cost assignment easy definition

What is Cost Assignment?

Share This...

Cost assignment.

Cost assignment is the process of associating costs with cost objects, such as products, services, departments, or projects. It encompasses the identification, measurement, and allocation of both direct and indirect costs to ensure a comprehensive understanding of the resources consumed by various cost objects within an organization. Cost assignment is a crucial aspect of cost accounting and management accounting, as it helps organizations make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

There are two main components of cost assignment:

• Direct cost assignment: Direct costs are those costs that can be specifically traced or identified with a particular cost object. Examples of direct costs include direct materials, such as raw materials used in manufacturing a product, and direct labor, such as the wages paid to workers directly involved in producing a product or providing a service. Direct cost assignment involves linking these costs directly to the relevant cost objects, typically through invoices, timesheets, or other documentation.
• Indirect cost assignment (Cost allocation): Indirect costs, also known as overhead or shared costs, are those costs that cannot be directly traced to a specific cost object or are not economically feasible to trace directly. Examples of indirect costs include rent, utilities, depreciation, insurance, and administrative expenses. Since indirect costs cannot be assigned directly to cost objects, organizations use various cost allocation methods to distribute these costs in a systematic and rational manner. Some common cost allocation methods include direct allocation, step-down allocation, reciprocal allocation, and activity-based costing (ABC).

In summary, cost assignment is the process of associating both direct and indirect costs with cost objects, such as products, services, departments, or projects. It plays a critical role in cost accounting and management accounting by providing organizations with the necessary information to make informed decisions about pricing, resource allocation, budgeting, and performance evaluation.

Example of Cost Assignment

Let’s consider an example of cost assignment at a bakery called “BreadHeaven” that produces two types of bread: white bread and whole wheat bread.

BreadHeaven incurs various direct and indirect costs to produce the bread. Here’s how the company would assign these costs to the two types of bread:

• Direct cost assignment:

Direct costs can be specifically traced to each type of bread. In this case, the direct costs include:

• Direct materials: BreadHeaven purchases flour, yeast, salt, and other ingredients required to make the bread. The cost of these ingredients can be directly traced to each type of bread.
• Direct labor: BreadHeaven employs bakers who are directly involved in making the bread. The wages paid to these bakers can be directly traced to each type of bread based on the time spent working on each bread type.

For example, if BreadHeaven spent $2,000 on direct materials and $1,500 on direct labor for white bread, and $3,000 on direct materials and $2,500 on direct labor for whole wheat bread, these costs would be directly assigned to each bread type.

• Indirect cost assignment (Cost allocation):

Indirect costs, such as rent, utilities, equipment maintenance, and administrative expenses, cannot be directly traced to each type of bread. BreadHeaven uses a cost allocation method to assign these costs to the two types of bread.

Suppose the total indirect costs for the month are $6,000. BreadHeaven decides to use the number of loaves produced as the allocation base , as it believes that indirect costs are driven by the production volume. During the month, the bakery produces 3,000 loaves of white bread and 2,000 loaves of whole wheat bread, totaling 5,000 loaves.

The allocation rate per loaf is:

Allocation Rate = Total Indirect Costs / Total Loaves Allocation Rate = $6,000 / 5,000 loaves = $1.20 per loaf

BreadHeaven allocates the indirect costs to each type of bread using the allocation rate and the number of loaves produced:

• White bread: 3,000 loaves × $1.20 per loaf = $3,600
• Whole wheat bread: 2,000 loaves × $1.20 per loaf = $2,400

After completing the cost assignment, BreadHeaven can determine the total costs for each type of bread:

• White bread: $2,000 (direct materials) + $1,500 (direct labor) + $3,600 (indirect costs) = $7,100
• Whole wheat bread: $3,000 (direct materials) + $2,500 (direct labor) + $2,400 (indirect costs) = $7,900

By assigning both direct and indirect costs to each type of bread, BreadHeaven gains a better understanding of the full cost of producing each bread type, which can inform pricing decisions, resource allocation, and performance evaluation.

Other Posts You'll Like...

TCP CPA Practice Questions Explained: Liquidating Distributions from C Corporations

“I Shouldn’t Be Able to Do This”: How Colbi Passed Her CPA Exams

Common Tax Provision Journal Entries for a Business

How to Calculate Deferred Tax Assets or Liabilities for a Business

How to Calculate Current Taxes Payable or Receivable for a Business

How to Calculate Income Tax Expense for a Business

Helpful links.

• Learn to Study "Strategically"
• How to Pass a Failed CPA Exam
• Samples of SFCPA Study Tools
• SuperfastCPA Podcast

The 5 Biggest Myths About CPA Exam Study

From 8 Hours a Day to 8 Hours a Week, How Branden Passed His CPA Exams

5 High Impact CPA Study Strategies

How Melodie Passed Her CPA Exams by Making Every Morning Count

Inconsistent CPA Study? Try These 4 Strategies

Want to pass as fast as possible, ( and avoid failing sections ), watch one of our free "study hacks" trainings for a free walkthrough of the superfastcpa study methods that have helped so many candidates pass their sections faster and avoid failing scores....

Make Your Study Process Easier and more effective with SuperfastCPA

Take Your CPA Exams with Confidence

• Free "Study Hacks" Training
• SuperfastCPA PRO Course
• SuperfastCPA Review Notes
• SuperfastCPA Audio Notes
• SuperfastCPA Quizzes

Get Started

• Free "Study Hacks Training"
• Read Reviews of SuperfastCPA
• Busy Candidate's Guide to Passing
• Subscribe to the Podcast
• Purchase Now
• Nate's Story
• Interviews with SFCPA Customers
• Our Study Methods
• SuperfastCPA Reviews
• CPA Score Release Dates
• The "Best" CPA Review Course
• Do You Really Need the CPA License?
• 7 Habits of Successful Candidates
• "Deep Work" & CPA Study

Module 5: Job Order Costing

Introduction to accumulating and assigning costs, what you will learn to do: assign costs to jobs.

Financial and managerial accountants record costs of production in an account called Work in Process. The total of these direct materials, direct labor, and factory overhead costs equal the cost of producing the item.

In order to understand the accounting process, here is a quick review of how financial accountants record transactions:

Let’s take as simple an example as possible. Jackie Ma has decided to make high-end custom skateboards. She starts her business on July 1 by filing the proper forms with the state and then opening a checking account in the name of her new business, MaBoards. She transfers $150,000 from her retirement account into the business account and records it in a journal as follows:

For purposes of this ongoing example, we’ll ignore pennies and dollar signs, and we’ll also ignore selling, general, and administrative costs.

After Jackie writes the journal entry, she posts it to a ledger that currently has only two accounts: Checking Account, and Owner’s Capital.

Debits are entries on the left side of the account, and credits are entries on the right side.

Here is a quick review of debits and credits:

You can view the transcript for “Colin Dodds – Debit Credit Theory (Accounting Rap Song)” here (opens in new window) .

Also, this system of debits and credits is based on the following accounting equation:

Assets = Liabilities + Equity.

• Assets are resources that the company owns
• Liabilities are debts
• Equity is the amount of assets left over after all debts are paid

Let’s look at one more initial transaction before we dive into recording and accumulating direct costs such as materials and labor.

Jackie finds the perfect building for her new business; an old woodworking shop that has most of the equipment she will need. She writes a check from her new business account in the amount of $2,500 for July rent. Because she took managerial accounting in college, she determines this to be an indirect product expense, so she records it as Factory Overhead following a three-step process:

• Analyze transaction

Because her entire facility is devoted to production, she determines that the rent expense is factory overhead.

2. Journalize transaction using debits and credits

If she is using QuickBooks ® or other accounting software, when she enters the transaction into the system, the software will create the journal entry. In any case, whether she does it by hand or computer, the entry will look much like this:

3. Post to the ledger

Again, her computer software will post the journal entry to the ledger, but we will follow this example using a visual system accountants call T-accounts. The T-account is an abbreviated ledger. Click here to view a more detailed example of a ledger .

Jackie posts her journal entry to the ledger (T-accounts here).

She now has three accounts: Checking Account, Owner’s Capital, and Factory Overhead, and the company ledger looks like this:

In a retail business, rent, salaries, insurance, and other operating costs are categorized into accounts classified as expenses. In a manufacturing business, some costs are classified as product costs while others are classified as period costs (selling, general, and administrative).

We’ll treat factory overhead as an expense for now, which is ultimately a sub-category of Owner’s Equity, so our accounting equation now looks like this:

Assets = Liabilities + Owner’s Equity

147,500 = 150,000 – 2,500

Notice that debits offset credits and vice versa. The balance in the checking account is the original deposit of $150,000, less the check written for $2,500. Once the check clears, if Jackie checks her account online, she’ll see that her ledger balance and the balance the bank reports will be the same.

Here is a summary of the rules of debits and credits:

Assets = increased by a debit, decreased by a credit

Liabilities = increased by a credit, decreased by a debit

Owner’s Equity = increased by a credit, decreased by a debit

Revenues increase owner’s equity, therefore an individual revenue account is increased by a credit, decreased by a debit

Expenses decrease owner’s equity, therefore an individual expense account is increased by a debit, decreased by a credit

Here’s Colin Dodds’s Accounting Rap Song again to help you remember the rules of debits and credits:

Let’s continue to explore job costing now by using this accounting system to assign and accumulate direct and indirect costs for each project.

When you are done with this section, you will be able to:

• Record direct materials and direct labor for a job
• Record allocated manufacturing overhead
• Prepare a job cost record

Learning Activities

The learning activities for this section include the following:

• Reading: Direct Costs
• Self Check: Direct Costs
• Reading: Allocated Overhead
• Self Check: Allocated Overhead
• Reading: Subsidiary Ledgers and Records
• Self Check: Subsidiary Ledgers and Records
• Introduction to Accumulating and Assigning Costs. Authored by : Joseph Cooke. Provided by : Lumen Learning. License : CC BY: Attribution
• Colin Dodds - Debit Credit Theory (Accounting Rap Song). Authored by : Mr. Colin Dodds. Located at : https://youtu.be/j71Kmxv7smk . License : All Rights Reserved . License Terms : Standard YouTube License
• What the General Ledger Can Tell You About Your Business. Authored by : Mary Girsch-Bock. Located at : https://www.fool.com/the-blueprint/general-ledger/ . License : All Rights Reserved . License Terms : Standard YouTube License

Privacy Policy

• Accounting Tutorials
• Accounting Articles
• Accounting Tests
• Accounting Dictionary
• My Studyboard

Cost objects and cost assignment in accounting

In this article, we will define cost objects and discuss how the choice of a cost object affects the cost assignment process and hence outcome.

• 1. Cost object definition

A cost object is anything we want to determine the cost of.

Examples of cost objects are: a product, a product line, a brand category, a service, a project, an activity or task, a process, a department, a business segment, a channel, a customer, a supplier, a geographic area, etc.

For reporting purposes, organizations usually have to determine the cost of their products or services. But, internally the organizations can create additional reports where they try to measure costs of various cost objects (e.g., departments, product lines, segments, suppliers) in order to get more insights into operations, performance, risks, and opportunities.

• 2. Cost object choice and cost assignment

The choice of the cost object impacts whether a specific cost can be directly traced to it or not. For example, raw materials that are part of a product usually can be traced to specific products via materials requisition forms. But, it might be more challenging to trace the same information (about raw materials used) to product lines when different products use the same raw materials. The ability to trace specific costs to cost objects in an economically feasible (i.e., cost effective) way determines whether a specific cost is a “direct cost” or “indirect cost”.

Direct costs of a cost object can be traced to that cost object in an economically feasible (cost-effective) way.

Indirect costs of a cost object cannot be traced to that cost object in an economically feasible (cost-effective) way. As the result, indirect costs are allocated to cost objects using some kind of allocation rule.

