Cost Allocation: Definition, and Example on How the Cost Allocation Works

ABC allocation system considers the different bases of allocation for the different cost drivers. On the contrary, the traditional system of allocation uses a single basis which may not be accurate. Direct cost can be allocated to the specific cost object under consideration. It does not need to be allocated as the entire cost is related to the same cost object. As opposed to the IT department above, a personal cost center would exclude physical materials. This type of cost center allows a company to isolate only the cost of headcount without being distorted by equipment, materials, or other goods.

  • As CEO and Co-Founder, Mike leads FloQast’s corporate vision, strategy and execution.
  • If costs are allocated to the wrong cost objects, the company may be assigning resources to cost objects that do not yield as much profits as expected.
  • Maximize working capital with the only unified platform for collecting cash, providing credit, and understanding cash flow.
  • The number of invoices issued, the number of employee hours worked, and the total of purchase orders are all examples of cost drivers in cost accounting.

Allocating indirect expenses is also important for decision-making purposes. With this information, you can determine which areas of your business need improvement and how changes in production will affect overall profitability. Cost allocation can also show you which departments or products are spending too much money on indirect expenses, and which ones aren’t using enough of them. This enables you to make more informed staffing decisions in the future based on how your company’s needs change over time. Finally, cost allocation allows companies to compare their performance against similar businesses. Indirect costs are costs that are not directly related to a specific cost object like a function, product, or department.

Indirect costs

It helps to understand which cost object consumes more benefit brought by the cost driver and allocates the cost. A cost center manager is only responsible for keeping costs in line with the budget and does not bear any responsibility regarding revenue or investment decisions. Internal management utilizes cost center data to improve operational efficiency and maximize profit.

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. For your business to make money, you must charge prices that not only cover your expenses, but also provide a profit. Cost allocation is the process of identifying and assigning costs to the cost objects in your business, such as products, a project, or even an entire department or individual company branch. Cost allocation provides the management with important data about cost utilization that they can use in making decisions.

Just-In-Time: History, Objective, Productions, and Purchasing

Make the most of your team’s time by automating accounts receivables tasks and using data to drive priority, action, and results. Transform your invoice-to-cash cycle and speed up your cash application process by instantly matching and accurately applying customer payments to customer invoices in your ERP. Perform pre-consolidation, group-level analysis in real-time with efficient, end-to-end transparency and traceability. Reduce risk and save time by automating workflows to provide more timely insights. ABC system is considered to be more fair and transparent considering the fair bases for the allocation of the cost. The main difference between ABC costing and the traditional system of allocation is the basis for the allocation.

What is a cost allocation base?

Cost allocation is a method used to assign costs to cost objects for a specific department, project, program, or other area. A direct cost is anything that your business can directly connect to a cost object. Tied directly to production, direct costs are the only costs that need not be allocated, but instead are used when calculating cost of goods sold. A cost driver is a variable that can change the costs related to a business activity.

Benefits of cost allocation

Indirect cost is incurred to facilitate production but can not be traced directly with the cost object. By breaking out cost center activities, a company can gauge the cost of administrative operating the business. Companies may decide it is not useful to have the expenses of a specific area segregated from other activities.

Cost centers only contribute to a company’s profitability indirectly, unlike a profit center, which contributes to profitability directly through its actions. Managers of cost centers, such as human resources and accounting departments are responsible for keeping their costs in line or below budget. That which is not direct—that is about as clear a definition of indirect costs as many people will find in their quest to understand the difference between direct and indirect costs. Indirect costs are one of the most confusing, misunderstood and controversial concepts in nonprofit financial management. Terms like “administrative costs,” “overhead” and “indirect” are often used interchangeably when they can represent very different things.

Since they are not GAAP-compliant, cost accounting cannot be used for a company’s audited financial statements released to the public. Since cost-accounting methods are developed by and tailored to a specific firm, they are highly customizable and adaptable. Managers appreciate cost accounting because it can be adapted, tinkered with, and implemented according to the changing needs of the business. Unlike the Financial Accounting Standards Board (FASB)-driven financial accounting, cost accounting need only concern itself with insider eyes and internal purposes. Management can analyze information based on criteria that it specifically values, which guides how prices are set, resources are distributed, capital is raised, and risks are assumed. Marginal costing (sometimes called cost-volume-profit analysis) is the impact on the cost of a product by adding one additional unit into production.

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Understand customer data and performance behaviors to minimize the risk of bad debt and the impact of late payments. Monitor changes in real time to identify and analyze customer risk signals. On the contrary, the traditional cost allocation system is considered to be an arbitrated method of cost allocation. Hence, managers might not be able to report valuation for the inventory without using cost allocation. Hence, knowing what product or department is taking a greater proportion of funds is important for weighing alternatives and making a decision on which cost object should be given priority. For instance, the wages paid to direct workers on the plant producing product-A can be entirely allocated to product-A.


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