Allocation Method: Cost Allocation Methods Explained

Allocation Method: Cost Allocation Methods Explained
Allocation Method: Cost Allocation Methods Explained

Different cost allocation method (s) are used to allocate factory overhead costs to units of production.  Allocations are made to create financial statements that conform to the applicable accounting system. 

The most common distribution methods are listed in the following paragraphs along with comments on their advantages and disadvantages.

What Is Cost Allocation Method?

The cost allocation methodology determines which services are provided and how much these services cost.  It also establishes a basis for apportioning these costs among divisions or cost centers based on their respective shares of such costs.

A cost allocation basis may include headcount, revenue, units produced, direct labor hours or dollars, machine hours, activity hours, and square footage.

Companies often implement a cost allocation methodology as a means of controlling costs.  Under an efficient cost allocation methodology, business units are directly responsible for the services they consume. 

As a result, both the service provider and the respective consumers of the service become aware of the requirements for the services and their usage, as well as how such usage affects the costs incurred.

When business units begin to see the value of the services they consume, they can make more informed choices, such as making trade-offs between service level and cost, and comparing internal costs with external providers.

ALSO CHECK: Cost Object: Definition, Types, Examples & Benefits

How Does It Work?

Using an allocation basis, costs are allocated to each business unit or cost centre that incurred the costs based on their proportionate share of the costs. 

For example, if headcount is the basis for allocating insurance costs and the total number of employees is 1,000, then a department with 100 employees will be allocated 10% of the insurance costs.

Although there are many ways to calculate cost allocations, it is important to ensure that the reasoning behind them is documented.  This is often done by establishing formulas or distribution tables.

Once the calculation is established and the cost allocation is calculated, journal entries are created to transfer the costs from the supplier entity or the payer entity to the corresponding consumer entities. 

During each financial period, as recurring expenses arise, this calculation is repeated and allocation entries are made.

ALSO CHECK: SALES BUDGET: Step-by-step Guide To Preparing A Sales Budget

What Are The Types of Cost Allocation?

Cost allocation is based on different types of costs, which generally fall into one of three categories.

Direct Costs

These costs are directly related to the product or service.  In your company’s financial statements, these costs can be linked to goods sold.  For a small clothing store, this may include the cost of inventory.

Direct Labor

This cost category includes costs directly related to the production of the items or services your company sells.  Direct labor costs include the wages of workers involved in making the goods your company sells.

Direct Materials

As the name suggests, this category includes costs associated with resources used to produce a finished product.  Direct materials include fabric used to make clothes or glass used to make tables.

Indirect Costs

These costs are not directly related to the product or service, but are necessary to create the product or service.  Indirect costs include the wages of those who work in the operational area.  It also lists the costs of materials you use in such small quantities that their cost is easily overlooked.

Manufacturing Overhead

This category includes warehousing costs and any other costs directly related to the production of the products sold.  Manufacturing overhead includes wages for warehouse managers as well as warehouse costs such as rent and utilities.

Overheads Costs

These include expenses that support the company as a whole but are not directly related to production.  Some examples of overhead costs are marketing, operations, and utilities for a storefront.

Product Costs

This category is also called “production costs” or “overhead costs”.  This category includes the cost of making or purchasing the product you are selling.  All manufacturing overhead costs are also listed in this category.

ALSO CHECK: INDIRECT LABOR: Definition, Examples and Costs

What is the Direct Allocation Method?

The direct allocation method is a technique of allocating departmental maintenance costs to other parts of the business.  This concept is used to fully load operations departments with the overhead they are responsible for. 

For example, a cleaner provides cleaning services for all company premises, while the maintenance department is responsible for the company’s equipment and the IT department maintains the information technology systems.  These are all service departments.

ALSO CHECK: WAREHOUSE LOGISTICS: Guide To Improve The Processes

How To Determine Cost Allocation

Cost allocation is not an exact science when it comes to cost objects.  Some cost allocation methods are based on units produced, square footage, hours, staff, or usage.

Let’s say you have a building with a photo studio on the first floor and a salon on the second floor;  you will use square meters as the cost object.  The area of ​​the salon is 2,000 square meters, and the studio is 1,000 square meters. 

