What is cost allocation?

Definition and Examples of Cost Allocation

How Cost Allocation Works

Types of Cost Allocation

Definition and Examples of Cost Allocation

Cost allocation is a method used to assign costs to cost objects within a specific department, project, program, or another area.

Cost allocation methods include simple calculations, which can be useful for small business owners who need accurate financial information to help them determine the prices of their products or services and make overall decisions. Understanding these methods can assist in understanding your expenses and their positive impact on profits.

How Cost Allocation Works

Cost allocation essentially works by assigning costs to smaller areas within the business overall so you can see profit or loss at a more granular level. When using cost allocation, you may find that the actual production cost per unit is higher than expected.

It is important to remember that cost objects will vary depending on your type of business and industry. This means you may consider raising prices to maintain a certain profit margin. On the flip side, you may decide to discontinue a product that has proven to consume too much money.

To calculate cost allocation accurately, you must first identify the cost object and then begin to estimate the actual cost.

Types of Cost Allocation

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

Direct costs: These are the easiest costs to assign to a specific cost object, as they are directly related to it. For example, a direct cost may be the labor cost required to produce a product or the materials used.

Indirect costs: When you have an indirect cost, it is not related to a specific cost object but is still necessary for operations. For example, indirect costs can be security expenses or administrative costs that are not related to a specific department.

Infrastructure costs: Infrastructure costs – or operational costs – are those associated with the daily operations of your business. These costs accumulate regardless of actual production but support productivity. Operating costs may include insurance, rent, and legal fees.

Costs can be fixed or variable depending on the type. Fixed costs are constant, while variable costs can change based on other factors.

The type of cost impacts how the cost will be allocated later. For example, if you are allocating rent costs, it will be allocated to operating costs. You are likely to use the square footage method to allocate the cost.

When allocating costs directly related to a product, you may use the unit production allocation method to consider overhead costs alongside direct costs to create the product. This will allow you to determine the price you should charge.

Key Takeaways

Cost allocation helps business owners identify opportunities for success within their products or services. Cost objects can include anything you want to measure and assign a cost to, such as products, programs, projects, or even customers. Cost allocation methods include square footage, units produced, labor usage, and number of people.

Source: https://www.thebalancemoney.com/what-is-cost-allocation-5223089