Cost allocation (also called cost assignment) is the process of finding cost of different cost objects such as a project, a department, a branch, a customer, etc. It involves identifying the cost object, identifying and accumulating the costs that are incurred and assigning them to the cost object on some reasonable basis.
Cost allocation is important because it the process through which costs incurred in producing a certain product or rendering a certain service is calculated. If costs are not accurately calculated, a business might never know which products are making money and which ones are losing money. If cost are misallocated, a business may be charging wrong price to its customers and/or it might be wasting resources on products that are wrongly categorized as profitable.
Typical cost allocation mechanism involves:
- Identifying the object to which the costs have to be assigned,
- Accumulating the costs in different pools,
- Identifying the most appropriate basis/method for allocating the cost
Cost object is an item for which a business need to separately estimate cost.
Examples of cost object include a branch, a product line, a service line, a customer, a department, a brand, a project, etc.
Cost pool is the account head in which costs are accumulated for further assignment to cost objects.
Examples of cost pools include factory rent, insurance, machine maintenance cost, factory fuel, etc. Selection of cost pool depends on the cost allocation base used. For example if a company uses just one allocation base say direct labor hours, it might use a broad cost pool such as fixed manufacturing overheads. However, if it uses more specific cost allocation bases, for example labor hours, machine hours, etc. it might define narrower cost pools.
Cost driver is any variable that ‘drives’ some cost. If increase or decrease in a variable causes an increase or decrease is a cost that variable is a cost driver for that cost.
Examples of cost driver include:
- Number of payments processed can be a good cost driver for salaries of Accounts Payable section of accounting department,
- Number of purchase orders can be a good cost driver for cost of purchasing department,
- Number of invoices sent can be a good cost driver for cost of billing department,
- Number of units shipped can be a good cost driver for cost of distribution department, etc.
While direct costs are easily traced to cost objects, indirect costs are allocated using some systematic approach.
Cost allocation base
Cost allocation base is the variable that is used for allocating/assigning costs in different cost pools to different cost objects. A good cost allocation base is something which is an appropriate cost driver for a particular cost pool.