Examining the importance of cost allocation

The process of cost allocation involves the method of identifying and assigning cost of services that are essential to the running of a company or any other kind of organization. As opposed to a cost-rating, the allocation process is not so focused on the exact amount of cost, and is more focused on allocating or allocating costs to the right department within the company. From this point of view the concept of cost allocation could be considered an instrument to track all the costs that are associated with an daily operation more effectively since each cost is linked to certain departments or departments within the organisation.

An example of cost-allocation would be the salary or wages of an employee who is assigned to a particular department. In hospitals, nurses usually works on an area or wing and the cost is allotted to the overall running of the department. If the nurse is working during the assigned shift within the unit the benefits and salary earned are attributed to the particular unit. If, however, the nurse has to cover for another unit or floor, such as an entire shift in the emergency department the benefits and salary earned during that time could be assigned to the unit that the nurse was working in rather than his or the floor or wing she is assigned to.

There are many reasons why cost allocation is crucial. It’s all about accurate cost allocation within an organisation and making it possible to determine the exact nature of expenses that were incurred during the running of a particular area of the company. This is not just important data to take into consideration when making an operating budget it is also crucial when calculating taxes to be paid to state, local and federal tax authorities. In many countries the manner in which expenses are allocated could affect the amount of money that an organization is taxed, which makes it essential to adhere to any regulations of the government related to the cost allocation within the business.

Another benefit of cost-allocation involves the simple process of keeping track of expenses to plan internal operations. Although some costs are indirect, that affect in more than one aspect of the business however, there is an obligation to determine expenses in a way that is rational and precise. Even if the costs are incremental, that is, they are spread across several accounting periods, making sure that they are correctly allocated will make a huge difference in the way every unit of the business or any other entity operates within the confines of the budget overall. If it is evident that one department will be over its budget, steps are taken to make reductions in the cost of services that are not essential and then find ways to reduce the budget overall in order to continue funding of vital functions.

Companies of all kinds and sizes are involved in the process of cost allocation. Companies employ this method to help plan and ensuring that they stay within budget. Non-profit organizations utilize this tool to provide as many services to their members as is feasible, yet remaining able to make the most efficient use of their resources. Family members can also make use of the idea of cost allocation when they plan the budget for their family’s operating expenses. In order to identify and correctly assigning the costs, this method of allocation can help provide clarity and organization to the financial plan in a manner which would be very difficult otherwise.

Direct Costs

In finance direct costs are cost that are related to the specific department, project or task. Sometimes, they are referred to as hard costs, expenditures such as these are associated all over the world in every type of business, starting by conducting research and developing, and moving through marketing and sales campaigns as well as the creation of various types of products and services. Direct costs are usually a fixed cost However, there are instances where a variable cost could also fall under this category.

The first step to understand the distinction between what constitutes and doesn’t constitutes cost-direct is find the costs that only pertain to a particular project and do not have anything to do with any other project which is occurring simultaneously. To qualify as an actual hard cost the cost must pertain to the resources that will benefit this particular project. For instance when the goal is to build a phone then the costs for casing for the handset, the internal circuit boards, and wiring will all fall under that category called direct expenses. Furthermore, the wage that are paid for construction of the phone is also an indirect cost.

When costs do not aid a specific project or task The cost is classified as indirect. Electricity, for instance that are used to run an establishment that houses different product lines and other functions could not be considered direct costs since they benefit more than one particular project. These expenses are shared between diverse projects, rather than being tied to just particular activity.

Every business won’t analyze direct costs in the same manner. Based on the organization’s structure what is considered to be a hard cost in one culture could be considered an indirect expense in a different culture. So long as the guidelines used internally to determine the difference between what is and isn’t directly incurred costs are consistent and consistent, it’s still possible to identify the historical cost or the price of items that are sold with a high degree of precision. This same consistency allows you to evaluate the absorption costs between one time period and the next, and then determine whether there has been growth in direct expenses associated to a specific task or project.

Indirect costs

Indirect costs are expenses of business which are not directly linked to a specific product or service in the overall process. Costs of this kind are likely to affect the general operation of the business, which makes it difficult to attribute the cost to a specific department or assign them to some specific task. Costs like this are often referred to as overhead, which describes the general application of these expenses.