The ability to (directly) trace costs to cost objects usually depends on:

• The design of operations
• The availability of technology for information gathering and processing
• The materiality of the cost

Complex operations make it more challenging to trace costs to cost objects. The lack of information gathering and processing technology or poorly organized information systems (e.g., accounting, operations) also make it more difficult to trace costs to cost objects. Finally, immaterial costs (e.g., relatively small costs) are often not directly traced to cost objects because the benefit from tracing immaterial costs is lower than the cost associated with tracing that information. We have to remember that in a reporting process the benefits from reporting should outweigh the costs associated with preparing those reports.

Ideally, we want to be able to directly trace costs to the cost objects. But in practice, often available data does not allow cost tracing, and the result, organizations need to allocate costs to cost objects. The issue with cost allocation is that it is less accurate and can be subjective depending on the allocation process and rules.

• About Us
• Contact Us
• Privacy Policy
• Site Map
• Terms of Service

Cost Allocation

The process of identifying, accumulating, and assigning costs to costs objects

What is Cost Allocation?

Cost allocation is the process of identifying, accumulating, and assigning costs to costs objects such as departments, products, programs, or a branch of a company. It involves identifying the cost objects in a company, identifying the costs incurred by the cost objects, and then assigning the costs to the cost objects based on specific criteria.

When costs are allocated in the right way, the business is able to trace the specific cost objects that are making profits or losses for the company. 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.

Types of Costs

There are several types of costs that an organization must define before allocating costs to their specific cost objects. These costs include:

1. Direct costs

Direct costs are costs that can be attributed to a specific product or service, and they do not need to be allocated to the specific cost object. It is because the organization knows what expenses go to the specific departments that generate profits and the costs incurred in producing specific products or services . For example, the salaries paid to factory workers assigned to a specific division is known and does not need to be allocated again to that division.

2. Indirect costs

Indirect costs are costs that are not directly related to a specific cost object like a function, product, or department. They are costs that are needed for the sake of the company’s operations and health. Some common examples of indirect costs include security costs, administration costs, etc. The costs are first identified, pooled, and then allocated to specific cost objects within the organization.

Indirect costs can be divided into fixed and variable costs. Fixed costs are costs that are fixed for a specific product or department. An example of a fixed cost is the remuneration of a project supervisor assigned to a specific division. The other category of indirect cost is variable costs, which vary with the level of output. Indirect costs increase or decrease with changes in the level of output.

3. Overhead costs

Overhead costs are indirect costs that are not part of manufacturing costs. They are not related to the labor or material costs that are incurred in the production of goods or services. They support the production or selling processes of the goods or services. Overhead costs are charged to the expense account, and they must be continually paid regardless of whether the company is selling goods or not.

Some common examples of overhead costs are rental expenses, utilities, insurance, postage and printing, administrative and legal expenses , and research and development costs.

Cost Allocation Mechanism

The following are the main steps involved when allocating costs to cost objects:

1. Identify cost objects

The first step when allocating costs is to identify the cost objects for which the organization needs to separately estimate the associated cost. Identifying specific cost objects is important because they are the drivers of the business, and decisions are made with them in mind.

The cost object can be a brand , project, product line, division/department, or a branch of the company. The company should also determine the cost allocation base, which is the basis that it uses to allocate the costs to cost objects.

2. Accumulate costs into a cost pool

After identifying the cost objects, the next step is to accumulate the costs into a cost pool, pending allocation to the cost objects. When accumulating costs, you can create several categories where the costs will be pooled based on the cost allocation base used. Some examples of cost pools include electricity usage, water usage, square footage, insurance, rent expenses , fuel consumption, and motor vehicle maintenance.

What is a Cost Driver?

A cost driver causes a change in the cost associated with an activity. Some examples of cost drivers include the number of machine-hours, the number of direct labor hours worked, the number of payments processed, the number of purchase orders, and the number of invoices sent to customers.

Benefits of Cost Allocation

The following are some of the reasons why cost allocation is important to an organization:

1. Assists in the decision-making process

Cost allocation provides the management with important data about cost utilization that they can use in making decisions. It shows the cost objects that take up most of the costs and helps determine if the departments or products are profitable enough to justify the costs allocated. For unprofitable cost objects, the company’s management can cut the costs allocated and divert the money to other more profitable cost objects.

2. Helps evaluate and motivate staff

Cost allocation helps determine if specific departments are profitable or not. If the cost object is not profitable, the company can evaluate the performance of the staff members to determine if a decline in productivity is the cause of the non-profitability of the cost objects.

On the other hand, if the company recognizes and rewards a specific department for achieving the highest profitability in the company, the employees assigned to that department will be motivated to work hard and continue with their good performance.

Additional Resources

Thank you for reading CFI’s guide to Cost Allocation. In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Break-Even Analysis
• Cost of Production
• Fixed and Variable Costs
• Projecting Income Statement Line Items
• See all accounting resources

• Share this article

Create a free account to unlock this Template

Access and download collection of free Templates to help power your productivity and performance.

Already have an account? Log in

Supercharge your skills with Premium Templates

Take your learning and productivity to the next level with our Premium Templates.

Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI's full course catalog and accredited Certification Programs.

Already have a Self-Study or Full-Immersion membership? Log in

Access Exclusive Templates

Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.

Already have a Full-Immersion membership? Log in

Close Management

Reconciliation Automation

Connected Compliance

Accounting Operations

Accounting Automation Platform

Scalability & Usability

Integrations

Accounting Manager

Internal Audit Manager

Success Stories

Video Testimonials

Partner Program

Become a Partner

All Resources

FloQast Blog

Checklists & Templates

Customer Video Testimonials

Whitepapers

Customer Success Stories

FloQast Studios

Services & Support

Customer Success Management

Request Support

Professional Education & Training Courses

FloQademy - Join/Sign in

The FloQast Advantage

What is Cost Allocation? Definition & Process

Jul 16, 2020 Michael Whitmire

Working with the former accountants now working at FloQast, we decided to take a look at some of the pillars of the accounting professions.

The key to running a profitable enterprise of any kind is making sure that your prices are high enough to cover all your costs — and leave at least a bit for profit. For a really simple business — like the proverbial lemonade stand that almost every kid ran — that’s pretty simple. Your costs are what you (or your parents) paid for lemons and sugar. But what if it’s a more complex business? Then you might need to brush up on cost accounting, and learn about allocation accounting . Let’s walk through this using the hypothetical company, Lisa’s Luscious Lemonade. 

What is cost allocation ?

The cost allocation definition is best described as the process of assigning costs to the things that benefit from those costs or to cost centers . For Lisa’s Luscious Lemonade, a cost center can be as granular as each jug of lemonade that’s produced, or as broad as the manufacturing plant in Houston. 

Let’s assume that the owner, Lisa, needs to know the cost of a jug of lemonade. The total cost to create that jug of lemonade isn’t just the costs of the water, lemons, sugar and the jug itself, but also includes all the allocated costs to make it. 

Let’s start by defining some terms…

Direct costs are costs that can be traced directly to the product or service itself. For manufacturers, these consist of direct materials and direct labor. They appear in the financial statements as part of the cost of goods sold .

Direct materials are those that become an integral part of the finished product. This will be the costs of the water, sugar, lemons, the plastic jug, and the label. 

Direct labor includes the labor costs that can be easily traced to the production of those finished products. Direct labor for that jug will be the payroll for the workers on the production line. 

Indirect costs are the costs that can’t be easily traced to a product or service but are clearly required for making whatever an enterprise sells. This includes materials that are used in such insignificant quantities that it’s not worth tracing them to finished products, and labor for employees who work in the factory, but not on the production line. 

Overhead costs encompass all the costs that support the enterprise that can’t be directly linked to making the items that are sold. This includes indirect costs , as well as selling, marketing, administration, and facility costs. 

Manufacturing overhead includes the overhead costs that are directly related to making the products for sale. This includes the electricity, rent, and utilities for the factory and salaries of supervisors on the factory floor. 

Product costs are all the costs in making or acquiring the product for sale. These are also known as manufacturing costs or total costs . This includes direct labor, direct materials, and allocated manufacturing overhead. 

What is the process?

The first step in any cost allocation system is to identify the cost objects to which costs need to be allocated. Here, our cost objec t is a jug of lemonade. For a more complex organization, the cost object could be a product line, a department, or a branch. 

Direct costs are the simplest to allocate. Last month, Lisa’s Luscious Lemonades produced 50,000 gallons of lemonade and had the following direct costs:

                                    Total costs     Cost per gallon Direct materials        $142,500               $2.85 Direct labor                   $37,500                   $.75

How are costs allocated?

Allocating overhead costs is a bit more complex. First, the overhead costs are split between manufacturing costs and non-manufacturing costs. Some of this is pretty straightforward: the factory floor supervisor’s salary is clearly a manufacturing cost, and the sales manager’s salary is a non-manufacturing cost. But what about the cost of human resources or other service departments that serve all parts of the organization? Or facilities costs, which might include the rent for the building, insurance, utilities, janitorial services, and general building maintenance?

Human resources and other services costs might be logically split based on the headcount of the manufacturing versus non-manufacturing parts of the business. Facilities costs might be split based on the square footage of the manufacturing space versus the administrative offices. Electricity usage might be allocated on the basis of square footage or machine hours , depending on the situation. 

Let’s say that for Lisa’s Luscious Lemonades, after we split the overhead between manufacturing and non-manufacturing costs, we have the following annual manufacturing overhead costs : 

Supervisor salary                                  $84,000 Indirect costs                                         $95,000 Facility costs                                           $150,000 Human resources                                  $54,000 Depreciation                                          $65,000 Electricity                                                $74,000 Total manufacturing overhead             $522,000

In a perfect world, it would be possible to keep an accurate running total of all overhead costs so that management would have detailed and accurate cost information. However, in practice, a predetermined overhead rate is used to allocate overhead using an allocation base . 

This overhead rate is determined by dividing the total estimated manufacturing overhead by the estimated total units in the allocation base . At the end of the year or quarter, the allocated costs are reconciled to actual costs. 

Ideally, the allocation base should be a cost driver that causes those overhead costs . For manufacturers, direct labor hours or machine-hours are commonly used. Since Lisa only makes one product — gallon jugs of lemonade — the simplest cost driver is the number of jugs produced in a year. 

If we estimate that 600,000 gallons of lemonade are produced in a year, then the overhead rate will be $522,000 / 600,000 = $.87 per gallon.

Our final cost to produce a gallon of Lisa’s Luscious Lemonade is as follows:

Direct materials                             $2.85 Direct labor                                     $0.75 Manufacturing overhead               $0.87 Total cost                                         $4.47

What is cost allocation used for?

Cost allocation is used for both external reporting and internally for decision making. Under generally accepted accounting principles (GAAP), the matching principle requires that expenses be reported in the financial statements in the same period that the related revenue is earned. 

This means that manufacturing overhead costs cannot be expensed in the period incurred, but must be allocated to inventory items, where those costs remain until the inventory is sold, when overhead is finally expensed as part of the cost of goods sold. For Lisa’s Luscious Lemonade, that means that every time a jug of lemonade is produced, another $4.47 goes into inventory. When a jug is sold, $4.47 goes to the cost of goods sold. 

However, for internal decision-making, the cost allocation systems used for GAAP financials aren’t always helpful. Cost accountants often use activity-based costing , or ABC, in parallel with the cost allocation system used for external financial reporting . 

In ABC, products are assigned all of the overhead costs that they can reasonably be assumed to have caused. This may include some — but not all — of the manufacturing overhead costs , as well as operating expenses that aren’t typically assigned to products under the costing systems used for GAAP. 

AutoRec to keep you sane

Whatever cost accounting method you use, it’s going to require spreadsheets that you have to reconcile to the GL. Combine that with the other reconciliations you have to do to close out the books, and like Lisa’s controller, you might be ready to jump into a vat of lemonade to drown your sorrows. 

