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BlackLine Blog

June 13, 2018

What is Cost Allocation? An Introduction to Cost Allocations

Michael shultz.

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• Cost Allocation Example & Definition

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.

When cost allocations are carried out, a basis for the allocation must be established, such as the headcount in each branch or department.

• Cost Allocation Methodology

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.

The basis for allocating costs may include headcount, revenue, units produced, direct labor hours or dollars, machine hours, activity hours, and square footage.

Companies will often implement a cost allocation methodology as a means to control costs. Under an effective cost allocation methodology, business units become directly accountable for the services they consume. As a result, both the service provider and the respective consumers of that service become aware of service requirements and usage, and how such usage influences the costs incurred.

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.

• Process for Performing Cost Allocations

Using a basis for allocation, costs are spread to each business unit or cost center that incurred the cost based on their proportional share of the cost. For example, if headcount forms the basis of allocation for insurance costs, and there are 1000 total employees, then a department with 100 employees would be allocated 10% of the insurance costs.

While there are numerous ways cost allocations can be calculated, it is important to ensure the reasoning behind them is documented. This is often done by establishing allocation formulas or tables.

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.

• What Does a Cost Allocation System Do?

A cost allocation system consists of a way to track which entity within an organization provides a product and/or service, the entity that consumes the products and/or services, and a means of distributing this cost from the provider to the consumer or consumers. Depending on the operating structure of the company, the cost allocation may be performed by internal invoice, through a chargeback module in the ERP system, or more commonly, through journal entries performed by accounting staff each financial period.

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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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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 ."

The Comprehensive Guide to Cost Allocation in Accounting

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

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

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

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

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

What Is the Concept of Allocation?

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

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

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

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

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

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

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

What Doesn’t the Term Allocation Mean?

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

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

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

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

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

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

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

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

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

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

Where the Term Allocation Originated From?

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

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

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

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

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

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

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

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

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

How Allocation Relates to Accounting?

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

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

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

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

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

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

3 Examples of Allocation Being Used in Accounting Practice

Example #1 of allocation being used in accounting practice.

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

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

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

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

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

Example #2 of Allocation Being Used in Accounting Practice

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

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

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

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

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

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

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

Example #3 of Allocation Being Used in Accounting Practice

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

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

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

How to Do Cost Allocation in Simple Steps?

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

Step 1: Identify the Costs That Need to Be Allocated

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

Step 2: Choose the Appropriate Method of Cost Allocation

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

Step 3: Determine the Allocation Base

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

Step 4: Allocate the Costs

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

Step 5: Review and Adjust the Cost Allocation

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

Which Industries Can Cost Allocation Be Applied?

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

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

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

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

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

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

Manufacturing

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

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

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

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

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

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

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

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

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

Information Technology

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

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

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

Construction

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

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

Transportation

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

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

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

Food and Beverage

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

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

Real Estate

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

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

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

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

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

Pros of Cost Allocation

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

Improved Decision Making

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

Better Resource Allocation

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

Increased Profitability

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

Better Budget Planning

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

Improved Internal Control

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

Better Understanding of Overhead Costs

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

Improved Cost Reporting

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

Better Negotiations

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

Cons of Cost Allocation

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

Time-Consuming Process

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

Increased Complexity

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

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

Unreliable Data

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

Resistance to Change

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

Limited Flexibility

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

Potential for Misallocation

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

Dependence on Cost Allocation

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

Frequently Asked Questions- Cost Allocation in Accounting

What are the main objectives of cost allocation.

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

What Is Direct Cost Allocation?

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

What Is Step-Down Allocation?

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

What Is Sequential Allocation?

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

What Is Activity-Based Costing?

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

Why Is Cost Allocation Important for Businesses?

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

How Does Cost Allocation Impact Resource Allocation?

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

How Does Cost Allocation Impact Pricing Decisions?

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

The Comprehensive Guide to Cost Allocation in Accounting – Conclusion

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

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

The Comprehensive Guide to Cost Allocation in Accounting – Recommended Reading

Corporate Accountant: What Are the Responsibilities, Duties, & Salary of a Corporate Accountant?

How Can Business Intelligence Help with Budget Planning (in 2023)

Standard Costing- Common Problems (And How to Solve Them)

 Updated: 5/19/2023

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Danica De Vera

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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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Home » Resource Allocation: Definition, Methods and Examples

Resource Allocation: Definition, Methods and Examples

June 13, 2023 max 7min read.

This article covers:

What Is Resource Allocation?

Benefits of resource allocation, how to allocate resources effectively, resource allocation methods, examples of resource allocation.

In the vast landscape of organizational management, one crucial concept looms large: resource allocation. Picture a complex puzzle, with various pieces representing the finite resources available to a company or project. 

The art and science of resource allocation involve deciphering how to distribute those pieces strategically, maximizing productivity, and achieving desired outcomes.

At its core, resource allocation refers to assigning resources, be it financial, human, or material, to different tasks, projects, or departments. It requires a delicate balance between efficiency and effectiveness as organizations strive to optimize resource utilization while meeting objectives.