There are many instances of indirect expenses that can be found in both large and small enterprises. An all-inclusive supply of supplies to support the management of the company is an instance. Items like pen, paper and other necessities used in the recording and general clerical tasks of every department are typically considered indirect costs. Similar to that the auditing of the books of accounts or the creation of documents for legal purposes are costs that affect the whole operation and are generally considered indirect in their nature.

Many of the costs associated with the maintenance and maintenance of facilities for business are classified as indirect expenses. Utility bills like electricity water, electricity, and Internet access are all expenses which benefit businesses generally and are considered overhead expenses. The cost of leasing or renting commercial space is also an overhead expense which makes it an indirect expense.

There are many examples of what appear to be an indirect expense but is actually a direct expense. A good example is salary and wages for employees. If employees are performing their duties as usual that benefit the entire business Their salaries and wages are considered indirect expenses. However, if these workers are assigned to work on a particular project that is the primary area of their time for several weeks or days the wages or salary could be considered to be as a direct expense, and the cost is directly applied to the specific project.

Overhead Costs

A company may earn some amount of money, however, it is unlikely that it will be considered to be a profit. It is because a business is usually required to cover expenses. They are often called overhead expenses. Examples of overhead costs include maintenance, salaries, and production costs.

It is standard for businesses to keep track of their gross and net income. This is crucial because these numbers reflect two different figures. Gross income is all of the cash businesses take into. It could be extremely significant.

Certain businesses have a broad array of expenses and others have only just a handful of expenses. In any case, nearly every company has at minimum overhead expenses. Net income is the amount of money left after overhead costs have been taken care of.

The amount could be much lower , and it may not even exist in the first place. It is possible for a business to have overhead expenses which consume the entire earnings. In some cases companies’ expenses may even lead them to fall in debt.

If overhead costs are not calculated the business will not know how much it’s earning. When ABC Toys buys its merchandise from a manufacturer, a part of the cash it earns from its merchandise will be used to purchase additional merchandise, but also pay for things like transportation, electricity as well as salaries. Even even if ABC Toys manufactures its own products, there will be costs to purchase equipment as well as raw material.

The way overhead costs are classified will depend on the company’s accounting practices. Some companies are basic in the estimation of their costs. Others, however, employ complex procedures which may require multiple departments to be able to access their overhead expenses. Certain businesses track their overhead expenses by categories. For instance, manufacturing companies can determine their manufacturing costs and non-manufacturing expenditures independently.


The term “cost” is usually considered to be a sacrifice that is made in the course of economic activities in order to attain a certain goal for example, to exchange, consume or create. All kinds of organizationsincluding businesses, non-profits, government-related entities are subject to expenses. To fulfill their missions and goals the organization purchases resources, then transforms them in an appropriate manner, and then provides products or services to its clients or customers. Costs are charged to carry out these actions. To plan and control the process it is necessary to make decisions about things like pricing programs, evaluation of programs as well as outsourcing, costing of products, and investment. Different costs are required for various reasons. In each case it is necessary to determine costs to aid management in making better choices.

Once they are incurred, the expenses are first assessed and added to a classification system. Costs that have some or all of the characteristics mentioned in common can be put to cost pools. The cost pools are then assigned in different ways, for specific purposes from the cost pool to cost items. Cost objects can be defined as an element, a the product or service that is a client or another cost pool or a part of an enterprise where management requires an additional measure and the accumulation of costs. Costs assigned to a costs object can be either indirect or direct. Direct costs can be tracked and allocated on the expense object a fair cost-effective way. The occurrence of an indirect cost is not as easily identified. Without a direct connection with the object of cost an indirect cost needs an intermediate activity that helps create a formula. When an indirect cost is allocated through using this formula it is then as allocated. The method used to establish the linkage in between is known as the base of allocation.


