What is cost allocation?

View all blog posts under Articles

One of the many tasks a finance professional may be called upon to manage is allocating funds across departments for shared services. Cost allocation methods take a shared service, such as company-wide technical support, by allowing an organization to properly assign associated expenses to each department based on how they use the service, clarifying and validating expenditures.

A straightforward cost allocation definition states that this process is the assignment of shared costs to a specific object, whether it’s a department, a job, or even a certain task, without arbitrary appointment. What this means is a multitude of financial data is collected and redistributed using a process that aligns specific expenditures, often grouped into a single cost, with the areas of business actually using them.

An accountant looks at an invoice and numbers on computer monitors

Compiling and reorganizing all this information is a highly detail-oriented process that begins with the creation of a base in which to frame out allocation. The cost allocation base provides a rational way to assign overhead. From there, equations can be created using the base to properly distribute funds. With such a complex and comprehensive process, the individual overseeing the cost allocation process should have extensive experience organizing and working with numbers. A bachelor’s degree in accounting can be highly beneficial for individuals dealing with common accounting practices.

What is cost allocation and why do it?

Because cost allocation focuses on how an organization charges its funding sources, it provides managers with more visibility into their organization than simply which department is spending what on a particular service. Cost allocation can be used to analyze performance across different business units, providing insight into the true value drivers within an organization. Management can utilize this information to make decisions about products, investments, and operations simply by having a clearer understanding of how expenditures are broken down. Cost allocation can also help improve forecast accuracy and adds a layer of detail to financial reporting.

Managing a detailed cost allocation strategy helps an organization

  • Identify the actual cost of services being provided within each business segment
  • Share the costs of facilities and support services between departments or groups
  • Ensure accuracy of cost-based user fees
  • Comply with state law and minimizing audit issues
  • Ensure reimbursement for allowable overhead costs is received

Not only does cost allocation provide insight into how services are used within an organization, but the information also helps financial analysts and others interpret financial data to determine profitability. Knowing how much a department is spending over how much revenue it’s generating can create a telling picture as to the level of efficiency within a specific business segment. It can also demonstrate which products or services are proving to be a good financial investment, and which should be more closely evaluated.

Shared costs

Shared costs encompass a wide variety of expenses. For clarification, they can be broken down into a few specific groups:

  • Direct costs consist of any expenses related to a product or service that benefit a specific source. For example, if a single department utilizes a company-wide license for a specific computer program, that expense can be tied directly to the unit.
  • Shared costs are expenses related to a product or service that can benefit more than one source. For example, if the marketing department and the product development team share a single service account for a social media management application, this would be considered a shared cost.
  • Indirect costs are shared costs whose benefits aren’t readily apparent, yet the product or service is necessary to the operation of the organization. These costs are unique in that they can be allocated individually or grouped together into a single line item of “indirect expenses.” Annual audit and accounting fees, general liability insurance, and even some salary pay for certain personnel are all examples of costs subject to indirect cost allocation.
  • Administrative costs are costs associated with the business rather than departments. They are sometimes broken out on their own and other times they’re grouped into the indirect expense category. When an organization feels like such costs can be clearly identified, it may select to separate them; however, no clear definition exists on what this specific cost category entails.
  • Overhead costs include the general expenses incurred by management. Overhead costs can range in type. For example, nonprofits often include fundraising expenses in this category.

Cost allocation methods

After properly identifying the expenses subject to cost allocation, it’s important to select the right method for accurately distributing the information. There are three primary cost allocation methods used by organizations based on how the expenditures are generated.

The step method is best when all costs are internal. For this method, one department within an organization provides a service directly to another. This allocation process ensures the department utilizing the service gets charged for the work of the other department. For example, when a creative services team designs a flyer for the marketing team, cost allocation would charge the marketing team for the time it took to create the piece.

The reciprocal method uses simultaneous equations to allocate costs from one service department to multiple others. Working between departments like the step method, this strategy creates an accurate distribution of costs because of the level of detail with which each charge is broken down. Using this method allows executives to judge how efficiently each service department operates.

The simplest option is direct method cost allocation, which ties costs directly to the department or product acquiring them. An example of this method would be a manufacturing department which allocates costs back to the production department, as well as to the product itself. Often, this method of cost allocation helps inform price changes to a product and keeps costs under closer control.

Where to learn more about this and other accounting strategies

You can gain knowledge about key accounting principles, like cost allocation, with the right educational background. An online Bachelor of Science in Accounting from University of Alabama at Birmingham helps you gain competency in every aspect of accounting in order to compete in today’s job market. From broad topics like financial literacy and business communications to more in-depth coverage of internal reporting and cost determination, this bachelor’s program can help you build strong accounting skills essential for employment in any business.

For more information, please contact an enrollment advisor today.

Recommended Reading:

Accountant vs. auditor: What career should you pursue?

2019 Accounting Trends You Need to Know

What you can learn about internal auditing at UAB

Sources:

Understanding cost allocation and indirect cost rates under the Uniform Guidance (2 CFR 200) Part I & II by RCAC

Indirect Cost Allocation by Government Finance Officers Association

Cost Allocation by MRSC

Profitability and Cost Analysis: An Eye on Value by KPMG

Direct Allocation Method by International Financial Reporting Tool at AuditIT

Accounting & the Cost Allocation Reciprocal Method Formula by Chron

Online Bachelor of Science in Accounting – University of Alabama at Birmingham