Resource allocation methods vary, with some relying on intuitive decision-making. In contrast, others employ systematic approaches such as cost-benefit analysis , priority setting, or mathematical models. These methods help stakeholders determine the allocation that offers the most value and impact.

Let us learn all about resource allocation in this article.

Resource Allocation Definition:

Resource allocation refers to assigning and distributing available resources, such as financial capital, human capital, equipment, and time, among different activities, projects, or departments within an organization.

Resource allocation is a fundamental management process that efficiently utilizes limited resources to achieve organizational goals. It is a strategic tool that enables organizations to optimize operations, make informed decisions, and drive sustainable growth and success.

Resource allocation plays a crucial role in determining the success and sustainability of a business or project. Effective resource allocation allows organizations to:

• Optimize productivity : By strategically allocating resources, organizations can maximize output and productivity, ensuring that resources get utilized most efficiently.
• Prioritize initiatives : Resource allocation enables organizations to prioritize projects or activities based on their strategic importance, urgency, or potential return on investment. It helps identify and focus on high-priority initiatives, avoiding waste or misalignment of resources.
• Manage risks : By allocating resources appropriately, organizations can mitigate risks and uncertainties associated with projects or activities. It allows for contingency planning and ensures that resources are available when needed, reducing the likelihood of delays or failures.
• Enhance decision-making : Resource allocation provides a structured framework for decision-making. It helps stakeholders evaluate trade-offs, analyze cost-benefit ratios, and make informed choices regarding the allocation of resources.
• Foster innovation and growth : Effective resource allocation supports innovation and growth by directing resources toward research and development, new initiatives, and strategic opportunities. It enables organizations to adapt to changing market dynamics and invest in future success.

Resource allocation benefits organizations, including increased efficiency, reduced costs, and improved project success rates. Let us look at them in detail.

• Increased efficiency : By allocating resources strategically, organizations can ensure their resources get used to their full potential. This leads to better efficiency and productivity, as tasks can get completed more quickly.
• Reduced costs : Proper resource allocation can help organizations minimize unnecessary expenses. By avoiding overallocation or underutilization of resources, organizations can save money on things like excess inventory, idle workforce, and redundant equipment.
• Improved project success rates : Resource allocation is essential for successful project management. By allocating the right resources to suitable projects, organizations can boost the chances of project success. This involves assigning resources with the necessary skills and expertise to specific tasks and ensuring that projects are adequately staffed and equipped.

Here are some additional benefits of effective resource allocation:

• Improved employee morale : When employees get the resources they need to do their jobs effectively, they are more likely to be motivated and engaged. This can lead to improved productivity, decreased turnover, and increased customer satisfaction.
• Enhanced decision-making : By having a clear understanding of the availability and capabilities of their resources, organizations can make useful decisions about how to allocate them. This can indeed result in improved strategic planning and execution, as well as more efficient use of resources.
• Increased agility : Effective resource allocation can help organizations respond more swiftly to changes in the market or the environment. It can give them a competitive advantage and help them achieve their goals more quickly.

To allocate resources effectively, organizations can follow a systematic approach that involves the following steps:

Here are the steps on how to allocate resources effectively:

• Identify your resources. What resources do you have available? This includes financial capital, human resources, equipment, technology, and other assets.
• Prioritize your tasks. What tasks are most important? Which ones need to get done first? Consider the urgency, importance, and potential return on investment of each task.
• Create a resource allocation plan. How will you allocate your resources to the different tasks? Make sure that you consider the resource requirements of each task, the availability of resources, and any dependencies or constraints.
• Monitor and adjust your plan as needed. How are your resources being used? Are you on track to accomplish your goals? Make adjustments to your plan as needed.

Here are some additional tips for effective resource allocation:

• Be flexible and adaptable. Things change, so be ready to adjust your resource allocation plan as needed.
• Communicate with your team. Keep your team updated on your resource allocation plan and any changes that you make.
• Get feedback. Ask your team for feedback on your resource allocation plan. It can help you identify any areas where you can improve.

Effective resource allocation is essential for any organization to achieve its goals. By following these steps, you can ensure that your resources get used effectively and that you are on track to meet your goals.

Resource allocation methods provide structured approaches to distributing resources within an organization effectively. Here are four commonly used methods:

Critical Path Method (CPM) : 

You may define the critical path and the order of work that determines the minimal project length using the critical path method. CPM works by analyzing task dependencies, durations, and resource requirements. This helps you identify the optimal allocation of resources to critical tasks. By allocating resources efficiently, you can minimize project delays and maximize productivity.

Here are the steps involved in CPM:

• Identify all the tasks in the project.
• Determine the dependencies between tasks. This means identifying which tasks must get completed before other tasks can start.
• Estimate the duration of each task.
• Calculate the critical path. You do this by finding the longest sequence of tasks that must get completed on schedule for the project to get completed on time.
• Allocate resources to critical tasks. You can do it by ensuring that there are enough resources available to complete the critical tasks on time.

Earned Value Management (EVM) : 

Earned value management (EVM) is a technique that integrates cost, schedule, and scope to track and measure project progress. EVM compares the value of work completed against the planned budget and schedule. This helps project managers identify deviations from the plan and take corrective actions to ensure that the project concludes on schedule and within the allotted budget.

