Cost Allocation

Cost Allocation

Cost allocation (also called cost assignment) is the process of finding cost of 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 because it the process through which costs incurred in producing a certain product or rendering a certain service is calculated. 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 misallocated, 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.

Mechanism

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

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.

Cost pool

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

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.

Example

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:

Mr. A salary                                                   16,000
Mr. B salary                                                   12,000
Rent                                                                   10,000
Electricity                                                            8,000
Direct materials consumed in making tea & coffee   7,000
Direct raw materials for shakes                            6,000
Music rentals paid                                              800
Internet & wi-fi subscription                              500
Magazines                                                              400

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.

Solution

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:

Rent                                        10,000 Number of customers
Electricity                                 8,000 United consumed by each product
Music rentals paid                    800 Number of customers
Internet & wifi subscription    500 Number of customers
Magazines                                    400 Number of customers

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:

                                                                        Tea & Coffee Shakes

Revenue                                                                  50,000 60,000

Costs:

  Salaries                                                                    16,000 12,000

  Direct materials                                                     7,000 6,000

  Manufacturing overheads allocated                             11,000 8,800

Total costs                                                          34,000 26,800

Profit earned                                                         16,000 33,200

Manufacturing overheads allocated to Tea & Cofee = $1.1×10,000

Manufacturing overheads allocated to Shakes = $1.1×8,000

source: accountingexplained