Examining the importance of cost allocation


Cost allocation is the process of identifying and assigning the costs of services necessary for the operation of a business or other type of entity. Unlike a cost rating, the allocation is less concerned with the actual amount of the cost, and more concerned with allocating or assigning the cost to the correct unit within the organization. From this perspective, cost allocation can be seen as a tool that helps track all costs associated with the ongoing operation more efficiently, since each cost is associated with specific departments or groups of departments within the organization.

A simple example of cost allocation would be the wages or salary of an employee assigned to work in a specific department. In a hospital, a nurse is normally assigned to a specific wing or floor, with the costs allocated to the general operation of that unit. As long as the nurse continues to work his or her assigned shift within that unit, the salary and benefits accrued are associated with that unit. However, if the nurse is called upon to fill in on another floor or unit, such as spending an entire shift working in the emergency room, the salary and benefits earned for that period of time may very well be allocated to the unit where the nurse worked, instead of his or her permanent wing or floor.

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There are several reasons why cost allocation is important. One has to do with accurately assigning costs within an organization, so that it is possible to know exactly what types of costs were incurred in the operation of a given area in the organization. This is not only important information to consider when creating an operating budget, but is also key in calculating taxes that must be paid to local, state, and federal tax agencies. In a number of countries around the world, the way that costs are allocated can have an impact on how much the organization pays in taxes, making it necessary to comply with any government regulations that have to do with the allocation of costs within the organization.

Another benefit of cost allocation has to do with simply keeping track of expenses for internal planning purposes. While some expenses are indirect costs and benefit more than one area of the operation, there is still a need to allocate direct costs in a manner that is logical and accurate. Even when the costs are incremental, meaning they are stretched out over several accounting periods, making sure the costs are assigned properly can make a big difference in how well each unit within the business or other entity works within their share of the overall budget. When it is apparent that one unit will exceed its assigned budget, steps can be taken to implement cutbacks on non-essential service costs, while finding ways to adjust the overall budget to allow for the continuing support of essential functions.

Organizations of all types and sizes engage in the task of cost allocation. Businesses use this strategy as a tool for planning and keeping within a budget. Non-profit entities utilize the tool as a way of providing as many services to its members as possible, while still making the most effective use of its resources. Even households can make use of the concept of cost allocation when planning the operating budget for the family. As a means of identifying and properly assigning costs, this approach to allocation helps to provide focus and structure to financial planning in a way that would be extremely difficult otherwise.

Direct Costs

In finance, direct costs are those costs that are associated with a specific project, department, or activity. Sometimes referred to as hard costs, expenses of this type are found with just about every type of business activity, beginning with research and development, moving through sales and marketing campaigns, and into the production of different types of goods and services. A direct cost is often some type of fixed expense, but there are some situations where a variable expense may also fall into this category.

The key to understanding what does and does not constitute direct costs is to identify costs that apply only to a specific project, and have nothing to do with any other activity that is taking place concurrently. In order to be a true hard cost, the expense must be for resources that benefit that one project. For example, if the project is to construct a telephone, the costs for the handset casing, internal circuit boards, and the wiring would all fall into the category of direct costs. In addition, the wages paid in exchange for the labour to build the telephone would also be a direct cost.

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In situations where expenses do not go to benefit a specific task or project, the cost would be considered indirect. Utilities, such as electricity, used to operate a facility that houses several different product lines or other activities would not be considered direct costs, since those utilities benefit more than one specific project. Expenses of this type would be shared among the different projects, rather than be tied directly to any one activity.

Not every business operation will evaluate direct costs in exactly the same way. Depending on the structure of the company, something that is considered a hard cost in one business culture may be classified as an indirect cost in a different culture. As long as the internal guidelines for determining what is and is not a direct cost remain consistent, it is still possible to properly determine the historical cost or the cost of goods sold with a high degree of accuracy. That same consistency makes it possible to compare the absorption costing from one period to the next, and determine if there has been an increase in direct costs associated with a particular function or project.