EVM works by tracking three key metrics:

• Planned value (PV) : This is the budgeted cost of the work that has gotten scheduled for completion at a given point in time.
• Earned value (EV) : It is the value of the work that you have actually completed at a given point in time.
• Actual cost (AC) : This is the actual cost of the work completed at a given time.

Resource Leveling : 

Resource leveling is a project management methodology that helps you balance the demand for resources with the available supply. It does this by adjusting task schedules or adding or removing resources. The goal of resource leveling is to optimize resource allocation while maintaining project constraints and deadlines.

Resource leveling can be used to:

• Avoid resource overloading: This can lead to errors, accidents, and burnout.
• Avoid resource underutilization: This can waste resources and lead to cost overruns.
• Minimize conflicts: This can improve morale and productivity.
• Maximize resource utilization efficiency: This can save money and time.

Resource leveling can be a complex process, but it is an extremely valuable tool for project managers. If you are a project manager, I encourage you to learn more about resource-leveling.

Resource Smoothing : 

Resource smoothing focuses on maintaining a constant resource utilization rate by adjusting the project schedule. It aims to minimize resource fluctuations by redistributing tasks within the available time frame while considering resource constraints. Resource smoothing helps avoid resource peaks and valleys, prevent resource bottlenecks, and ensure a more stable and balanced allocation of resources.

Here are a few examples of resource allocation in different contexts:

Financial Resource Allocation : 

A multinational corporation has a budget for marketing activities. To effectively allocate financial resources, they analyze market research data, identify target markets , and allocate funds to various marketing campaigns, such as digital advertising, social media promotions, and sponsored events. They allocate resources based on the potential return on investment and the strategic objectives of each campaign.

Human Resource Allocation : 

A software development company is working on multiple projects simultaneously. They allocate their human resources by assigning programmers, designers, and testers to different projects based on their skills, expertise, and project requirements. They ensure each project team has the workforce to meet deadlines and deliver high-quality software solutions.

Material Resource Allocation : 

A construction company has limited equipment, such as excavators, cranes, and trucks. They allocate these resources by analyzing project schedules, equipment requirements, and availability. They assign the equipment to different construction sites based on project priorities, ensuring optimal utilization and avoiding delays caused by equipment shortages.

Departing Thoughts

Resource allocation is a fundamental element of effective management and planning. It enables people and organizations to optimize their resources, make sound judgments, and achieve their objectives. By comprehending the advantages and implementing best practices, people and organizations can fully utilize resource allocation and achieve success.

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Resources can be allocated to various organizational areas, including departments, projects, specific tasks, initiatives, or particular individuals/team members.

The three key elements of resource allocation are:

• Resources: These refer to the available assets, such as financial capital, human resources, equipment, technology, and time.
• Allocation: It involves the process of assigning and distributing resources to specific tasks, projects, or departments based on their needs and priorities.
• Optimization: This element focuses on maximizing the utilization and effectiveness of resources, ensuring they get allocated most efficiently and beneficially possible.

Resource allocation methods are structured approaches or techniques used to distribute resources effectively. Some common methods include the Critical Path Method (CPM) for project management, Earned Value Management (EVM) for tracking project progress, Resource Leveling for balancing resource demand and supply, and Resource Smoothing for maintaining a constant resource utilization rate. These methods help organizations make informed decisions about resource allocation, optimize resource utilization, and improve project outcomes.

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Cost Allocation

Cost allocation definition.

The process of charging a cost, or a group of costs, to the funding sources that receive the benefit of the goods or services purchased. For purposes of this discussion, funding sources are defined as either Sponsored Awards or other, non-award budgets.

Allocation Methods

If a cost solely benefits one funding source, it should be charged entirely to that funding source. If a cost benefits more than one funding source, the cost should be charged to each funding source in the same proportion as it provides benefit.

There are two methods for allocating a cost to multiple funding sources:

• Example: A lab purchases 12 gallons of solution. 3 gallons of solution are used on Award A and 9 gallons on Award B. 25% (3/12) is charged to Award A and 75% (9/12) is charged to Award B.
• ​Example: A lab purchases syringes for use in experiments on two Awards. It is impossible to tell in advance exactly how many syringes will be used for each Award, and it would not be cost effective to track the use of each syringe. Instead, the lab allocates the cost of the syringes based on the amount of effort the lab personnel who uses the syringes expends on each Award. If the effort allocation is 70/30 on Awards A and B, the cost of the syringes would also be 70/30.

Costs may not be allocated based on:

• Amount of available funds on an Award;
• Budgetary convenience, e.g., accommodating an Award that is either over or under budget;
• Avoidance of restrictions on an Award; and/or
• Offset where costs are charged to Award A one time and Award B the next time.