Enter FloQast AutoRec. Rather than spend hours every month reconciling accounts, AutoRec leverages AI to match one-to-one, one-to-many, or many-to-many transactions in minutes. Simple set up means you can start using it in minutes because you don’t need to create or maintain rules. Try it out, and see how much time you can save this month. 

Ready to find out more about how FloQast can help you tame the beast of the close?

Michael Whitmire

As CEO and Co-Founder, Mike leads FloQast’s corporate vision, strategy and execution. Prior to founding FloQast, he managed the accounting team at Cornerstone OnDemand, a SaaS company in Los Angeles. He began his career at Ernst & Young in Los Angeles where he performed public company audits, opening balance sheet audits, cash to GAAP restatements, compilation reviews, international reporting, merger and acquisition audits and SOX compliance testing. He holds a Bachelor’s degree in Accounting from Syracuse University.

Related Blog Articles

Study: Accountants Understand Financial Transformation’s Importance, but Lack Cohesive Adoption Plans

Report: Accountants Want Financial Transformation, but Lack of Fulfillment and Confidence Stand in the Way

Study: Compliance and Controls Processes Are Struggling

COST ASSIGNMENT Definition

COST ASSIGNMENT involves assigning costs of an account to the accounts that are responsible or accountable for incurring the cost. For example, the cost of issuing purchase orders is allocated to the various objects procured. The cost assignment is done through assignment paths and cost drivers. The assignment path identifies the source account (the account whose cost is being assigned "Issue Purchase Orders" in the above example) and destination accounts (the accounts to which the costs are being allocated the various cost objects procured by issuing purchase orders in the above example). The cost driver identifies the measure or rationale on the basis of which the assignment needs to be done, that is, whether the costs of issuing purchase orders need to be assigned to various cost objects evenly, based on some defined percentage values, or based on some criterion, like the number of purchase orders of each cost object issued. Defining the cost drivers and assignment paths (i.e., source and destination accounts) enable proper assignment and accounting of the various costs incurred in the organization.

Learn new Accounting Terms

GOING LONG is the purchase of commodities, bonds, or stock with no immediate intention of selling them, i.e. the purchase is for long term investment or speculation. See GOING SHORT .

CONDUCIVE is tending to bring about or being partly responsible for, e.g. current working conditions may not be conducive to productivity.

Suggest a Term

*  = required field

Enter a term, then click the entry you would like to view.

• Search Search Please fill out this field.

What Is Cost Accounting?

Understanding cost accounting.

• Cost vs. Financial Accounting
• Cost Accounting FAQs

The Bottom Line

• Corporate Finance

Cost Accounting: Definition and Types With Examples

Yarilet Perez is an experienced multimedia journalist and fact-checker with a Master of Science in Journalism. She has worked in multiple cities covering breaking news, politics, education, and more. Her expertise is in personal finance and investing, and real estate.

• Accounting Explained With Brief History and Modern Job Requirements
• Accounting Equation
• Current and Noncurrent Assets
• Accounting Theory
• Accounting Principles
• Accounting Standard
• Accounting Convention
• Accounting Policies
• Principles-Based vs. Rules-Based Accounting
• Accounting Method
• Accrual Accounting
• Cash Accounting
• Accrual Accounting vs. Cash Basis Accounting
• Financial Accounting Standards Board (FASB)
• Generally Accepted Accounting Principles (GAAP)
• International Financial Reporting Standards (IFRS)
• IFRS vs. GAAP
• US Accounting vs. International Accounting
• Understanding the Cash Flow Statement
• Breaking Down The Balance Sheet
• Understanding the Income Statement
• Financial Accounting
• Financial Accounting and Decision-Making
• Financial vs. Managerial Accounting
• Cost Accounting CURRENT ARTICLE
• Certified Public Accountant (CPA)
• Chartered Accountant (CA)
• Accountant vs. Financial Planner
• Tax Accounting
• Forensic Accounting
• Chart of Accounts (COA)
• Double Entry
• Closing Entry
• Introduction to Accounting Information Systems
• Inventory Accounting
• Last In, First Out (LIFO)
• First In, First Out (FIFO)
• Average Cost Method

Cost accounting is a form of managerial accounting that aims to capture a company's total cost of production by assessing the variable costs of each step of production as well as fixed costs, such as a lease expense.

Cost accounting is not GAAP-compliant , and can only be used for internal purposes.

Key Takeaways

• Cost accounting is used internally by management in order to make fully informed business decisions.
• Unlike financial accounting, which provides information to external financial statement users, cost accounting is not required to adhere to set standards and can be flexible to meet the particular needs of management.
• As such, cost accounting cannot be used on official financial statements and is not GAAP-compliant.
• Cost accounting considers all input costs associated with production, including both variable and fixed costs.
• Types of cost accounting include standard costing, activity-based costing, lean accounting, and marginal costing.

Investopedia / Theresa Chiechi

Cost accounting is used by a company's internal management team to identify all variable and fixed costs associated with the production process. It will first measure and record these costs individually, then compare input costs to output results to aid in measuring financial performance and making future business decisions. There are many types of costs involved in cost accounting , each performing its own function for the accountant.

Types of Costs

• Fixed costs are costs that don't vary depending on the level of production. These are usually things like the mortgage or lease payment on a building or a piece of equipment that is depreciated at a fixed monthly rate. An increase or decrease in production levels would cause no change in these costs.
• Variable costs are costs tied to a company's level of production. For example, a floral shop ramping up its floral arrangement inventory for Valentine's Day will incur higher costs when it purchases an increased number of flowers from the local nursery or garden center.
• Operating costs are costs associated with the day-to-day operations of a business. These costs can be either fixed or variable depending on the unique situation.
• Direct costs are costs specifically related to producing a product. If a coffee roaster spends five hours roasting coffee, the direct costs of the finished product include the labor hours of the roaster and the cost of the coffee beans.
• Indirect costs are costs that cannot be directly linked to a product. In the coffee roaster example, the energy cost to heat the roaster would be indirect because it is inexact and difficult to trace to individual products.

Cost Accounting vs. Financial Accounting

While cost accounting is often used by management within a company to aid in decision-making, financial accounting is what outside investors or creditors typically see. Financial accounting presents a company's financial position and performance to external sources through financial statements , which include information about its revenues , expenses , assets , and liabilities . Cost accounting can be most beneficial as a tool for management in budgeting and in setting up cost-control programs, which can improve net margins for the company in the future.

One key difference between cost accounting and financial accounting is that, while in financial accounting the cost is classified depending on the type of transaction, cost accounting classifies costs according to the information needs of the management. Cost accounting, because it is used as an internal tool by management, does not have to meet any specific standard such as  generally accepted accounting principles (GAAP) and, as a result, varies in use from company to company or department to department.

Cost-accounting methods are typically not useful for figuring out tax liabilities, which means that cost accounting cannot provide a complete analysis of a company's true costs. 

Types of Cost Accounting

Standard costing.

Standard costing assigns "standard" costs, rather than actual costs, to its cost of goods sold (COGS) and inventory. The standard costs are based on the efficient use of labor and materials to produce the good or service under standard operating conditions, and they are essentially the budgeted amount. Even though standard costs are assigned to the goods, the company still has to pay actual costs. Assessing the difference between the standard (efficient) cost and the actual cost incurred is called variance analysis.

If the variance analysis determines that actual costs are higher than expected, the variance is unfavorable. If it determines the actual costs are lower than expected, the variance is favorable. Two factors can contribute to a favorable or unfavorable variance. There is the cost of the input, such as the cost of labor and materials. This is considered to be a rate variance.

Additionally, there is the efficiency or quantity of the input used. This is considered to be a volume variance. If, for example, XYZ company expected to produce 400 widgets in a period but ended up producing 500 widgets, the cost of materials would be higher due to the total quantity produced.

Activity-Based Costing

Activity-based costing (ABC) identifies overhead costs from each department and assigns them to specific cost objects, such as goods or services. The ABC system of cost accounting is based on activities, which refer to any event, unit of work, or task with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. These activities are also considered to be cost drivers , and they are the measures used as the basis for allocating overhead costs .

Traditionally, overhead costs are assigned based on one generic measure, such as machine hours. Under ABC, an activity analysis is performed where appropriate measures are identified as the cost drivers. As a result, ABC tends to be much more accurate and helpful when it comes to managers reviewing the cost and profitability of their company's specific services or products.

For example, cost accountants using ABC might pass out a survey to production-line employees who will then account for the amount of time they spend on different tasks. The costs of these specific activities are only assigned to the goods or services that used the activity. This gives management a better idea of where exactly the time and money are being spent.

To illustrate this, assume a company produces both trinkets and widgets. The trinkets are very labor-intensive and require quite a bit of hands-on effort from the production staff. The production of widgets is automated, and it mostly consists of putting the raw material in a machine and waiting many hours for the finished good. It would not make sense to use machine hours to allocate overhead to both items because the trinkets hardly used any machine hours. Under ABC, the trinkets are assigned more overhead related to labor and the widgets are assigned more overhead related to machine use.

Lean Accounting

The main goal of lean accounting is to improve financial management practices within an organization. Lean accounting is an extension of the philosophy of lean manufacturing and production, which has the stated intention of minimizing waste while optimizing productivity. For example, if an accounting department is able to cut down on wasted time, employees can focus that saved time more productively on value-added tasks.

When using lean accounting, traditional costing methods are replaced by value-based pricing  and lean-focused performance measurements. Financial decision-making is based on the impact on the company's total value stream profitability. Value streams are the profit centers of a company, which is any branch or division that directly adds to its bottom-line profitability.

Marginal Costing

Marginal costing (sometimes called cost-volume-profit analysis ) is the impact on the cost of a product by adding one additional unit into production. It is useful for short-term economic decisions. Marginal costing can help management identify the impact of varying levels of costs and volume on operating profit. This type of analysis can be used by management to gain insight into potentially profitable new products, sales prices to establish for existing products, and the impact of marketing campaigns.

The  break-even point —which is the production level where total revenue for a product equals total expense —is calculated as the total fixed costs of a company divided by its contribution margin. The contribution margin , calculated as the sales revenue minus variable costs, can also be calculated on a per-unit basis in order to determine the extent to which a specific product contributes to the overall profit of the company.

History of Cost Accounting

Scholars believe that cost accounting was first developed during the  industrial revolution  when the emerging economics of industrial supply and demand forced manufacturers to start tracking their fixed and variable expenses in order to optimize their production processes.

Cost accounting allowed railroad and steel companies to control costs and become more efficient. By the beginning of the 20th century, cost accounting had become a widely covered topic in the literature on business management.

How Does Cost Accounting Differ From Traditional Accounting Methods?

In contrast to general accounting or financial accounting, the cost-accounting method is an internally focused, firm-specific system used to implement  cost controls . Cost accounting can be much more flexible and specific, particularly when it comes to the subdivision of costs and inventory valuation. Cost-accounting methods and techniques will vary from firm to firm and can become quite complex.

Why Is Cost Accounting Used?

Cost accounting is helpful because it can identify where a company is spending its money, how much it earns, and where money is being lost. Cost accounting aims to report, analyze, and lead to the improvement of internal cost controls and efficiency. Even though companies cannot use cost-accounting figures in their financial statements or for tax purposes, they are crucial for internal controls.

Which Types of Costs Go Into Cost Accounting?

These will vary from industry to industry and firm to firm, however certain cost categories will typically be included (some of which may overlap), such as direct costs, indirect costs, variable costs, fixed costs, and operating costs.

What Are Some Advantages of Cost Accounting?

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.

What Are Some Drawbacks of Cost Accounting?

Cost-accounting systems ,and the techniques that are used with them, can have a high start-up cost to develop and implement. Training accounting staff and managers on esoteric and often complex systems takes time and effort, and mistakes may be made early on. Higher-skilled  accountants  and  auditors  are likely to charge more for their services when evaluating a cost-accounting system than a standardized one like GAAP.