Indirect costs

Indirect costs are business expenses that are not directly related to a particular product or function within the general operation. Costs of this type tend to have an impact on the overall operation of the business, making it very difficult to charge the costs to a specific department or associate them with one function. Costs of this type are sometimes referred to as overhead, a term that helps to describe the broad application of these costs.

There are many examples of indirect costs that occur in both small and large businesses. A general supply for the administration of the business is one example. Items such as paper, pens, and other essentials that are utilized in the record keeping and general clerical functions of each department are often classified as an indirect cost. In like manner, services such as auditing the accounting books or the preparation of legal documents are expenses that impact the entire operation and are usually considered indirect in nature.

Several of the expenses related to the upkeep and maintenance of business facilities are considered indirect costs. Utilities such as electricity, water, and Internet access are expenses that benefit the business in general and thus are classified as overhead expenses. In like manner, the cost of renting or leasing business space is also part of the overhead, making it an indirect cost.

There are examples of what may appear to be an indirect cost actually being a direct cost. One example has to do with employee salaries. When the employees are performing their usual functions, they are benefiting the business as a whole; their wages and salaries are considered indirect costs. However, if those same employees are assigned to a specific project that is the sole focus of their workday for a period of several days or weeks, their wages or salaries can be considered a direct cost, with that cost directly applied to that project.

Overhead Costs

A business may take in one sum of money, but it is not likely that all of it can be considered profit. This is because a business is generally required to pay expenses. Those expenses are commonly referred to as overhead costs. Examples of an overhead cost include salaries, maintenance, and production expenses.

It is common for businesses to track their net and gross income. This is important because these figures represent two different values. Gross income refers to all of the money that a business takes in. This figure may be very large.

Some businesses have a wide variety of expenses to pay, while others only have a few expenses. In either case, almost every business will have at least some overhead costs. Net income refers to the amount of money that remains once overhead costs have been deducted.

This amount can be significantly lower and may not exist at all. This is because it is possible for a company to have overhead costs that consume all of its income. In some instances, a company's expenses can even cause them to be in debt.

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Without calculating overhead costs, a business cannot know exactly how much money it is making. If ABC Toys buys its merchandise from a factory, some of the money that it receives from the merchandise must be used to not only buy more merchandise but also to pay for items such as electricity, transportation, and salaries. Even if ABC Toys manufactures its own merchandise, there will still be costs such as purchasing machinery and raw materials.

How overhead costs are categorized depends on a company's accounting methods. Some businesses are very basic in the figuring of their expenses. Other businesses, however, have very complex methods that may require various departments to individually access their overhead costs. Some businesses access their overhead cost by category. For example, manufacturers may calculate their manufacturing expenses and their non-manufacturing expenses separately.


A cost is generally understood to be that sacrifice incurred in an economic activity to achieve a specific objective, such as to consume, exchange, or produce. All types of organizations- businesses, not-for-profits, governmental- incur costs. To achieve missions and objectives, an organization acquires resources, transforms them in some manner, and delivers units of product or service to its customers or clients. Costs are incurred to perform these activities. For planning and control, decisions are made about areas such as pricing, program evaluation, product costing, outsourcing, and investment. Different costs are needed for different purposes. In each instance, costs are determined to help management make better decisions.

When incurred, costs are initially reviewed and accumulated by some classification system. Costs with one or more characteristics in common may be accumulated into cost pools. Costs are then reassigned, differently for specified purposes, from these cost pools to one or more cost objects. A cost object is an activity, a unit of product or service, a customer, another cost pool, or a segment of an organization for which management needs a separate measurement and accumulation of costs. Costs assigned to a cost object are either direct or indirect. A direct cost can be traced and assigned to the cost object in an unbiased, cost-effective manner. The incurrence of an indirect cost cannot be so easily traced. Without such a direct relationship to the cost object, an indirect cost requires an in-between activity to help establish a formula relationship. When the indirect cost is assigned through the use of this formula, the cost is considered allocated. The activity used to establish the in-between linkage is called the basis of allocation.