Allocation Best Practices

• Document the allocation methodology. Documentation should explain how the allocation methodology is reasonably related to the costs being allocated. Document how measures such as headcount, square footage, or hours directly relate to the benefit received. Documentation should be retained along with the purchase receipt and made available for review.
• The allocation methodology must be used consistently in like circumstances.
• Routinely review the methodology to ensure it continues to represent a reasonable basis for distributing costs. The methodology should be updated if it is determined that it no longer represents a reasonable distribution of costs.
• Review estimated allocations on a routine basis. If a cost has been allocated based on an estimate, that cost can be reallocated - if needed - using a cost transfer . Ensure that reallocations are completed promptly so that accurate costs are recorded on the appropriate funding source within 90 days, per GIM 15 , of the original expense posting date.
• Update allocations when a funding source is no longer available or a new source has been added. The methodology should not change unless it no longer provides a reasonable representation of the benefit provided.
• The end dates of all Awards should be taken into consideration. The benefit received on each Award may be impacted if, for example, two Awards have significantly different end dates.

Allocation Examples

Allocation based on usage: .

The cost of lab supplies allocated based on the quantity used on each Award.

A Principal Investigator uses 5 gallons of solution per month on Award A and 7 gallons of the same solution per month on Award B. The department orders 12 gallons of solution per month at $10 per gallon including tax and shipping for a total cost of $120. Award A should be charged $50 ($10/gallon x 5 gallons) and Award B should be charged $70 ($10/gallon x 7 gallons).

Allocation based on number of experiments:

The cost of syringes allocated based on the number of experiments on each Award.

A Principal Investigator uses syringes to conduct experiments on two of his research Awards. The PI keeps a log of how many experiments are performed on each Award each week. Syringes are ordered every two weeks at $1 per syringe. The log indicates the following:

• Week 1: 25 Experiments
• Week 2: 39 Experiments
• Week 1: 19 Experiments
• Week 2: 16 Experiments

The total cost of the syringes is $99 (99 experiments x $1/syringe). Award A should be charged $64 (64 experiments x $1/syringe) and Award B should be charged $35 (35 experiments x $1/syringe).

Allocation based on number of hours: 

The cost of a computer program allocated based on hours used for each Award.

A researcher uses the same computer program for two Awards. Because the Awards require significantly different usage of the program and the tasks are long, the researcher keeps a log of how much time they use the program for each Award, rounded to the hour. The department is billed quarterly for use of the program. At the end of the quarter, the amount billed is $500 for 50 hours ($10/hour) of work on the two Awards. The researcher’s log shows that 40 hours were used on Award A for a cost of $400 and 10 hours were used on Award B for $100.  

Allocation based on percentage effort: 

The cost of lab supplies allocated based on the PI's percentage of effort charged to each Award.

A PI spends 70% effort on Award A and 30% effort on Award B. The PI uses lab supplies totaling $6,000/month on the two Awards. Award A is charged $4,200 (70% of $6,000) and Award B is charged $1,800 (30% of $6,000).

Allocation based on square footage: 

Student assistant salary allocated based on the square footage of two laboratories.

A student is paid a salary of $1,200 a month to clean two laboratories conducting similar research. The only research performed in Lab A is on Award A and the only research performed in Lab B is on Award B. In this example, the square footage of the laboratories could be used as a reasonable basis to allocate the student's salary. Lab A is 1,400 square feet and Lab B is 1,000 square feet. Award A should be charged $700 (1,400 sq. ft./2,400 sq. ft. x $1,200) and Award B should be charged $500 (1,000 sq. ft./2,400 sq. ft. x $1,200).

Allocation based on FTEs: 

The cost of renting space allocated based on the number of FTEs on each Award.

The Center for Penguin Research is located in Alaska and pays $10,000 in monthly rent. There are three FTEs employed on Award A, six FTEs employed on Award B, and one FTE paid from another non-award funding source. These are all the FTEs at this site and the only two Awards with work performed and managed at this site. Award A should be charged $3,000 monthly rent (3/10 FTEs x $10,000 monthly rent) and Award B should be charged $6,000 (6/10 FTEs x $10,000 monthly rent). The remaining $1,000 monthly rent cannot be charged to either Award.

Post Award Fiscal Compliance email: [email protected]

For questions and issues relating to Effort Reporting, email: [email protected]

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• Cost Classifications
• Relevant Cost of Material
• Manufacturing Overhead Costs
• Conversion Costs
• Quality Costs
• Revenue Expenditure
• Product Cost vs Period Cost
• Direct Costs and Indirect Costs
• Prime Costs and Conversion Costs
• Relevant vs Irrelevant Costs
• Avoidable and Unavoidable Costs
• Cost Allocation
• Joint Products
• Accounting for Joint Costs
• Service Department Cost Allocation
• Repeated Distribution Method
• Simultaneous Equation Method
• Specific Order of Closing Method
• Direct Allocation Method

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

Related Topics

• Cost Behavior

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Allocation Method: Cost Allocation Methods Explained

• by Covenant
• July 23, 2022
• 7 minute read

Table of Contents Hide

What is cost allocation method, how does it work, direct costs, direct labor, direct materials, indirect costs, manufacturing overhead, overheads costs, product costs, what is the direct allocation method, how to determine cost allocation, what is allocation method for direct deposit, define cost objects., create a cost pool., allocation method faqs, what is cost allocation, how does cost allocation work, what is cost allocation used for, how do you calculate a company’s external report.