The total cost of renting the building is $6,000 per month.  To split the rent between two units, you must first divide the total rent by the total floor area of ​​the building:

$6,000 (overall rent) ÷ 3,000 sq. ft. (total space) = $2 per sq. ft.

Second, you’ll want to calculate your photography studio rental fee:

$2 (price per sq. ft.) x 1,000 (studio sq. ft.) = $2,000

Thirdly, you can calculate the salon rent:

$2 (price per sq. ft.) x 2,000 (salon sq. ft.) = $4,000

Your space rent should be $2,000 for studio overhead and $4,000 for salon overhead.

Other scenarios might include allocating payroll costs based on employee cost centers or allocating payment processing costs based on transactions per location or franchise.

ALSO CHECK: VARIANCE REPORT: Detailed Guide To Variance Reporting

What Is Allocation Method For Direct Deposit?

Direct deposit distribution is the automatic distribution of regular, recurring electronic deposits to one or more eligible accounts.  To set up a direct deposit allocation, please use the attached form to indicate which accounts you wish to fund and the amount to be applied to each account. 

Your direct deposits will be automatically distributed according to your instructions.  Direct deposits can be transferred to almost any account.  Transfer funds to money markets or club accounts for taxes, holidays, vacations, and more. 

Create family savings by transferring funds to your spouse’s or children’s accounts.  Get tax benefits with deductions for depository accounts.  You can even speed up your loan repayments by setting aside funds to supplement your regular monthly payments.

ALSO CHECK: ACCUMULATED AMORTIZATION: How To Calculate It On The Balance Sheet

How Do I Allocate Costs?

Cost objects differ depending on the type of business.  However, the cost allocation process consists of the same steps regardless of what your company produces.

Define cost objects.

To begin allocating costs, you need to make a list of the cost objects of your business.  Remember that anything in your business that creates costs is a cost object.  Review each product line, project, and department to ensure you have collected all cost objects.

Create a cost pool.

Next, make a detailed list of all business expenses.  It is appropriate to categorize expenses based on the reason for each amount.  Categories should cover utilities, insurance, square footage, and any other expenses your business incurs.

Allocate

Now that you have listed the cost objects and created the cost pool, you are ready to allocate costs.  As shown in the example above, add up the costs of each cost object. 

At first glance, your report should justify all the expenses related to your business.  If expenses aren’t adding up properly, use the list to identify where you can make adjustments to get back on track.

Conclusion

The cost allocation method is a method used by business owners to calculate profitability for financial reporting purposes.  To ensure that the company’s finances are on track, costs are separated or divided into different categories depending on the area of ​​the business they affect.

For example, a cost allocation for a small clothing boutique would include costs for materials, shipping, and marketing.  Consistently calculating these costs will help the store owner ensure that the profit from sales will be higher than the costs of owning and operating the store.  If not, the owner could easily determine where to raise prices or cut costs.

For a larger company, this process will be applied to each department or individual location.  Many companies use cost allocation to determine which areas receive bonuses each year.

Allocation Method FAQs

What Is Cost Allocation?

This is a method used to estimate costs associated with cost objects in specific categories within an enterprise.  Cost objects can include a product or service you sell, a specific department of your company, or the cost of working with a supplier.

How Does Cost Allocation Work?

Cost allocation essentially works by assigning costs to smaller areas within the overall business so that you can view profits or losses at a more detailed level.  When you use cost allocation, you may find that your actual manufacturing cost per unit is higher than expected.

What Is Cost Allocation Used For?

Cost allocation is used for many reasons, both external and internal.  The reports generated by this process are excellent resources for business decision making, performance monitoring and cost justification.

How Do You Calculate A Company’s External Report?

External reports are generally calculated based on Generally Accepted Accounting Principles (GAAP).  According to GAAP, expenses can be reflected in the financial statements only during the period during which the corresponding income is received.  For this reason, general production costs are divided and allocated to separate commodity and material values.  When inventory is sold, overhead is expensed as part of cost of goods sold (COGS).

References

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