Cost allocations can be done over time frames. If more than two cost objects are part of a single program or facility and the cost pool shared by the unit is a common expense for the users and needs to be divided or assigned to the users. The bases of allocation are typically determined by some of the criteria listed below: cause-and effect benefit derived, fairness or the ability to bear. The choice of a criteria could affect the choice of a base. For instance, the assignment of the cost of an activity that is common to all products or programs that are based on the amount of revenue is a capacity to bear basis. However, the same allocation that is based on the number of units of service consumed by every program or product line will reflect the benefits that are derived or the cause-and-effect criterion. Cost allocation refers to the process of assigning indirect costs for one of the cost objects based on the formula. Since this isn’t an exact assignment, and it result in different sums being allocated based on the base for allocation, or on the methodology (formula) chosen Some people consider the process of cost allocation as being arbitrary kind, at least to a certain extent.

The cost of assets that have a long lifespan are assigned and reclassified as expenses over two or more time frames. Other than land, which isn’t allocated, the reclassification process of tangible assets is referred to as depreciation (for any other resource that the natural resource) and loss (for naturally occurring resources) expense. The basis for these allocations usually either the time of day or the amount of work. Different methods of depreciation as well as depletion are accessible. The expenses of long-lived intangible assets, like patents, are divided over time periods and classified as amortization expenses. The foundation to allocate these costs is usually time.

Cost allocations over a time frame are usually distributed divided into organizational segments referred to as responsibility centers, or across the units of a product or services or programs where a full cost is required. The allocations could differ based on whether a particular product or program is costed to report financials as well as reimbursement to government contracts and reporting to government agencies, targeted pricing or costing or life-cycle analysis of profitability. Responsibility centers receive allocations designed to encourage the managers of these centers to be more objective in their decision-making and to give each center a cost that is reflective of the sacrifices made by the entire company for the benefit that of each center. These allocations may make up a cost or transfer of cost pools from one department to the next.


Allocations may raise ethical questions. Most often, the federal government awards contracts to private companies in a cost-plus manner which means that all of the costs actually for completing the contract, plus a percentage of the profit is refunded to the company that is performing the contract. Contractors who complete both private and government contracts might choose to use the formula that tends to assign more indirect costs to government contracts over non-governmental ones. The contractor might also want at including into reimbursement request the costs which are not allowed by the government agency. Contractors may also try to double-count an expense by making it an actual cost of the contract, or as element the indirect cost pool assigned for the project. In addition, contractors may try to get a reimbursement pay for some of the expenses of capacity that isn’t being utilized. Audits are conducted on the cost of government contracts to find out if there are any unjustified cost.


Non-profit and service organizations also allocate costs, as well. The cost object could be a service unit or a single client or a group (category) or group of customers. The costs associated with the service company are usually professional labor as well as indirect costs that support the labor. The base for allocating these indirect costs is usually professional duration (either in the form of billable hours or total) or the price of those hours, which are a reflection of either cause and effect or benefits received requirements. For non-profit organisations the percentages to be distributed can be calculated using the number of the units of the resource at being used, like the total number of full-time equivalents, the amount in square feet, or the number of lines for telephones. One important thing to keep in mind is that the underlying principles of distribution are identical for profit as well as non-profit companies. There is only one difference the cost items will be different.

In contrast to many non-profit and service organizations have inventory that has to be accounted for both internal and external reporting. In these situations an object of cost is a single unit of inventory. Costs that are associated with the acquisition and the carrying of inventory are typically straightforward costs that can be easily and attributed to the entire inventory even if they are not assigned to specific units.


Manufacturers have to estimate the resources needed to make their products. When costing a unit of product to be valued in inventory production, the costs of production are allocated. When using the product being the cost item, the costs of production include direct cost (traceable use of labor and materials) as well as indirect cost (all related to costs associated with production which are referred to as overhead). The indirect costs of production are assigned. In the past, manufacturers that employed technologically intensive processes utilized a single base of allocation that was based on labor whether in hours or in cost, which was a part of an indirect cost pool. A company that uses a more capital-intensive technology could utilize a non-labor basis like machine hours. Nowadays, many companies produce diverse products using a variety of technology that has varying levels of complexity. They require the most sophisticated cost assignment system that makes use of multiple bases of allocation and several indirect cost pools for example, activity-based costing.