Different cost allocation method (s) are used to allocate factory overhead costs to units of production.  Allocations are made to create financial statements that conform to the applicable accounting system. 

The most common distribution methods are listed in the following paragraphs along with comments on their advantages and disadvantages.

The cost allocation methodology determines which services are provided and how much these services cost.  It also establishes a basis for apportioning these costs among divisions or cost centers based on their respective shares of such costs.

A cost allocation basis may include headcount, revenue, units produced, direct labor hours or dollars, machine hours, activity hours, and square footage.

Companies often implement a cost allocation methodology as a means of controlling costs.  Under an efficient cost allocation methodology, business units are directly responsible for the services they consume. 

As a result, both the service provider and the respective consumers of the service become aware of the requirements for the services and their usage, as well as how such usage affects the costs incurred.

When business units begin to see the value of the services they consume, they can make more informed choices, such as making trade-offs between service level and cost, and comparing internal costs with external providers.

ALSO CHECK: Cost Object: Definition, Types, Examples & Benefits

Using an allocation basis, costs are allocated to each business unit or cost centre that incurred the costs based on their proportionate share of the costs. 

For example, if headcount is the basis for allocating insurance costs and the total number of employees is 1,000, then a department with 100 employees will be allocated 10% of the insurance costs.

Although there are many ways to calculate cost allocations, it is important to ensure that the reasoning behind them is documented.  This is often done by establishing formulas or distribution tables.

Once the calculation is established and the cost allocation is calculated, journal entries are created to transfer the costs from the supplier entity or the payer entity to the corresponding consumer entities. 

During each financial period, as recurring expenses arise, this calculation is repeated and allocation entries are made.

ALSO CHECK: SALES BUDGET: Step-by-step Guide To Preparing A Sales Budget

What Are The Types of Cost Allocation?

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

These costs are directly related to the product or service.  In your company’s financial statements, these costs can be linked to goods sold.  For a small clothing store, this may include the cost of inventory.

This cost category includes costs directly related to the production of the items or services your company sells.  Direct labor costs include the wages of workers involved in making the goods your company sells.

As the name suggests, this category includes costs associated with resources used to produce a finished product.  Direct materials include fabric used to make clothes or glass used to make tables.

These costs are not directly related to the product or service, but are necessary to create the product or service.  Indirect costs include the wages of those who work in the operational area.  It also lists the costs of materials you use in such small quantities that their cost is easily overlooked.

This category includes warehousing costs and any other costs directly related to the production of the products sold.  Manufacturing overhead includes wages for warehouse managers as well as warehouse costs such as rent and utilities.

These include expenses that support the company as a whole but are not directly related to production.  Some examples of overhead costs are marketing, operations, and utilities for a storefront.

This category is also called “production costs” or “overhead costs”.  This category includes the cost of making or purchasing the product you are selling.  All manufacturing overhead costs are also listed in this category.

ALSO CHECK: INDIRECT LABOR: Definition, Examples and Costs

The direct allocation method is a technique of allocating departmental maintenance costs to other parts of the business.  This concept is used to fully load operations departments with the overhead they are responsible for. 

For example, a cleaner provides cleaning services for all company premises, while the maintenance department is responsible for the company’s equipment and the IT department maintains the information technology systems.  These are all service departments.

ALSO CHECK: WAREHOUSE LOGISTICS: Guide To Improve The Processes

Cost allocation is not an exact science when it comes to cost objects.  Some cost allocation methods are based on units produced, square footage, hours, staff, or usage.

Let’s say you have a building with a photo studio on the first floor and a salon on the second floor;  you will use square meters as the cost object.  The area of ​​the salon is 2,000 square meters, and the studio is 1,000 square meters. 

The total cost of renting the building is $6,000 per month.  To split the rent between two units, you must first divide the total rent by the total floor area of ​​the building:

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

Second, you’ll want to calculate your photography studio rental fee:

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

Thirdly, you can calculate the salon rent:

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

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

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

ALSO CHECK: VARIANCE REPORT: Detailed Guide To Variance Reporting

Direct deposit distribution is the automatic distribution of regular, recurring electronic deposits to one or more eligible accounts.  To set up a direct deposit allocation, please use the attached form to indicate which accounts you wish to fund and the amount to be applied to each account. 

Your direct deposits will be automatically distributed according to your instructions.  Direct deposits can be transferred to almost any account.  Transfer funds to money markets or club accounts for taxes, holidays, vacations, and more. 

Create family savings by transferring funds to your spouse’s or children’s accounts.  Get tax benefits with deductions for depository accounts.  You can even speed up your loan repayments by setting aside funds to supplement your regular monthly payments.

ALSO CHECK: ACCUMULATED AMORTIZATION: How To Calculate It On The Balance Sheet

How Do I Allocate Costs?

Cost objects differ depending on the type of business.  However, the cost allocation process consists of the same steps regardless of what your company produces.

To begin allocating costs, you need to make a list of the cost objects of your business.  Remember that anything in your business that creates costs is a cost object.  Review each product line, project, and department to ensure you have collected all cost objects.