Cost accounting is an informal set of flexible tools that a company's managers can use to estimate how well the business is running. Cost accounting looks to assess the different costs of a business and how they impact operations, costs, efficiency, and profits. Individually assessing a company's cost structure allows management to improve the way it runs its business and therefore improve the value of the firm. These are meant to be internal metrics and figures only. Since they are not GAAP-compliant, cost accounting cannot be used for a company's audited financial statements released to the public.

Fleischman, Richard K., and Thomas N. Tyson. "The Economic History Review: Cost Accounting During the Industrial Revolution: The Present State of Historical Knowledge." Economic History Review , vol. 46, no. 3, 1993, pp. 503-517.

• Terms of Service
• Editorial Policy
• Privacy Policy

• Recently Active
• Top Discussions
• Best Content

By Industry

• Investment Banking
• Private Equity
• Hedge Funds
• Real Estate
• Venture Capital
• Asset Management
• Equity Research
• Investing, Markets Forum
• Business School
• Fashion Advice
• Corporate Finance Resources
• Technical Skills
• Accounting Articles

Cost Allocation

The process of identifying a company’s costs and assigning those costs to cost objects

Chris currently works as an investment associate with Ascension Ventures, a strategic healthcare venture fund that invests on behalf of thirteen of the nation's leading health systems with $88 billion in combined operating revenue. Previously, Chris served as an investment analyst with New Holland Capital, a hedge fund-of-funds  asset management  firm with $20 billion under management, and as an investment banking analyst in  SunTrust Robinson Humphrey 's Financial Sponsor Group.

Chris graduated Magna Cum Laude from the University of Florida with a Bachelor of Arts in Economics and earned a Master of Finance (MSF) from the Olin School of Business at Washington University in St. Louis.

Currently an investment analyst focused on the  TMT  sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a  BS  from The Tepper School of Business at Carnegie Mellon.

• What Is Cost Allocation?
• Types Of Costs
• How To Allocate Costs
• Why Do We Need To Allocate Costs?
• Examples Of Cost Allocation & Calculations

What is Cost Allocation?

Cost allocation is the process of identifying a company’s costs and assigning those costs to cost objects. Cost objects are the products, services, and activities of different departments of a company. 

This process of allocating costs helps a business determine which parts of the company are responsible for what costs. 

Sometimes it is difficult to draw the connection between allocated costs and their cost objects. When this happens, companies can use spreading costs. 

Spreading costs occur when businesses spread the responsibility for production expenses across various areas. 

When businesses can accurately allocate their costs, they are able to easily assess what particular cost objects are creating profits and losses for the company. On the other hand, if businesses are unable to allocate their costs correctly, their profit and loss calculations will be off. 

Also, businesses must charge a price for their goods and services that covers their expenses and allows them to make a profit.  

Intuitively, one can recognize the importance of cost allocation for the optimal performance of a company. Incorrect cost allocation calculations are extremely detrimental to any business and disrupt the ability to operate properly.

Cost allocation is necessary for any business, but as companies get larger and more complex, it becomes even more important to allocate costs accurately. 

Key Takeaways

Cost allocation is fundamental and necessary for any business, big or small. 

It helps with assessing profits and losses and the management of staffing. 

Cost allocation allows companies to explain the pricing of their goods and services to customers. 

Allocating costs is necessary for companies to maintain efficiency and financial accountability. 

Types of Costs

Companies have various types of costs, and it is important to be able to distinguish between the different types when allocating them. 

We can break them down into a few different categories.

• Direct costs:  direct costs are those that can be traced to a certain product or service offered by a company. Included in direct costs are materials and labor that go into the production of a good. 
• Indirect costs :  these expenses are those that go into the production of a good but do not have a connection to a specific cost object. Examples of indirect costs include rent, utilities, and office supplies.
• Fixed costs : these costs remain constant, regardless of a company’s production volume. (e.g., rent)
• Variable costs : these costs increase or decrease as a company’s volume of production changes (e.g., supplies). 
• A few examples of fixed overhead costs include rent, insurance, and workers’ salaries. Variable overhead costs include supplies and energy expenses, which both change as the  volume of production  increases or decreases. 

How to Allocate Costs

Now that we understand the different types of costs, we can better understand the processes involved in cost allocation. Regardless of what good or service a company produces, the process remains consistent across industries. 

• Identify  Cost Objects : anything within a business that creates an expense is considered a cost object. The first step for allocating costs is to note all the cost objects of your company. 

Electricity usage

Water usage

Fuel consumption

• Fixed cost allocation:  this method assigns particular direct costs with cost objects. Drawing direct connections between costs and cost objects makes this method one of the most simple.
• Proportional allocation:  proportional allocation deals with the distribution of indirect costs across associated cost objects. Sometimes proportional allocation divides costs equally across cost objects, while other times, it considers other factors (i.e., size) and divides costs accordingly. 
• Activity-based allocation:  this method is commonly considered the more accurate method of allocating costs. Activity-based allocation utilizes precise documentation to determine costs within departments and allocates the costs appropriately. 

Why Do We Need to Allocate Costs?

A company must allocate its costs in order to optimize its business activities.

Recognizing Profits And Losses

Understanding the distribution of expenses helps companies analyze which areas of their business may be profitable or which areas may be causing a loss. This allows companies to determine whether or not certain expenses can be justified or not. 

Companies do not know how much to charge the customer’s goods and services without cost allocation. Once non-profitable cost objects are identified, companies can cut expenses in those departments and focus their efforts on profitable cost objects. 

Management Decisions

Cost allocation is also important for a company to manage its staff. In areas where the company is not profitable, it can evaluate the staff performance of that department. Often, the losses incurred by part of a company are due to the underperformance of employees. 

Similarly, companies can analyze the allocation of their costs to determine where they are profitable and award the employees of that department. 

Using cost allocation to motivate employees offers the administration of a company an objective, quantitative justification for their management decisions. 

Transfer Pricing

Transfer pricing is the practice of charging for goods and services at an arm's length. The practice is used by departments the organization to charge for the goods and services exchanged within the same firm.

Cost allocation is vital for deriving transfer pricing, the exchange price of goods or services between two companies. 

Examples of Cost Allocation & Calculations

Now we understand cost allocation, the different types, and why we need it. Here are several examples of different ways a company might allocate its costs. 

Example 1: Square Footage

Christina’s business has an office and a manufacturing space. The square footage of the office is 1,000 square feet, and the manufacturing space is 1,500 square feet. The rent for the two spaces is $10,000 per month. The company will allocate the rent expense between the two spaces. 

$10,000 (rent) / 2,500 square feet = $4 per square foot

• Calculate the rental cost for the office

$4 x 1,000 = $4,000

This means that Christina will allocate $4,000 of the rent to the office.

• Calculate the rental cost for the manufacturing space

$4 x 1,500 = $6,000

This means that Christina will allocate $6,000 of the rent to the manufacturing space.

Example 2: Units Produced

Alex’s manufacturing company makes water bottles. In January, Alex produced 5,000 water bottles with direct material costs of $2.50 per water bottle and $3.00 in direct labor costs per water bottle. 

Alex also had $6,500 in overhead costs in January. Using the number of units produced as his allocation method, Alex can calculate his overhead costs using the overhead cost formula. 

• Calculate the overhead costs: 

$6,500 / 5,000 = $1.30 per water bottle

• Add the overhead costs to the direct costs to find the total costs:

$1.30 + $2.50 + $3.00 = $6.80 per backpack

So, Alex’s total costs in January were $6.80 per backpack. If Alex had not allocated the overhead costs, he would have most likely underpriced the backpacks, which would have resulted in a loss of income. 

Everything You Need To Build Your Accounting Skills

To Help you Thrive in the Most Flexible Job in the World.

Researched and authored by Rachel Kim |  LinkedIn

Free Resources

To continue learning and advancing your career, check out these additional helpful  WSO  resources:

• Accounting Ratios
• Amortization
• Depreciated Cost

Get instant access to lessons taught by experienced private equity pros and bulge bracket investment bankers including financial statement modeling, DCF, M&A, LBO, Comps and Excel Modeling.

or Want to Sign up with your social account?

Our Recommendations

• Best Small Business Loans for 2024
• Businessloans.com Review
• Biz2Credit Review
• SBG Funding Review
• Rapid Finance Review
• 26 Great Business Ideas for Entrepreneurs
• Startup Costs: How Much Cash Will You Need?
• How to Get a Bank Loan for Your Small Business
• Articles of Incorporation: What New Business Owners Should Know
• How to Choose the Best Legal Structure for Your Business

Small Business Resources

• Business Ideas
• Business Plans
• Startup Basics
• Startup Funding
• Franchising
• Success Stories
• Entrepreneurs
• The Best Credit Card Processors of 2024
• Clover Credit Card Processing Review
• Merchant One Review
• Stax Review
• How to Conduct a Market Analysis for Your Business
• Local Marketing Strategies for Success
• Tips for Hiring a Marketing Company
• Benefits of CRM Systems
• 10 Employee Recruitment Strategies for Success
• Sales & Marketing
• Social Media
• Best Business Phone Systems of 2024
• The Best PEOs of 2024
• RingCentral Review
• Nextiva Review
• Ooma Review
• Guide to Developing a Training Program for New Employees
• How Does 401(k) Matching Work for Employers?
• Why You Need to Create a Fantastic Workplace Culture
• 16 Cool Job Perks That Keep Employees Happy
• 7 Project Management Styles
• Women in Business
• Personal Growth
• Best Accounting Software and Invoice Generators of 2024
• Best Payroll Services for 2024
• Best POS Systems for 2024
• Best CRM Software of 2024
• Best Call Centers and Answering Services for Busineses for 2024
• Salesforce vs. HubSpot: Which CRM Is Right for Your Business?
• Rippling vs Gusto: An In-Depth Comparison
• RingCentral vs. Ooma Comparison
• Choosing a Business Phone System: A Buyer’s Guide
• Equipment Leasing: A Guide for Business Owners
• HR Solutions
• Financial Solutions
• Marketing Solutions
• Security Solutions
• Retail Solutions
• SMB Solutions

Business News Daily provides resources, advice and product reviews to drive business growth. Our mission is to equip business owners with the knowledge and confidence to make informed decisions. As part of that, we recommend products and services for their success.

We collaborate with business-to-business vendors, connecting them with potential buyers. In some cases, we earn commissions when sales are made through our referrals. These financial relationships support our content but do not dictate our recommendations. Our editorial team independently evaluates products based on thousands of hours of research. We are committed to providing trustworthy advice for businesses. Learn more about our full process and see who our partners are here .

What Is Cost Allocation?

Cost allocation is a process businesses use to identify costs. Here's everything you need to know.

Table of Contents

Entrepreneurs, small business owners and managers need accurate, timely financial data to run their operations. Specifically, understanding and connecting costs to items or departments helps them create budgets, develop strategies and make the best business decisions for their organizations. This is where cost allocation comes in. Detailed cost allocation reports help businesses ensure they’re charging enough to cover expenses and make a profit. 

While a detailed cost allocation report may not be vital for extremely small businesses, more complex businesses require cost allocation to optimize profitability and productivity.

What is cost allocation?

Cost allocation is the process of identifying and assigning costs to business objects, such as products, projects, departments or individual company branches. Business owners use cost allocation to calculate profitability. Costs are separated or allocated, into different categories based on the business area they impact. These amounts are then used in accounting reports . 

For example, say you’re a small clothing manufacturer. Your product line’s cost allocation would include materials, shipping and labor costs. It would also include a portion of the operation’s overhead costs. Calculating these costs consistently helps business leaders determine if profits from sales are higher than the costs of producing the product line. If not, it can help the owner pinpoint where to raise prices or cut expenses .

For a larger company, cost allocation is applied to each department or business location . Many companies also use cost allocation to determine annual bonuses for each area.