When determining the cost of the output unit remains the cost object at the end of the line, the method used by producers may require cost assignments in an interim cost pool (object) prior to assigning the output unit. For example the batch technology allows the cost assignment first assigned to a specific job-order (batch) and the total cost allocated to the order is combined with the units in each batch in order to calculate the the price of one output unit. In addition, for a particular time period within the process technology, costs are accrued through (assigned to) each manufacturing process; each cost to each process is then divided over the total number of (equivalent) units created by the process to calculate the cost of the output.

Manufacturers also have to pay expenses for service departments (such as costs for computer centers) to support departments of production. These costs of service departments are indirect to an unit of production, and for total costing, they must be allocated first to specific production areas and later to units of output. The allocations that are made are known as allocations to the service department, and the foundation of allocation is usually an act that is reflective of the demands placed on the service department from the other department, in both in service and production.


Allocations are also essential for joint production processes. If two or more distinct identifiable final products begin to share an identical production process, they are referred to as joint products. The moment at which they become distinct is known by the term split-off. Manufacturing expenses incurred prior this split-off date are termed joint costs, and must be distributed across the various joint products for costing to be used for product costing. The basis for allocating joint costs usually include (1) an estimate of the relative value of sales when split off, (2) the net real-time value of split-off (as an approximate estimate of the value of sales after split-off), (3) final sales value at the end of the manufacturing process in addition to (4) the amount of physical units in the joint products split off.

Most would view this list of bases ordered in descending order preference of usage. There are usually additional costs for production beyond the point at which split-off occurs. These costs are incurred to finish every joint product. For a particular joint product the net realizable price at split-off is determined by subtracting any additional cost of completing the joint from the value of sales of the final joint product.


There are three primary ways to allocate the costs of service departments to the production departments or programs that are not for profit: (1) the direct method; (2) the step method as well as (3) the method of reciprocity. The foundation for the allocating the costs of service areas must be ideally causally linked to the demands placed to the service area by other departments. Both the cause-and-effect as well as the benefits received criteria are considered. If the service areas offer services to one another (referred in the context of reciprocal service) The methods of reciprocity is most reliable and the next method is the step followed by the direct method, which is most inaccurate. With different service and production departments as cost objects, costs are initially accumulated on a department-by-department basis. Departments that are directly involved in projects or units of production or service are departments of production. Other departments are called service departments. The issue of allocation is to transfer cost of the service department to production departments or programs to allow for both evaluation of performance and program or product costing. In a production department these costs allocated to service departments are later transferred to the units of product or service on the basis of allocation each production department employs to determine the indirect cost.

The direct method does not consider reciprocal services. The expenses of a service department are allocated to departments that produce them according to the degree to which each department utilizes (or in budgeting reasons plans to utilize) the services provided by that service company. The “extent” is determined on the basis of a percentage, either the quantity of services offered from the department’s service to each of departments of production or the quantity of services that the department can provide in full or normal capacity. Fixed and variable costs can be divided in a separate manner and result in a dual allocation procedure (for example, variable expenses are based on actual usage, while fixed expenses based on budgeted use).

The step method partly considers reciprocal services by allocating costs from service departments to production departments in a sequential manner. The department that offers the most service to other departments is first allocated; the department that provides the second highest amount of support to other departments in the service chain is allocated next, and so on. The dollar totals of expenses incurred within service departments may help break up a tie in usage and allocate the largest amount first. Once a department is assigned, it is not considered for subsequent allocations.

The reciprocal method is based on all reciprocal services creating a set of simultaneous equations, each one for each service department. For a particular service department, the equation is an equation that calculates the total allocable cost and direct expenses of the costs for the service department that are allocated to each of the other departments in the service, depending on the usage of this department of other departments’ services. When these equations are resolved the resulting allocable cost (sometimes called the artificial or reciprocal cost) is then distributed to the departments, including service and production, based on the initial percentage of usage.

Two other issues such as fairness and the acquisition of the service either from within or outside, are related to the distribution of an average cost. The amount of the common cost for a service allocated to an department that is using the service could be higher than what it would cost the department to get similar services from outside. A alternative to the reciprocal method gives an analysis to assist the manager of an using department determine whether to get the service from a different department within the company or contract with an outside company for the service through a different company. What amount of service department’s expense that is assigned to a department that uses it could be contingent upon the degree that other departments utilize this particular service. This doesn’t seem to be fair.

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