Next, make a detailed list of all business expenses.  It is appropriate to categorize expenses based on the reason for each amount.  Categories should cover utilities, insurance, square footage, and any other expenses your business incurs.

Now that you have listed the cost objects and created the cost pool, you are ready to allocate costs.  As shown in the example above, add up the costs of each cost object. 

At first glance, your report should justify all the expenses related to your business.  If expenses aren’t adding up properly, use the list to identify where you can make adjustments to get back on track.

The cost allocation method is a method used by business owners to calculate profitability for financial reporting purposes.  To ensure that the company’s finances are on track, costs are separated or divided into different categories depending on the area of ​​the business they affect.

For example, a cost allocation for a small clothing boutique would include costs for materials, shipping, and marketing.  Consistently calculating these costs will help the store owner ensure that the profit from sales will be higher than the costs of owning and operating the store.  If not, the owner could easily determine where to raise prices or cut costs.

For a larger company, this process will be applied to each department or individual location.  Many companies use cost allocation to determine which areas receive bonuses each year.

This is a method used to estimate costs associated with cost objects in specific categories within an enterprise.  Cost objects can include a product or service you sell, a specific department of your company, or the cost of working with a supplier.

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 detailed level.  When you use cost allocation, you may find that your actual manufacturing cost per unit is higher than expected.

Cost allocation is used for many reasons, both external and internal.  The reports generated by this process are excellent resources for business decision making, performance monitoring and cost justification.

External reports are generally calculated based on Generally Accepted Accounting Principles (GAAP).  According to GAAP, expenses can be reflected in the financial statements only during the period during which the corresponding income is received.  For this reason, general production costs are divided and allocated to separate commodity and material values.  When inventory is sold, overhead is expensed as part of cost of goods sold (COGS).

• blackline.com – What is Cost Allocation? An Introduction to Cost Allocations
• thebalance.com – What Is Cost Allocation?
• businessnewsdaily.com – What Is Cost Allocation?

Editor’s Recommendation

• Cost Object: Definition, Types, Examples & Benefits
• SALES BUDGET: Step-by-step Guide To Preparing A Sales Budget
• INDIRECT LABOR: Definition, Examples and Costs
• WAREHOUSE LOGISTICS: Guide To Improve The Processes
• VARIANCE REPORT: Detailed Guide To Variance Reporting
• ACCUMULATED AMORTIZATION: How To Calculate It On The Balance Sheet

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Cost Allocation Uncovered: Methods & Calculations

What was that invoice for and where does the other bill come from? Unfortunately for numerous service companies, these questions are posed way too often, resulting in tons of additional spendings appearing out of thin air. Fortunately, there is one way to prevent this situation from happening - it’s called cost allocation.

Arkadiusz Terpiłowski

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Cost allocation - key takeaways

After reading this article, you should be able to: 

• define cost allocation and factor 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 spendings to departments and projects with great 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 costs objects came from.

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

What is the cost allocation used for? 

Alright, but what is the point of calculating all of these things? 

Cost allocation is very helpful not only when it’s time to sum up the employee performance, results of particular project managers or finances that may interest the stakeholders. On a daily basis, it can also help you: 

• make sure that budgets are on track - applies to the budget of the entire company, as well as finances of particular departments or projects, 
• point to the fields of operation that generate excessive costs and act on the information, 
• check whether the money is really spent on the right endeavors.

In other words, cost allocation is the process of identifying the source of the costs and evaluating its 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 possible, costs in cost allocation are divided into 3 categories: 

Direct costs 

Direct costs in cost allocation are the 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 the wages and salaries, but they may also cover other resources required for the project. Therefore, allocating costs such as this is basically a piece of cake, as they are generated directly by the department, services or other costs 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 are costs that are not associated with any organizational unit in particular; they are simply needed to keep the company running and growing. 

The indirect costs usually involve the spendings made by all the support staff that help the production department do its job, as well as their wages These include cost objects such as: marketing and sales specialists, administration employees, and any other support department. Indirect costs also often refer to internal projects. 

However, there is one more type of indirect costs 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, i.e. security expenses, business management, etc.

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 service companies, profit only from their projects and they do not 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 how the process of identifying them looks like. 

• Define which costs you want to allocate

First, calculate 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 to get a bigger picture. But let's see how examples of cost shape the profitability of the operations.

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

• the costs of 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 or expenses that need to be allocated. 

• 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 will use the former of indicators - the billable hours . That method is considered to be the simplest way of allocating costs in a proportional manner.

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 1800 hours. For Project B, the number of hours needed is 1200. Both projects combined require 3000 hours to complete. Therefore, Project A accounts for 60% of all billable hours in the company, while Project B includes only 40% of them. These are the proportions we are going to use in the cost allocation in this method.

• Allocate the costs proportionally

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

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

Project B, on the other hand, only requires 40% of all the billable hours. Therefore, it should pay 40% of the costs - 40 000$. 

What if I have more operations on my hands? 

Admittedly, the example we have shown you above is very simple and it only reflects the reality for small companies. But what if you have a little (or much) more operations on your hands? 

In that case, project scheduling software can help you - and Primetric is one of them. Here’s how it handles the most common cases of 

Cost allocation in Primetric - project estimates

Let’s start with a simple example of project budgets. 