Cost allocations can be made both within and across time periods. If two or more cost objects share a common facility or program, the cost pool of the shared unit is a common cost to the users and must be divided or allocated to them. Bases of allocation typically are based on one of the following criteria: cause-and-effect, benefits derived, fairness, or ability to bear. The selection of a criterion can affect the selection of a basis. For example, the allocation of the costs of a common service activity across product lines or programs based on relative amounts of revenue is an ability to bear basis, whereas the same allocation based on the relative number of service units consumed by each product line or program would reflect either the benefits derived or the cause-and-effect criteria. Cost allocation then is the assignment of an indirect cost to one or more cost objects according to some formula. Because this process is not a direct assignment and results in different amounts allocated depending on either the basis of allocation or the method (formula) selected, some consider cost allocation to be of an arbitrary nature, to some extent.

Costs of long-lived assets are allocated and reclassified as an expense across two or more time periods. For anything other than land, which is not allocated, the reclassification of tangible assets is called depreciation (for anything other than natural resources) or depletion (for natural resources) expense. The bases for these allocations are normally either time or volume of activity. Different methods of depreciation and depletion are available. The costs of long-lived intangible assets, such as patents, are allocated across time periods and reclassified as amortization expense. The basis for these allocations is normally time.

Cost allocations within a time period are typically across either organizational segments known as responsibility centers or across units of product or service or programs for which a full cost is needed. Allocations may differ depending on whether a product or program is being costed for financial reporting, government contract reimbursement, reporting to governmental agencies, target pricing or costing, or life-cycle profitability analysis. Allocations to responsibility centers are made to motivate the centers' managers to be more goal-congruent in their decisions and to assign to each center an amount of cost reflective of all the sacrifices made by the overall organization on behalf of the center. These allocations can be part of a price or transfers of cost pools from one department to another.


Allocations can involve ethical issues. Often the federal government issues contracts to the private sector on a cost-plus basis; that is, all the actual costs incurred to complete a contract plus a percentage of profit is reimbursed to the contractor performing the contract. A contractor completing both governmental and private-sector contracts may select a formula that tends to allocate more indirect costs to governmental contracts than to nongovernmental ones. A contractor may also try to include in reimbursement requests costs that are not allowable by the governmental agency. A contractor may even try to double-count a cost item by including it as a direct cost of the contract and as a part of an indirect cost pool allocated to the contract. Lastly, a contractor may attempt to have a reimbursement cover some of the costs of unused capacity. Audits are made of costs of government contracts to identify inappropriate costs.


Service and not-for-profit organizations allocate costs, too. The cost object can be a unit of service, an individual client, or a cluster (category) of clients. The costs of a service firm are typically professional labor and indirect costs in support of the labor. The basis for allocating these indirect costs is often professional labor hours (either billable or total) or the cost of such, reflective of either cause-and-effect or benefits-received criteria. For not-for-profit organizations, the proportions to be allocated are best figured in terms of units of the resource on hand, such as the number of full-time equivalents, amount of square footage, or number of telephone lines. An important point to remember is that the principles of allocation are the same for for-profit and not-for profit organizations. The only difference is that the cost objects will be dissimilar.

Merchandisers, unlike most service and not for-profit organizations, have inventory that must be costed for external and internal reporting purposes. In these cases, the cost object is a unit of inventory. Incidental costs associated with the acquisition and carrying of the inventory are mostly direct costs easily traceable clearly assignable to the entire inventory, if not to individual units.


Manufacturers need to cost the resources required to complete their products. In costing a unit of product for inventory valuation, costs of production are assigned. With the unit of product as the cost object, production costs are either direct costs (traceable usage of materials and labor) or indirect costs (all of the other production costs, referred to as overhead). The indirect production costs are allocated. Traditionally, manufacturers using labor-intensive technologies used a single basis of allocation based on labor, either in hours or in cost, associated with a single indirect cost pool. A manufacturer using a more capital intensive technology might use a non labor basis such as machine hours. Today many firms produce a varied set of products, using varied technologies with many levels of complexity. Such firms need a more refined cost assignment system that uses multiple bases of allocation with multiple indirect cost pools, such as activity based costing.

