofitable cost objects, https://www.kelleysbookkeeping.com/8-key-construction-accounting-best-practices-for-contractors/ the company’s management can cut the costs allocated and divert the money to other more profitable cost objects. An example of a fixed cost is the remuneration of a project supervisor assigned to a specific division. The other category of indirect cost is variable costs, which vary with the level of output.

Cost allocation example 1

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. The cost object can be a brand, project, product line, division/department, or a branch of the company. The company should also determine the cost allocation base, which is the basis that it uses to allocate the costs to cost objects. They are not related to the labor or material costs that are incurred in the production of goods or services. Overhead costs are charged to the expense account, and they must be continually paid regardless of whether the company is selling goods or not.