In Primetric, you can create a project budget right after you create a project itself. That’s because the system performs the cost allocations for direct cost in each estimated phase of the operation. As a result, the predicted costs of work are displayed right after you estimate the number of hours needed to complete the job. 

Financial report in Primetric 

But what if the project has already started and you see whether it stays in the budget? The easiest way to check that is to use the financial report for a project. 

Such a report is capable of combining numerous financial data, including: 

• project and company overheads, 
• costs of each hour of work completed in the project, 
• the comparison of costs and incomes. 

As a result, it can automatically calculate the final profit margin for the project and show how much costs in the company a given operation covers. 

Costs allocation in settlements

Information on the costs in a project can be found in the Budget tab. There, the costs are divided into 4 categories: 

• a dashboard with a general overview of the costs, 
• 3 separate tabs for scheduled, not settled and settled costs. 

There you can monitor all the incomes and expenses in your project and manage them accordingly. 

Overheads in Primetric 

In Primetric, you can also add both recurring and one-time overheads to the project - there is a special section dedicated just to these costs. These costs are later added or subtracted from the monthly invoice. 

Primetric also contains information on company overheads, such as bills, support department or office costs. They also affect the profits from the projects - in fact, each and every one of them has to pay for a part of them! 

Company overheads are included in the financial statements as Indirect costs - the costs that are not generated by any project directly. The information can be used for determining the third degree margin, an ultimate indicator for the profitability of your projects. 

Cost allocation in settlements reports 

Last but not least, cost allocation is clearly visible in the Settlements section. There you can find all the information on overheads, costs, incomes, and more. 

Benefits of cost allocation 

Fortunately, cost allocation is not only a burden, but also a huge business advantage. 

Just to name a few of its benefits, it can help you: 

• determine whether your projects are profitable, 
• what part the project play in covering the organizational costs, 
• check whether the rates are high enough to cover all the costs and generate profits, 
• determine whether the indirect costs are not eating up the majority of 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 the lost spendings to the people, teams or departments responsible for them, 
• calculate the real profitability of your business as a whole.

Want to know more about budgeting? 

Great - we have just what you need. 

Visit our blog and read more about: 

• Jira invoicing and the features you will need to do it right, 
• forecasting revenue before it becomes a problem, 
• project success factors that may take a toll on your budgeting, 
• professional service automation capable of taking the calculations off your hands, 
• project budget management software you can use to make the finances as simple as possible. 

And if you want to find out if our solutions have what you need to allocate costs, book a demo with our advisors or start a trial right now! 

Arkadiusz is Head of Growth and Co-founder at Primetric. Prior to that, Arkadiusz was at the helm of his own software development company where he oversaw operations. A great enthusiast of process improvements, his personal mission is to make software companies more profitable and efficient on their path to growth.

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Benefits of Cost Allocation for Businesses: Make Informed Decisions with Accurate Cost Tracking

By henry sheykin, what methods are used to allocate costs.

Cost allocation is the process of assigning costs incurred to one or more cost objects. Cost objects are activities, products, departments, projects or other items to which costs are assigned or allocated. There are three commonly used methods to allocate costs: direct, step, and reciprocal.

• Direct Method: This method assigns costs directly to cost objects on a one-to-one basis. This can be done manually or by using an automated system. For example, in the manufacturing industry, companies can assign the costs associated with producing an item directly to that item.
• Step Method: The Step method allocates costs to cost objects through a series of predetermined steps and assigns costs based on an estimated measure of activity or volume. This method is usually used when costs are difficult to be assigned on a direct basis. For example, allocating the electricity costs to multiple products manufactured by the company.
• Reciprocal Method: This method compares relative usage of the shared resource by each cost object and allocates costs to those cost objects accordingly. For example, the cost of maintenance of a common resource can be allocated between two departments or divisions using the reciprocal method.

It is important to consider the accuracy and consistency of the chosen cost-allocation method and the amount of effort required when selecting a method. Cost allocation should be carried out on a regular basis in order to ensure that costs are properly assigned and tracked.

Key Takeaways:

• Accurate measurement of resources used
• Consistent methodologies should be applied
• Costs should be allocated in the same accounting period
• Allocation of resources helps to evaluate expenses
• Improved accuracy in tracking expenses and budgeting
• Enables decision-making to prioritize activities and investments

How do companies allocate costs to products?

Cost allocation is a critical process for businesses and organizations of all types. It involves identifying, gathering and assigning costs to different products or services. Cost allocation is important because the costs of producing or providing a product or service determines how much the company can sell it for and how much profit they can make.

There are several methods companies use to allocate costs, including direct tracing, step allocation, and activity-based costing. Depending on the nature of the business, one or more of these methods may be used.

Here is an overview of the three main methods for allocating costs:

• Direct Tracing: This method traces costs directly to products in a one-to-one relationship. For example, the cost of a specific raw material to create a certain product can be traced directly to that product.
• Step Allocation: This method divides costs into categories with each category allocated to a number of products. For instance, indirect labor may be allocated among different products based on the number of labor hours used producing each product.
• Activity-Based Costing: This method assigns costs to products based on the activities necessary to produce the product. It can produce more precise cost allocation than other methods, but it can also be more complex and expensive to implement.