While for product costing a unit of output remains the final cost object, the technology a producer uses can require a cost assignment to an intermediate cost pool (object) prior to an assignment to a unit of output. For instance, a batch technology has a cost assignment first to an individual job order (batch); the total cost assigned to the job order is then unitized over the units in the batch to determine cost of one unit of output. Alternatively, for a given period in a process technology, costs are accumulated by (assigned to) each production process; the total cost assigned is then unitized across the total number of (equivalent) units produced by that process to cost-out a unit of output.

Manufacturers also incur service department costs (such as computer center costs) in support of production departments. These service department costs are indirect to a unit of production and for full costing must be allocated, first to respective production areas and then to the units of output. Such allocations are called service department allocations, and the basis of allocation is normally an activity reflective of the nature of demands made on the service department by other departments, both service and production.


Allocations are also required in a joint production process. When two or more separately identifiable final products initially share a common joint production process, the products are called joint products. The point at which they become separately identifiable is referred to as the split-off point. Manufacturing costs incurred prior to this split-off point are referred to as joint costs and need to be allocated across the different joint products for product costing purposes. The bases for allocating the joint costs typically include (1) relative sales value at split-off, (2) net realizable value at split-off (as an approximation of the sales value at split-off), (3) final sales value at the completion of the production process, and (4) the number of physical units of the joint products at split-off.

Many would consider this list of bases to be in an order of descending preference of use. Normally there are additional production costs beyond the split-off point. These additional costs are incurred in order to complete each joint product. For a given joint product, the net realizable value at split-off is calculated by subtracting the additional costs to complete from the final sales value of the finished joint product.


There are three basic methods to allocate service department costs to production departments or programs in a not-for-profit: (1) the direct method; (2) the step method; and (3) the reciprocal method. The basis for allocation of service area costs should ideally be causally related to the demands made on that area by other areas. Both cause-and-effect and benefits-received criteria are taken into account. If the service areas provide service to each other (referred to as reciprocal services), the reciprocal method is the most accurate, the step method next, and the direct method the least accurate. With different service and production departments as cost objects, costs are initially accumulated on a department-by-department basis. Departments working directly on programs or units of product or service are production departments. The other departments are service departments. The allocation problem then is to reassign service department costs to production departments or programs for both performance evaluation and product or program costing. Within a production department, these allocated service costs are then reallocated to units of service or product according to the bases of allocation that each respective production department uses for its indirect costs.

The direct method ignores reciprocal services. A service department's costs are allocated to the production departments according to the extent to which each production department uses (or, for budgeting purposes, intends to use) the services of the service department. This "extent" is determined on a percentage basis by either the amount of services actually provided by the service department to all the production departments or by the amount of services the service department is capable of providing at normal or full capacity. Variable and fixed costs may be allocated separately, resulting in a dual allocation process (for example, variable costs based on actual usage and fixed costs based on budgeted usage).

The step method partially takes reciprocal services into account by allocating service department costs to production departments on a sequential basis. The service department that provides the greatest amount of service to the other service departments is allocated first; the one providing the second greatest amount of service to the other service departments is allocated second; and so forth. The absolute dollar amounts of costs incurred within service departments can be used to break a tie in usage, the larger amount allocated first. Once a service department has been allocated, it is ignored for all subsequent allocations.

The reciprocal method takes into account all the reciprocal services by setting up a set of simultaneous equations, one equation per service department. For any given service department, its equation is: Total allocable cost direct costs of the service department costs allocated from each of the other service departments based on this department's use of the other service departments. Once these equations are solved, the resultant allocable cost (sometimes referred to as the reciprocal or artificial cost) is reallocated across all the other departments, service and production, according to the original percentage usages.

Two additional issues, fairness and acquiring the service from the inside or from the outside, concern the allocation of a common cost. The amount of common service cost allocated to a using department may be greater that what it would cost that department to obtain the same service from the outside. A variation of the reciprocal method provides an analysis to help the manager of a using department decide whether to obtain the service from another department within the organization or to contract outside for the service from another organization. The amount of a particular service department's cost allocated to a using department may be dependent on the extent to which other departments also use this service department. This does not seem to be fair.