Types of costs

If you’re starting a business , the cost allocation process is relatively straightforward. However, larger businesses have many more costs that can be divided into two primary categories: direct and indirect costs:

• Purchased inventory
• Materials used to make inventory
• Direct labor costs for employees who make inventory
• Payroll for those who work in operations
• Manufacturing overhead, including rent, insurance and utilities costs
• Other overhead costs, including expenses that support the company but aren’t directly related to production, such as marketing and human resources

What is a cost driver?

A cost driver is a variable that affects business costs, such as the number of invoices issued, employee hours worked or units of electricity used. Unlike cost objects, such as units produced or departments, a cost driver reflects the reason for the incurred cost amounts. 

How to allocate costs

While cost objects vary by business type, the cost allocation process is the same regardless of what your company produces. Here are the steps involved.

1. Identify your business’s cost objects.

Determine the cost objects to which you want to allocate costs, such as units of production, number of employees or departments. Remember that anything within your business that generates an expense is a cost object. Review each product line, project and department to ensure you’ve gathered all cost objects for which you must allocate costs.

2. Create a cost pool.

Next, create a detailed list of all business costs. Categories should cover utilities, business insurance policies, rent and any other expenses your business incurs.

3. Choose the best cost allocation method for your needs.

After identifying your business’s cost objects and creating a cost pool, you must choose a cost allocation method. Several methods exist, including the following standard ones: 

• Direct materials cost method: This cost allocation method assumes all products have the same allocation base and variable rate.
• Direct labor cost method: This cost allocation method is most helpful if labor costs can be allocated to one product or if expenses vary directly with labor costs.
• High/low method. This cost allocation method is best if you have more than one cost driver and each driver has different fixed or variable rates.
• Step-up or step-down method: With this cost allocation method, departments are first ranked and then the cost of services is allocated from one service department to another in a series of steps. 
• Full absorption costing (FAC): This cost allocation method combines direct material and direct labor costs with a predetermined FAC rate based on company historical data or industry standards.
• Variable costing: Consider this cost allocation method if your business has many variable cost allocations (costs that vary by quantity) and uses significant direct labor.

4. Allocate costs.

Now that you’ve listed cost objects, created a cost pool and chosen a cost allocation method, you’re ready to allocate costs. 

Here’s a cost allocation example to help you visualize the process: 

Dave owns a business that manufactures eyeglasses. In January, Dave’s overhead costs totaled $5,000. In the same month, he produced 3,000 eyeglasses with $2 in direct labor per product. Direct materials for each pair of eyeglasses totaled $5. Here’s what cost allocation would look like for Dave: Direct costs: $5 direct materials + $2 direct labor = $7 direct costs per pair Indirect costs: Overhead allocation: $5,000 ÷ 3,000 pairs = $1.66 overhead costs per pair Direct costs: $7 per pair + Indirect costs: $1.66 per pair Total cost: $8.66 per pair

As you can see, cost allocation helps Dave determine how much he must charge wholesale for each pair of eyeglasses to make a profit. Larger companies would apply this same process to each department and product to ensure sufficient sales goals.

5. Review and adjust cost allocations.

Cost allocations are never static. To be meaningful, they must be monitored and adjusted constantly as circumstances change.

What are the benefits of cost allocation?

Accurate, regular cost allocation can bring your business the following benefits: 

• Helps you run your business: The information you glean from cost allocation reports helps you perform vital functions like preparing income tax returns and creating financial reports for investors, creditors and regulators. 
• Informs business decisions: Cost allocation is an excellent business decision tool that can help you monitor productivity and justify expenses. Cost allocation gives a detailed overview of how your business expenses are used. From this perspective, you can determine which products and services are profitable and which departments are most productive. 
• Helps produce accurate business reports: Tax accounting, financial accounting and management accounting all require some kind of cost allocation. This information is the foundation of accurate business reports. 
• Can reveal accurate production costs: Knowing what it costs to create a product, including all expenses allocated to it, is essential to making good pricing decisions and allocating resources efficiently.
• Helps you evaluate staff: Cost allocation can help you assess the performance of different departments and staff members. If a department is not profitable, staff productivity may need improvement. 

Common cost allocation mistakes

To get the most from cost allocation, avoid these common mistakes:

• Equal or inflexible allocation : Cost allocation is not as simple as allocating any given cost over different product lines or departments. Some cost objects require more time, expense or labor than others, for example.
• Missing costs: Costing is meaningless if it doesn’t include all expenses. Don’t forget costs, such as overhead, time spent and intangible expenses.
• Failing to adjust as needed: Costs and priorities in business are changing constantly. Be sure your cost allocations are monitored and adjusted to meet your information needs.
• Not considering fluctuating revenue with indirect costs: If your business is seasonal or fluctuates over time, it’s important to account for that when allocating costs. 

Cost allocation and your business

Even if you operate a very small business, it’s essential to properly allocate your expenses. Otherwise, you could make all-too-common mistakes, such as charging too little for your product or spending too much on overhead. Whether you choose to start allocating costs on your own with software or with the help of a professional small business accountant , cost allocation is a process no business owner can afford to overlook.

Dachondra Cason contributed to this article. 

Building Better Businesses

Insights on business strategy and culture, right to your inbox. Part of the business.com network.

In order to continue enjoying our site, we ask that you confirm your identity as a human. Thank you very much for your cooperation.

The Comprehensive Guide to Cost Allocation in Accounting

Accounting is a fascinating field, and cost allocation is one of the most important concepts in accounting. Whether you’re an accounting student or an accountant just starting out, it’s important to understand how to allocate costs.

In this comprehensive guide, we’ll cover everything from what it means to its pros and cons. 

How Can Costs Be Allocated Among Departments or Product Lines When There Is No Clear Source?

Allocation is distributing costs among different departments or product lines in an organization. Trying to accurately estimate the cost of producing a good or rendering a service is a common challenge for many businesses.

This is especially true when there is no apparent source of the costs, as it requires the use of various techniques and methods to distribute the expenses fairly and reasonably.

What Is the Concept of Allocation?

Allocation (also known as “cost allocation”) is a process used to distribute the costs of a shared resource or expense among different departments, product lines, or activities within an organization.

This process is necessary to accurately determine the cost of producing a product, providing a service, or running a business. Allocation allows firms to identify the expenses incurred by each department or product line and helps make informed decisions about allocating resources.

The allocation concept has existed for centuries and is a fundamental part of modern accounting and financial management. The cost allocation process involves assigning costs to specific departments or product lines based on objective criteria, such as resource use or the benefit received from the expense.

The objective criteria used in the allocation process may vary depending on the type of business, but the goal is always to distribute the costs fairly and reasonably.

One of the main challenges of allocation is that many expenses cannot be traced directly to a specific department or product line. For example, the cost of electricity used to run a manufacturing plant cannot be directly traced to one particular product line.

In such cases, the cost of electricity must be allocated to different departments or product lines based on objective criteria, such as the number of hours each department uses the electricity or the production output of each product line.

There are different methods of allocation, each with its strengths and weaknesses. Some of the most common ways include direct allocation, step-down allocation, sequential allocation, and activity-based allocation. Each mode uses a different approach to allocating costs, but the goal is always to ensure that the costs are distributed fairly and reasonably.

What Doesn’t the Term Allocation Mean?

The term allocation” is commonly used in various contexts, such as finance, economics, project management, and resource management. However, it’s essential to understand that allocation ” doesn’t mean “equal distribution” or “uniform distribution” of resources.

Allocation refers to assigning a portion of resources, such as time, money, or labor, to specific tasks or activities. The goal of allocation is to optimize the use of resources to achieve the desired outcomes.

One of the most common misunderstandings about allocation is that it means dividing resources equally among tasks or activities. However, this is only sometimes the case. Resources are often not distributed evenly because different tasks or activities have different requirements and priorities.

For example, in project management, some jobs may require more time, money, or labor than others. In such cases, the project manager must allocate more resources to these critical tasks to ensure the project’s success.

Another misunderstanding about allocation is that it means distributing resources inflexibly and rigidly. Allocation is a flexible process that can be adjusted based on priorities or changes in resource availability. For example, in a business setting, the budget allocation may change based on market conditions or changes in customer demand. In these situations, the business must be able to reallocate its resources to respond to these changes.

The allocation also doesn’t mean that the resources are assigned once and never adjusted. Allocation is an ongoing process requiring constant monitoring and adjustments to ensure that resources are used optimally.

For example, in finance, the allocation of investments must be reviewed regularly to ensure that the portfolio is aligned with the investor’s goals and objectives.

Another misconception about allocation is that it only applies to tangible resources, such as money or equipment. However, allocation also applies to intangible resources like time and labor. These intangible resources are often more critical and limited than tangible ones. For example, allocating time is crucial in project management to ensure that projects are completed on time and within budget.

As you can see, allocation is a complex and flexible process that requires careful consideration of multiple factors, such as resource availability, priorities, and goals. It’s essential to understand that allocation doesn’t mean equal distribution or limited distribution of resources.

Instead, it’s a dynamic process that requires ongoing monitoring and adjustments to ensure the optimal use of resources. By avoiding common misconceptions about allocation, individuals and organizations can more effectively allocate their resources and achieve their desired outcomes.

Where the Term Allocation Originated From?

The word “allocation” comes from the Latin word “allocare.” The word allocation ” refers to setting aside or assigning a particular portion, amount, or portion of something for a specific purpose or recipient.

The allocation comes from the Latin prefix ad- (meaning “to”) and the noun loci (meaning “place”). The combination of these two words implies the idea of assigning a place, or portion of something, for a specific purpose.

In finance and economics, “allocation” refers to distributing resources, such as money, to different projects or initiatives based on their perceived importance and likelihood of success.

The allocation concept is ancient and can be traced back to the earliest civilizations, where resources were allocated based on the community’s needs. In early societies, central planning or direct control by the ruling class were common methods of allocation.

However, with the advent of market-based economies, the allocation has become more decentralized and is now primarily done through the market mechanism of supply and demand.

In modern economies, allocation is crucial in ensuring that resources are used efficiently and effectively. For example, in capital allocation, investors allocate their funds to different projects and businesses based on the perceived potential return on investment. This helps direct investment toward the most promising and profitable opportunities, thereby increasing the economy’s overall efficiency.

Similarly, prices play a crucial role in allocating goods and services in directing resources to where they are most needed. In a market economy, the interaction of supply and demand determines prices. When demand for a particular good or service is high, the price will increase, directing more resources toward its production. On the other hand, when demand is low, the price will decrease, reducing the allocation of resources to its production.

Government policies and regulations can also have an impact on allocation in addition to the market mechanism. For example, the government may allocate resources to specific sectors through funding or subsidies, such as education or healthcare.

Similarly, government regulations and taxes can also impact the allocation of resources by affecting the incentives for businesses and individuals to allocate their resources in a particular way.

How Allocation Relates to Accounting?

In accounting, allocation determines the cost of producing a product or providing a service. This information is then used to create accurate financial statements and make informed decisions about allocating resources in the future.

For example, a company may allocate resources to a new product line based on the expected revenue it will generate or distribute costs to specific departments based on their usage of resources.

The allocation also plays a crucial role in cost accounting . Cost accounting involves analyzing the cost of production, including direct and indirect costs, and using this information to make decisions about pricing and resource allocation.

By accurately allocating costs, a company can determine the actual cost of production and make informed decisions about pricing , production volume, and resource allocation.

In addition, allocation is used to allocate the costs of long-term assets, such as property, plant, and equipment. This is done through the process of depreciation, which is a systematic allocation of the cost of an asset over its useful life. Depreciation is used to determine the value of an investment for financial reporting purposes and the amount of tax that a company must pay.

Finally, allocation is also used in the budgeting process. In budgeting, an organization allocates resources to various departments and activities based on their priorities and goals. By accurately allocating resources, a company can ensure that it has enough resources to meet its goals and objectives while staying within its budget.

3 Examples of Allocation Being Used in Accounting Practice

Example #1 of allocation being used in accounting practice.