It is important to note that the method used to allocate costs will depend on the specific circumstances of the business, such as the type of products being produced, the complexity of the production process, and the accuracy required for cost accounting.

What is the Purpose of Cost Allocation?

Cost allocation is the process of identifying, aggregating and assigning indirect costs to different cost objects such as products, services and activities. Cost allocation is important for businesses to accurately assess the cost of producing goods and services, as well as to understand how overhead costs are distributed.

For example, in a large manufacturing firm, the cost of utilities, building maintenance and property taxes must be allocated to different buildings and departments. Allocation of these costs, in combination with properly allocating direct costs, provides the company with the true cost of doing business.

Below are some tips to help you perform cost allocation:

• Accurately measure resources used: An accurate understanding of the resources used is necessary in order to allocate the costs effectively.
• Make sure to use consistent methodologies: Different cost allocation methods might be applied and having a set of consistent methodologies will help ensure accurate cost allocations.
• Ensure that costs are allocated in the same accounting period: Allocating costs to the same period ensures that all the costs associated with that period are accounted for.

What are the Benefits of Cost Allocation?

1. Allocation of Resources Cost allocation allows organizations to allocate resources more effectively and efficiently. By assigning costs to individual cost centers, managers can assess the cost of each activity and determine the areas where cost reductions should be made.

2. Improved Accuracy Cost allocation can help organizations track different expense categories and make sure that the costs are being allocated fairly and accurately. This enables organizations to determine actual costs and ensure that cost savings are being achieved.

3. More Accurate Budgeting Cost allocation makes budgeting more accurate and allows managers to better forecast costs. By assigning costs accurately, organizations can assess the current budget and identify areas where additional funds may be needed.

4. Enables Decision-Making Cost allocation can help organizations make more informed decisions when it comes to activities and investments. By tracking costs and expenses accurately, organizations can analyze which activities are generating the highest ROI and prioritize those activities.

To maximize the benefits of cost allocation, organizations should establish a clear allocation methodology that is detailed and documented. This helps ensure that the costs are being allocated accurately and efficiently and that each cost center is being allocated its fair share. Organizations should also review their cost allocation regularly to make sure that it remains accurate and up-to-date.

What is the difference between direct and indirect cost allocation?

Direct Cost Allocation

Indirect Cost Allocation

Tips for Direct and Indirect Costs Allocation

• Make a list of all costs that need to be allocated and separated them into direct and indirect.
• Develop a system for assigning costs as accurately as possible to their respective products or activities.
• Analyze each cost to determine if it is fixed or variable, and if it is strictly assignable to a product or activity.
• Determine the cost allocation method that best applies to each cost and activity.
• Allocate the costs accurately in order to provide an accurate financial picture.

How do You Ensure Accurate Cost Allocation?

• Make sure that each cost is properly categorized and classified. This includes making sure that each cost is assigned to the correct cost object and that their costs are not split across multiple objects.
• Identify any fixed and variable costs, as well as any indirect or overhead costs. This allows for a more comprehensive understanding of cost behavior, which is essential for accurate cost allocation.
• Develop a formal budgeting process that takes into account the potential for cost overruns and other fluctuations in expenses. This helps to ensure that costs are allocated within the allocated budget interims.
• Perform periodic reviews of cost allocations to ensure that expenses are being distributed correctly. Reviewing allocations on an ongoing basis can help to identify any discrepancies or issues that may affect cost allocation accuracy.
• Analyze historical and current cost trends to help anticipate any future cost fluctuations. This can help to ensure that cost allocations accurately reflect the current cost picture.

How does cost allocation affect budgeting?

Cost allocation is the process of assigning costs to one or more cost objects, such as a project, department, or service. Cost allocation affects budgeting because it helps to provide a better understanding of the total cost of a project or service, allowing for better budget planning and management. In addition, cost allocation can help to identify areas where an organization can reduce costs or increase efficiency.

The following are examples of how cost allocation affects budgeting:

• Cost allocation can provide insights into how much money is spent on specific activities and allows budget planners to allocate resources accordingly.
• Cost allocation can help organizations identify suppliers or vendors with lower costs and determine the pricing structure for products and services.
• It can help organizations plan for future investments and forecast expenses more accurately.
• It can provide a more accurate projection of an organization’s income and expenses, allowing for shorter and more detailed budget cycles.

To ensure cost allocation affects your budgeting process positively, it is important to have a thorough understanding of the cost structure of your organization. It is also important to make sure that cost allocation is done in a timely manner, and that all stakeholders in the budgeting process are involved in the process. Furthermore, accurate records should be kept for all transactions that are allocated to specific cost objects.

Conclusion:

Cost allocation is an important process for businesses and organizations of all types, as it helps to track overhead costs, improve accuracy and efficiency, and make better decisions. It is important to identify and use a cost allocation methodology that is detailed and documented, so that the costs are allocated accurately and each cost center is allocated its fair share. Organizations should also review cost allocation regularly to ensure accuracy and stay up-to-date.

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