Last editedJul 20212 min read
Generally speaking, there are three types of costs that businesses need to deal with: direct costs, indirect costs, and overhead costs. Usually, it’s relatively simple to assign these costs to specific processes. But in some cases, it’s not always so straightforward. How do you spread a cost across different departments or product lines in situations where there isn’t a definitive source for the cost? It’s an accounting process referred to as “allocation.” Learn more about the meaning of allocation in accounting with our simple guide.
Allocations, also referred to as cost allocations, split costs between different activities, products, or departments (a more technical term for this is “cost objects”) within a company. This is necessary because the cost may not be directly traceable to a specific cost object, which means that allocation will be somewhat arbitrary. There are lots of examples of allocations in action. Take overheads, for instance. Overheads like utilities or rent may be allocated to different operating units within the company in situations where the cost is shared. Remember, cost allocation doesn’t just apply to manufacturing companies – it’s also an essential concept for service-based companies and non-profit organisations to understand.
How to calculate allocations
Usually, determining allocations involves some amount of estimation and guesswork. Returning to the example of overhead costs, you might decide to allocate the amount of rent/utilities owed based on the square footage of each operating unit. Alternatively, you may decide that the number of employees in each operating unit is a fairer method of allocation. There are lots of different ways that your company can allocate costs, so it’s all about finding a method that works for you.
Examples of allocations
We’ve already talked about how overheads are an excellent example of allocation, but there are many different cost allocations such as:
Salary – An employee that works across three or four main functions may have their salary allocated across these functions.
Electricity – If a single production facility is used to manufacture multiple products, the electricity used will be measured by just one meter. Consequently, cost allocation may be used to spread the cost of electricity across different product lines.
Land – Raw land may be purchased for a lump sum. If this land is intended to be developed into residential/commercial lots, cost allocation enables the developer to allocate the lump sum across these lots so that they can accurately report their profit margins.
Pros and cons of cost allocation
Allocation is essential for ensuring the accuracy of your business’s financial reporting. Accurate financial statements enable management to make appropriately informed decisions. If you have a faulty understanding of the costs involved in producing goods/services, incorrect decisions might be made. Cost allocation helps you to avoid that and make decisions that are right for your company. Furthermore, getting cost allocation right ensures that your business won’t experience any issues when it undergoes a financial audit.
However, there are a couple of drawbacks related to cost allocation that it’s important to consider. In short, improper cost allocations can lead to incorrect management decisions. Imagine a situation wherein a product is allocated an overhead cost that inflates the actual cost of overheads involved in its production. This could lead to the company terminating the product line, since the actual profit margin of the product may be obscured by the cost allocation model used by your company. As such, it’s vitally important to ensure the accuracy of your allocation methodology.
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