Allocating the Cost of Goods Sold In accounting, “cost of goods sold” (COGS) refers to the direct costs associated with producing a product or providing a service. These costs include the raw materials, labor, and overhead expenses incurred to produce the goods. COGS is crucial in determining a company’s gross profit because it represents the cost of producing and selling a product.

One example of allocation in accounting practice is when a company allocates the cost of goods sold to each product. This is done to understand the cost of producing each product and identify the most profitable products. 

The allocation process involves dividing the total COGS by the number of units sold to arrive at an average cost per unit. This average cost per unit is then applied to each unit of product sold to determine the COGS for that specific product.

This allocation process is vital because it allows the company to accurately determine the cost of producing each product. This information is then used to make informed business decisions such as pricing strategies, production decisions, and cost control measures. 

For example, suppose a company realizes that the cost of producing one product is much higher than the cost of producing another. In that case, it may choose to discontinue the higher-cost product or find ways to reduce the cost of production.

Example #2 of Allocation Being Used in Accounting Practice

One example of allocation in accounting practice is allocating indirect costs to different departments or products within a company. Indirect costs, such as rent, utilities, and office supplies, cannot be directly traced to a specific product or department. These costs must be allocated among different departments or products to calculate the cost of each accurately.

For example, consider a manufacturing company with three departments: production, research and development, and administration. The company has a total indirect cost of $100,000 for the year, which includes rent, utilities, and office supplies.

The company might determine the proportion of space each department uses to allocate these costs. If production uses 40% of the total space, R&D uses 30%, and administration uses 30%, the company would allocate 40% of the indirect costs to production, 30% to R&D, and 30% to administration.

Next, the company might allocate indirect costs based on the number of employees in each department. If production has 20 employees, R&D has 15, and administration has 10, the company would allocate indirect costs based on the ratio of employees in each department.

In this example, production would receive 40% of the indirect costs, R&D would receive 30%, and administration would receive 30%.

Finally, the company might allocate indirect costs based on the number of products produced in each department. If production produces 1000 products, R&D produces 500, and administration produces none, the company would allocate indirect costs based on the ratio of products produced in each department.

In this example, production would receive 67% of the indirect costs, R&D would receive 25%, and administration would receive 8%.

Example #3 of Allocation Being Used in Accounting Practice

Suppose a manufacturing company produces two products: Product A and Product B. To determine the cost of each product, the company must allocate the factory overhead costs, including utilities, rent, maintenance, and supplies, among other expenses. The overhead costs must be assigned to each product based on the proportion of total machine hours used to produce each product.

For example, if the company uses 60% of the total machine hours to produce Product A and 40% to produce Product B, then 60% of the factory overhead costs would be allocated to Product A and 40% to Product B. The company would then use the allocated overhead costs and the direct costs of material and labor to calculate the total cost of each product.

The allocation of overhead costs to each product is critical for the company to accurately determine the cost of goods sold and price its products competitively. The company can use an allocation method to ensure a fair and accurate picture of the costs of producing each product.

How to Do Cost Allocation in Simple Steps?

Cost allocation can be complex, but it doesn’t have to be. Here are five simple steps for cost allocation:

Step 1: Identify the Costs That Need to Be Allocated

The first step in cost allocation is identifying the costs that need to be allocated. This includes both direct and indirect costs. Direct costs can be easily traced to specific products or services, while indirect costs, such as rent and utilities, cannot.

Step 2: Choose the Appropriate Method of Cost Allocation

Once you have identified the costs that need to be allocated, the next step is to choose the appropriate cost allocation method. The most common methods include direct cost allocation, step-down allocation, sequential allocation, and activity-based costing. The method chosen will depend on the nature of the costs and the objectives of the cost allocation process.

Step 3: Determine the Allocation Base

The allocation base is the basis on which the costs will be allocated. This can be the number of units produced, the number of employees, or any other relevant factor that can be used to determine the cost of goods or services.

Step 4: Allocate the Costs

Once you have determined the allocation base, the next step is to allocate the costs. This can be done by dividing the total cost by the number of units, employees, or another relevant factor and multiplying this by the number of units, employees, or another relevant factor for each product, service, or department.

Step 5: Review and Adjust the Cost Allocation

Once the costs have been allocated, the final step is to review and adjust the cost allocation as necessary. This may involve reallocating costs based on new information or changes in the business.

Which Industries Can Cost Allocation Be Applied?

With the proper guidance, cost allocation can be applied to almost any industry. It’s all about the data you have and how you use it.

Let’s take a look at some of the industries that could benefit from cost allocation:

The healthcare industry is one of the most expensive in the world. It is also one of the most heavily regulated. These factors make cost allocation a necessity for many healthcare providers.

Healthcare organizations have many different costs, but the most significant sources are labor and supplies. Labor costs can be very high in this industry because it requires highly skilled people to perform various tasks, including surgery, patient care, and patient education. Supplies like bandages and IV bags are also expensive because they have to be sterile and meet regulatory requirements.

A hospital’s supply department has much control over its budget, but it also has little control over what happens in other departments, such as surgery or patient care. This makes it difficult to allocate costs accurately when they don’t know how much they will spend on supplies or how many patients they’ll see each year.

Cost allocation helps solve these problems by allowing managers to see which departments are consuming the most resources. They can adjust accordingly without guessing what’s happening behind closed doors (or behind locked doors).

Manufacturing

The manufacturing industry is one of the most common places where cost allocation can be applied. In this industry, it is crucial to know how much it costs to make each product and how much it costs to produce goods (including materials and labor) for sale.

With this information, manufacturers can determine how much they need to charge for their products to cover all of their expenses, including overhead costs like rent or electricity bills.

Cost allocation can also help manufacturers determine which products are more profitable than others so that they can focus on those areas instead of wasting time and money on less popular lines of goods. For example, suppose a company produces clothing and electronics but finds its clothing line more popular among consumers than its electronics line.

In that case, it may want to stop producing electronics altogether because there would need to be more demand for these products for them to make any money off of them.

This is an industry that benefits from cost allocation. Energy companies have long been able to allocate costs to different projects and branches, but they often face challenges when assigning overhead expenses. That’s because overhead costs are shared among the company’s functions, making them difficult to track.

Cost allocation software can help energy companies assign overhead expenses in a way that makes sense for each project or branch. The software also allows them to better understand where their money is going and gives them more flexibility in budgeting and forecasting future expenses.

Retailers are a great example of an industry that can benefit from cost allocation.

Retailers are often sold on the idea of one-stop shopping: you go to a store and buy everything you need, from clothing to food to furniture. But in reality, there are many different types of retailers, such as grocery stores, department stores, clothing stores, etc. And each has its own distinct set of costs for running that type of business. So how do these retailers know how much each product line contributes to their overall profits? They use cost allocation.

Cost allocation is a technique for allocating overhead costs across product lines based on their relative importance to the company’s overall performance. This way, retailers can determine which products contribute most (or least) to their bottom line and make decisions accordingly.

Information Technology

Information technology (IT) is one of the most significant cost allocation areas. IT costs are often divided into two categories: direct costs and indirect costs. The former refers to those costs that can be directly attributed to a particular project or product, while the latter refers to those costs that cannot be directly attributed.

Cost allocation in IT has many benefits. It helps managers determine how much it costs to develop a new product or service and where inefficiencies lie in their IT departments.

It also allows them to understand better how much revenue they’re generating from each product or service line, which will help them make better decisions about future investments in the company’s infrastructure.

Construction

This is one of the most apparent industries to apply cost allocation. Construction projects are often massive and complex, with many different stakeholders involved in the planning, execution, and completion of a project. It’s common for construction projects to have hundreds or thousands of contracts with hundreds or thousands of different suppliers.

Cost allocation helps ensure that those involved in the project are paid what they’re owed without overpaying anyone else who participated. It’s also used to ensure that a company only spends a little money on a project by ensuring that every expense is only charged once.

Transportation

This is the industry that can benefit the most from cost allocation.

Transportation has many parts that must work in unison to transport goods or passengers. It can be difficult to determine which part of a vehicle’s operation should be allocated to specific parts, and it usually requires a lot of math.

Cost allocation can make it easier for companies in this industry to understand which parts are costing them more than they expected so that they can make changes accordingly.

Food and Beverage

Food and beverage companies can benefit significantly from cost allocation. These companies are typically comprised of many different departments that must be managed to ensure the entire business runs smoothly. Each department has specific costs that it incurs, so allocating those costs among all of the departments will help you understand where your money is going and how it can be used most effectively.

Cost allocation is also helpful when dealing with food or beverage products because it allows you to track the costs associated with each product line and make sure you profit on every product line. This way, you know what kinds of products are selling well, which ones aren’t selling as well, and how much money each product line has made for your company.

Real Estate

This is one of the most common industries to use cost allocation methods. Real estate developers often create multiple project phases, which must be accounted for separately. The costs of these phases are usually allocated to determine how much profit (or loss) will be made in each phase.

This lets developers decide which phases should be completed first and what incentives may be offered to convince buyers to purchase units from those phases.

Utilities are another excellent example of an industry where cost allocation can be used.

They must deal with various costs, including purchasing raw materials, paying for labor, and buying equipment. The type of utility and the sector it operates in determine the cost of each of these. For example, a water utility may have very high costs for purchasing raw materials but low costs for labor and employee benefits because they only need a few employees or benefit packages.

Cost allocation can help utilities determine how much money they should spend on each part of their business so that they’re not overspending on one part while underinvesting in another.

Pros of Cost Allocation

Cost allocation is a common business practice. Companies use it to help determine the profitability of individual products, services, and departments within a company. Here are the pros of cost allocation:

Improved Decision Making

Cost allocation helps businesses make informed decisions by accurately determining the cost of goods or services. Companies can make informed decisions on pricing, production, and marketing strategies with a better understanding of the costs associated with producing a product or offering a service.

Better Resource Allocation

Cost allocation helps businesses to determine the costs associated with different departments, products, or services. This information can then be used to allocate resources more efficiently and allocate more resources to more profitable areas.

Increased Profitability

By allocating costs accurately, businesses can identify less profitable areas and make changes to improve profitability. This could involve reducing costs, improving efficiency, or adjusting pricing.

Better Budget Planning

Cost allocation helps businesses to create more accurate budgets. Companies can plan their budgets more effectively as they understand the costs associated with each product, service, or department.

Improved Internal Control

Cost allocation helps businesses to maintain better internal control over their operations. By allocating costs accurately, companies can track expenses and identify improvement areas. This helps to prevent fraud and embezzlement and increases accountability within the company.

Better Understanding of Overhead Costs

Overhead costs can be challenging to understand and allocate accurately. Cost allocation helps businesses to understand these costs better and allocate them to the proper departments or products. This allows companies to make informed decisions on pricing and production.

Improved Cost Reporting

Cost allocation helps businesses to produce more accurate cost reports. This allows companies to make informed pricing, production, and marketing strategies decisions. Cost reports are also essential for tax purposes and to meet regulatory requirements.

Better Negotiations

Cost allocation helps businesses to understand their costs better, which can be used in negotiations with suppliers and customers. Companies can better understand costs and negotiate better prices, terms, and conditions with suppliers and customers. This helps businesses to maintain better relationships and increase profitability.

Cons of Cost Allocation

Cost allocation can be an excellent tool for helping you understand where your money is going and how to save it, but this method has some drawbacks.

Time-Consuming Process

Cost allocation can be time-consuming and requires significant effort from various departments within the company. This can divert resources from other important tasks and may slow down other processes.

Increased Complexity

Cost allocation can be complex, especially for large organizations with multiple departments and products. This complexity can result in errors and misunderstandings, negatively impacting the accuracy of cost reports and other important financial information.

Implementing a cost allocation system can be expensive and require a significant investment in technology, software, and training. This cost can be a barrier for smaller organizations or those with limited resources.

Unreliable Data

Cost allocation is only as accurate as the data used in the process. Poor quality data, errors in data entry, and outdated data can all result in inaccurate cost reports and inefficient resource allocation.

Resistance to Change

Some employees may resist implementing a cost allocation system, especially if they feel the process may negatively impact their department or lead to job loss.

Limited Flexibility

Cost allocation systems are often rigid and lack the flexibility to adapt to changes in business conditions. This can result in inefficiencies and limit the ability of the company to respond to new opportunities or challenges.

Potential for Misallocation

If not implemented correctly, cost allocation can misallocate costs, negatively impacting decision-making and profitability.

Dependence on Cost Allocation

Overreliance on cost allocation can lead to a lack of creativity and initiative within departments. Employees may become too focused on cost allocation and need to be more focused on driving innovation and growth for the company. This can limit the ability of the company to adapt to changing market conditions.

Frequently Asked Questions- Cost Allocation in Accounting

What are the main objectives of cost allocation.

The main objectives of cost allocation are to accurately determine the cost of goods or services, improve resource allocation, increase profitability, create more accurate budgets, improve internal control, and provide better cost reporting.

What Is Direct Cost Allocation?

Direct cost allocation refers to assigning costs directly to specific products or services. This method is used when the costs can be easily traced to specific business areas.

What Is Step-Down Allocation?

Step-down allocation refers to allocating costs from one department to another department or product. This method is used when costs cannot be directly traced to specific products or services.

What Is Sequential Allocation?

Sequential allocation refers to allocating costs based on the sequence in which they are incurred. This method is used when costs cannot be directly traced to specific products or services.

What Is Activity-Based Costing?

Activity-based costing refers to allocating costs based on the activities involved in producing a product or offering a service. This method is used when multiple activities are involved in creating a product or service.

Why Is Cost Allocation Important for Businesses?

Cost allocation is essential for businesses as it helps them understand the costs associated with each business area and make informed pricing, production, and resource allocation decisions. This leads to improved profitability and better resource allocation.

How Does Cost Allocation Impact Resource Allocation?

Cost allocation helps companies determine the costs associated with each department, product, or service, which are used to allocate resources more efficiently. By allocating resources based on accurate cost

How Does Cost Allocation Impact Pricing Decisions?

Cost allocation helps companies understand the costs associated with each product or service used to make informed pricing decisions. By accurately determining the cost of goods or services, companies can ensure that their pricing is based on a solid understanding of the costs involved.

The Comprehensive Guide to Cost Allocation in Accounting – Conclusion

Allocation of costs is a critical component of any business. By allocating costs, you can ensure that your company makes the best use of its resources and operates efficiently.

The ability to allocate costs allows you to make strategic decisions about your business’s operations and management and take appropriate actions regarding financial reporting.

The Comprehensive Guide to Cost Allocation in Accounting – Recommended Reading

Corporate Accountant: What Are the Responsibilities, Duties, & Salary of a Corporate Accountant?

How Can Business Intelligence Help with Budget Planning (in 2023)

Standard Costing- Common Problems (And How to Solve Them)

 Updated: 5/19/2023

Meet The Author

Danica De Vera

Related posts.

The Price of Happiness: Examining Trade-Offs Between Wealth and Well-Being

In today’s society, the pursuit of wealth often leads to trade-offs in well-being. True contentment encompasses mental, emotional, and physical health, purpose, and relationships. Wealth does not guarantee happiness and can impact mental health, relationships, and sustainable living. Balancing wealth with well-being results in a more fulfilling life.

How Can Diversity of Thought Lead to Good Ethical Decisions?

Diversity of thought, or cognitive diversity, encompasses varied perspectives and beliefs. Embracing this diversity leads to better ethical decision-making by broadening perspectives, enhancing critical thinking, mitigating groupthink, fostering cultural competence, strengthening stakeholder engagement, promoting ethical leadership, improving risk management, and fostering employee engagement.

The 26 Most Influential Leadership Quotes from Silicon Valley Icons

Silicon Valley, a hotbed of innovation and entrepreneurship, is driven by a unique culture of risk-taking, an abundant talent pool, access to capital, and a strong sense of community. The region’s success is propelled by visionary leadership, resilience, innovation, risk-taking, and customer-centric approaches.

Subscribe to discover my secrets to success. Get 3 valuable downloads, free exclusive tips, offers, and discounts that we only share with my email subscribers.

Social media.

Quick links

• Terms of Service

Other Pages

Contact indo.

• 302-981-1733
• [email protected]

© Accounting Professor 2023. All rights reserved

Discover more from accounting professor.org.

Subscribe now to keep reading and get access to the full archive.

Type your email…

Continue reading

ACCOUNTING for Everyone

The Longest Running Online Certified Bookkeeping Course

What Methods Are Used to Allocate Overhead Costs: Key Strategies for Accurate Profitability Analysis

Basics of overhead costs.

In examining the allocation of overhead costs, understanding their nature is crucial for accurate profitability analysis. This encompasses comprehending their definition, their relationship to direct costs, as well as distinguishing between their fixed and variable components.

Definition and Types of Overhead

Overhead costs refer to expenses that are not directly tied to a specific product or service but are necessary for running the business. These costs often include rent, utilities, insurance, and salaries for administrative personnel. They are categorized into two types:

• Manufacturing Overhead : Costs associated with the production process but not directly traceable to individual units, such as factory rent or equipment maintenance.
• Administrative Overhead : Expenses related to the general operation of the company, like executive salaries or office supplies.

Direct Vs. Indirect Costs

Contrasting with overhead are direct costs , which can be directly attributed to specific projects or production activities. Direct costs typically include materials, labor, and expenses incurred solely for the execution of a project. Indirect costs , synonymous with overhead, cannot be traced to a single product or project without considerable effort or cost.

Fixed and Variable Costs

Overhead can also be split into fixed costs and variable costs based on their response to the level of business activity:

• Fixed Costs remain constant regardless of production volume. Examples include rent and salaried employee wages.
• Variable Costs fluctuate with changes in production levels. Utilities or raw materials can increase as production ramps up.

Accurately distinguishing and categorizing these costs are paramount for successful overhead allocation and the ensuing profitability analysis.

Overhead Allocation Methods

Accurately assigning overhead costs to client projects is crucial for profitability analysis. Various allocation methods provide different levels of precision, reflecting the true cost of each project.

Single Overhead Rate Method

The Single Overhead Rate Method involves calculating a plant-wide rate by dividing total estimated overhead costs by an allocation base, such as direct labor hours. This rate is then applied uniformly across all projects. For instance, if a company’s annual overhead costs are estimated at $8,000,000 and total direct labor hours are 250,000, the plant-wide rate would be $32 per direct labor hour. Each project is charged based on the hours it consumes, regardless of departmental differences or the complexity of activities involved.

Departmental Overhead Rate Method

Alternatively, the Departmental Overhead Rate Method assigns costs more precisely by department. Overhead is allocated using separate rates for each department, based on department-specific bases such as machine hours or labor hours. For example, the assembly department may have a higher overhead rate than the finishing department due to its extensive use of equipment. This method recognizes that different departments incur different overhead costs and provides a more accurate reflection of the costs attributable to each project.

Activity-Based Costing (ABC)

Activity-Based Costing (ABC) takes precision a step further by allocating overhead costs based on specific activities that drive overhead expenses within each project. It utilizes multiple allocation bases, reflecting the complexity of actual resource usage. ABC recognizes that costs are not just a factor of time but also the variety and intensity of activities. It identifies cost pools for activities such as quality testing, setup, or procurement, and assigns costs to projects based on their use of these activities. This activity-based costing method is the most granular and precise, suitable for complex and varied project work where overhead costs are not linear or uniform.

Determining Allocation Bases

In allocating overhead costs , the determination of a suitable allocation base is crucial for accurate profitability analysis . This process involves identifying bases and cost drivers that most accurately reflect the incurrence of costs.

Common Allocation Bases

The selection of an allocation base is a critical step in overhead cost distribution. It represents a quantifiable measure that serves as a standard for cost assignment. Common bases include:

• Total direct labor cost : Often used due to its correlation with production levels.
• Total direct labor hours : Reflects the time input on specific jobs or projects.
• Total machine hours : Suitable for highly automated processes where equipment usage drives costs.
• Materials used : Appropriate when the cost of materials is a significant component of overhead.

These bases are chosen for their direct relationship to the cost-incurred activity, thereby attributing overheads more accurately.

Selection of Cost Drivers

A cost driver is an activity or factor that incurs a cost. The selection process for cost drivers is strategic and should align with the way overhead costs are actually incurred. Common drivers include:

• Number of setups or machine setups
• Machine hours operated
• Number of processed orders

They are essential tools that businesses employ to link overhead costs with production activities, helping to establish a fair and rational cost allocation.

Use of Direct Labor Hours and Machine Hours

Direct labor hours and machine hours are two of the most prevalent methods used in overhead allocation:

• Direct labor hours : This involves calculating the total hours worked and using it as a divisor for total overhead costs, yielding an overhead rate per labor hour.
• Machine hours : In contrast, for capital-intensive setups, total machine hours provide a more accurate allocation basis by dividing total overhead costs by machine hours utilized.

Both metrics serve as proxies for cost causation and can be used to distribute overhead to client projects effectively. They are particularly useful for tracing activity levels and ensuring that each project bears a proportionate share of indirect costs.

By understanding and selecting appropriate allocation bases and cost drivers, businesses can achieve more accurate allocation of overhead costs and more precise profitability analyses.

Cost Pooling and Rate Determination

In the process of allocating overhead costs effectively, the creation of cost pools and the determination of predetermined overhead rates are foundational steps. They facilitate the accurate measurement of costs associated with client projects, which is imperative for profitability analysis.

Creating Cost Pools

A cost pool is a grouping of individual costs, typically of a similar nature, in an organized manner to simplify the allocation process. To create a cost pool, overhead costs are categorized based on their relationship to cost drivers or allocation bases, which could be direct labor hours, machine hours, or another measurable component. For example, all costs related to machinery maintenance may constitute a single cost pool, while all administrative expenses can form another. This segmentation allows for a more precise assignment of costs to specific projects by matching them with the relevant cost drivers.

Calculating Predetermined Overhead Rates

Calculating predetermined overhead rates is essential for assigning overhead costs to client projects before actual costs are known. These rates are calculated by:

Estimating Total Overhead Costs : Forecasting the total overhead expense expected for a designated time period.

Selecting an Allocation Base : Identifying a base that correlates well with the overhead costs, such as direct labor hours, machine hours, or any other quantifiable measure that drives overhead expenditure.

Dividing Estimated Overhead Costs by Allocation Base : The predetermined overhead rate is derived by dividing the total estimated overhead by the total number of allocation base units, usually expressed as a rate per unit.

For instance, if the estimated total overhead costs are \$8,000,000 and the allocation base is 250,000 direct labor hours, the predetermined overhead rate would be calculated as:

• Predetermined Overhead Rate = Total Overhead Costs / Total Allocation Base Units
• Predetermined Overhead Rate = \$8,000,000 / 250,000 direct labor hours
• Predetermined Overhead Rate = \$32 per direct labor hour

Consequently, each project can be charged \$32 in overhead for every direct labor hour assigned to it, allowing for consistent cost distribution before actual costs are fully realized.

Allocation to Client Projects

Accurate cost allocation to client projects is essential for evaluating the profitability of each project. Companies utilize various methods to distribute overhead costs to ensure that each project reflects the true costs of the resources used.

Direct Labor Cost Allocation

Direct labor cost allocation uses the number of labor hours spent on a project as the basis for allocating overhead. This method assumes a direct correlation between labor hours and the resources consumed. For instance, if SailRite Company estimates annual overhead costs of $8 million and allocates these costs based on 250,000 direct labor hours, the overhead rate might be $32 per direct labor hour. Consequently, for each labor hour recorded, $32 in overhead costs will be allocated to that client’s project.

Apportioning Indirect Costs

Indirect costs, such as rent, utilities, and administrative expenses, are not directly tied to any specific project but still need to be allocated fairly. One approach is to divide the total indirect costs by total labor hours to find a cost-per-hour rate. This rate is then applied to the labor hours of each project. Using a table can clarify the calculations:

Challenges in Allocation

The allocation process is not without challenges. Overhead costs can fluctuate, and the proportion of such costs that different activities consume may change over time. Approaches like activity-based costing (ABC) aim to refine the allocation by identifying the actual activities that incur costs and then assigning overhead more precisely. However, this method requires the careful tracking of all activities and can be more complex to implement.

Cost Management and Profit Analysis

The precise allocation of overhead costs is critical for enabling companies to analyze profitability, ensure accurate product cost information, and bolster the decision-making process.

Analyzing Profitability

Profit analysis hinges on the capability to trace overhead costs to specific client projects. This granularity allows a firm to discern the true profitability of each project. Allocation methods such as Activity-Based Costing (ABC) can assign overhead expenses to products and services more accurately by looking at the specific activities that contribute to overhead and determining the cost drivers associated with them.

Maintaining Accurate Product Cost Information

For companies to maintain accurate product cost information, overhead needs to be allocated systematically. The predetermined overhead rate, calculated using total estimated overhead costs divided by an allocation base like direct labor hours or machine hours, is often applied. For instance, if a company’s estimated annual overhead costs are $8,000,000 and the allocation base is 250,000 direct labor hours , the predetermined overhead rate would be $32 per direct labor hour .

Allocation Example:

The Role of Cost Accounting in Decision-Making

Cost accounting serves as a backbone in the decision-making process by providing critical financial insights. It enables management to identify areas where costs can be cut or investment can be increased for more profitable cost objects. This financial data informs strategic decisions and can lead to operational adjustments that optimize resource utilization and cost efficiency.

Operational Insights and Improvements

In the realm of overhead cost allocation, operational insights can significantly enhance cost efficiency and improve competitive pricing through meticulous data analysis. These insights help companies identify inefficiencies and price their products more competitively.

Enhancing Cost Efficiency

Businesses seek to enhance cost efficiency by scrutinizing every facet of their operational spending, ensuring expenses contribute to client project profitability. The Performance Improvement Diagnostic , often referred to as the PI X-ray, exemplifies a technique used to attain this objective by examining a company’s performance against 10 improvement levers. This can involve:

• Analyzing Overhead Costs : Regular reviews help identify areas with disproportionate spending. Strategies such as process optimization or renegotiation of contracts can be implemented to reduce these overheads.
• Continuous Improvement : Implementing methods like lean management, businesses strive for incremental enhancements to operational processes aimed at curtailing non-essential spending.

Leveraging Data for Competitive Pricing

Informed decision-making in product pricing relies heavily on accurate data concerning overhead costs. This knowledge shapes the sales price to maintain profitability while staying competitive:

For instance, if the calculated overhead rate is $50 per labor hour , and Product A requires 100 hours of direct labor, the allocated overhead would be $5,000. This figure helps determine the sales price of products or services by ensuring it reflects the true cost of production.

Practical Implementation and Tools

To achieve accurate profitability analysis, organizations can leverage software solutions that streamline overhead allocation as well as reporting tools that reflect performance against benchmarks.

Software Solutions for Overhead Allocation

Companies often utilize Excel for its flexibility in managing financial tasks, including the allocation of overhead costs. Excel provides a familiar environment with the ability to customize formulas and reporting layouts to accommodate various allocation methodologies. However, as the complexity of allocations increases, businesses might opt for specialized software. IBM ’s financial tools, for instance, offer a robust framework for cost allocation, embracing the data-intensive demands of large organizations. These tools are designed to integrate seamlessly with existing systems and deliver a suite of features that enhance allocation precision.

• Customizable allocation rules
• Integration with financial systems
• Automated calculations and reporting
• Scalability for growing data volumes

Reporting and Benchmarking

Accurate reporting is essential for analyzing profitability, and it often involves benchmarking against historical data and industry standards. Software tools that specialize in financial planning and analysis enable organizations to produce reports that align with these benchmarks. Such reports are crucial for making informed decisions. Moreover, the software can often store and compare multiple sets of benchmarks, providing a comprehensive view of an organization’s financial health.

• Visualization of cost allocations
• Comparisons to industry benchmarks
• Identification of trends over time

In conclusion, by implementing these practical tools, companies can significantly enhance the accuracy of their overhead cost allocations and profitability analyses.

Frequently Asked Questions

Allocating overhead costs accurately is crucial for assessing the profitability of client projects. These Frequently Asked Questions aim to clarify the methodologies involved in overhead cost distribution.

How are overhead costs distributed across different projects in cost accounting?

In cost accounting, overhead costs are typically distributed to different projects based on a predetermined overhead rate, such as a percentage of direct labor costs, direct labor hours, or direct material costs. The chosen allocation base should reflect the way in which overhead costs are incurred in relation to the projects.

Can you give examples of different overhead allocation methods?

Different overhead allocation methods include the direct labor hours method, where overhead is assigned based on the number of labor hours spent on a project, and the direct labor cost method, where overhead is allocated in proportion to the labor costs. Machine hours and percentage of direct materials cost are other common methods used to allocate overhead expenses.

In what ways does activity-based costing differ from traditional overhead allocation methods?

Activity-based costing (ABC) differs from traditional methods by assigning overhead costs to products or services based on the specific activities that each job requires. This approach tends to be more precise as it considers the complexity and resources needed for each activity, rather than using a blanket overhead rate.

What are some common examples of activity-based costing applications?

Activity-based costing applications include manufacturing environments where different products require varying amounts and types of labor, materials, and machine usage. Service industries also apply ABC to determine the cost of providing diverse services that consume different levels of resources.

How are overhead costs calculated and applied in the construction industry?

In the construction industry, overhead costs are calculated by totaling all indirect project costs, such as site security, utilities, and administrative expenses. These costs are then allocated to projects using methods like a percentage of construction costs, labor hours, or even by a fixed rate per unit of output.

Among various overhead allocation techniques, which is considered to provide the most accurate cost distribution?

Activity-based costing is often considered to provide the most accurate cost distribution since it aims to trace overhead costs to specific activities. However, the most appropriate method may vary depending on the complexity of operations and the nature of the work being performed.

Get More From Accounting for Everyone With Weekly Updates

Check your inbox or spam folder to confirm your subscription.

Leave a Reply Cancel reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed .

Cost Accumulation: Meaning, Types, and More

Cost accumulation: meaning.

Cost Accumulation is the process of collecting all costs information about the business with the help of the cost accounting system . It is a process of collection of all relevant data regarding the various costs incurred by the company at various stages of production. This calculation is the result or outcome of the cost accounting system prevalent or practices in the company.

Cost Accumulation calculates all manufacturing costs in a sequential pattern. It considers all costs in the production process, starting from inventory to the finished goods. The focus and the objective are to come up with the cost of a particular product or service by identifying various cost objects and their respective cost drivers . Here there exists a cause-effect relationship between cost object and their cost drivers. Thus Cost Accumulation becomes a very connected and integral part of the Cost Accounting System.

Whether Cost Accumulation a part of Managerial accounting too?

Job costing system, assumptions of process costing system, hybrid costing system, difference between job costing and process costing, cost accumulation vs cost assignment vs cost tracing.

The management of the company, after collecting and analyzing the cost data, makes calculative decisions regarding the day-to-day working of the company. The costing data helps the management at all stages of operations, including planning, monitoring, controlling, and decision making. The management also decides when and how the assignment of cost to a particular job or process will happen. And thus, Cost Accumulation becomes a part of both Cost Accounting and Managerial Accounting.

Types of Cost Accumulation

There are majorly three types of Cost Accumulation methods, as follows:-

Job Costing System is most useful when the total production quantity is small or there exist small batches of production. It is also relevant and important when each job is unique. It is a process of accumulating cost information about a particular project or a specific production or product. Under this system, linking and recording the accumulation of direct labor, direct materials, and manufacturing overhead costs happens with respect to the particular job or batch.

Also Read: Types of Costing

This system is widely useful in the delivery of a special or customized product. It also helps while asking for cost- reimbursements or stage-wise advances from the customer. Once the job completion happens, all the costs of the respective job are accumulated. And after that, that particular job sheet and costing exercise on that job also close. It is necessary to consider both direct and indirect costs under this system. At times calculation of indirect costs for a particular job may become difficult.

Thus under the Job Costing System, accumulation takes place according to the respective job order.

Process Costing System

Accumulation of cost through the Process Costing System occurs when the production of a huge amount of identical goods occurs. In this system, the accumulation of costs for a large batch of products takes place. And afterward, further allocation of all such accumulated costs takes place for an individual unit.

Process Costing System accumulates costs on the basis of departments or divisions. In this system, identification and booking of costs to respective cost centers take place. Cost centers are the places of origination of the costs. Accumulation of costs takes place according to the cost centers they belong to.

This method is best suitable when the production is very large in quantity. The production process is also generally continuous in nature without any customization.

Also Read: Cost Accounting Systems – Meaning, Importance And More

• The first assumption is that all products are identical in nature.
• The second assumption of this system is that the costs of all units of production are the same.

At the end of this process, the creation of a ‘Cost of Production Report’ takes place. This report shows the total cost for a particular cost center and the state of both opening and closing inventory. 

Manufacturing units where some production is large while some are small, this is best suitable. Under Hybrid Costing System, process costing is used where the production quantities are large. While if the product is in small batches, the Job System is used. Thus this hybrid system is widely used and now well accepted in such circumstances.

The key differences between both this system of cost accumulation and accounting are:

Sometimes, both Cost Assignment and Cost Accumulation are loosely called and referred to as the same. But it is not so, and they both are different. Cost Assignment is the identification and attachment of costs to the respective costs driver. It is a process of linking costs to their place of origin. Cost Assignment is mainly useful for an activity-based costing method, where linking of overhead expenses occurs where incurrence takes place of these overheads. Cost Allocation is the other name of Cost Assignment.

On the other hand, Cost Accumulation is a completely different concept. And here, the focus and objective are to collect all costs/total costs of that product or service. It is to know the overall cost of production and stages of the cost incurred and analyze this information about the costs for further management decisions. In this system, the process begins with recognizing cost objects and their respective cost drivers.

Cost Tracking is the third term here, which is useful in assigning costs to the departments. Cost Assignment and Cost Tracking helps in the Allocation of costs to the respective department. Thus the main focus of Cost Tracking is to trace back the origin of indirect costs and also establish a causal relationship with the cost driver.  

In simple words, Cost Assignment and Cost Tracking helps in the allocation of costs, and Cost accumulation helps in the collection of costs.

Cost Accumulation is an important step in the cost accounting process. Moreover, accumulating the costs according to the cost object and its drivers is the base of all other cost accounting processes. And the decision is with the management whether to adopt a Job, Process, or Hybrid Costing System. Moreover, it is of vital importance to accumulate costs without any error. Because all further processes are dependent on the accuracy of these figures. Thus Cost Accumulation is one of the important tools for the management of the company to guide and help them in making correct decisions.

Refer to Costing Terms for various other basic cost concepts.

RELATED POSTS

• Cost Accounting and Management Accounting
• Types of Costs and their Classification
• Cost Hierarchy – Meaning, Levels and Example
• Cost Object – Meaning, Advantages, Types and More
• Job Costing – Meaning, Benefits, Process and More
• Types of Cost Accounting

Sanjay Bulaki Borad

MBA-Finance, CMA, CS, Insolvency Professional, B'Com

Sanjay Borad, Founder of eFinanceManagement, is a Management Consultant with 7 years of MNC experience and 11 years in Consultancy. He caters to clients with turnovers from 200 Million to 12,000 Million, including listed entities, and has vast industry experience in over 20 sectors. Additionally, he serves as a visiting faculty for Finance and Costing in MBA Colleges and CA, CMA Coaching Classes.

Leave a Comment Cancel reply

Save my name, email, and website in this browser for the next time I comment.

Sign me up for the newsletter!